March 06, 2022 March 06, 2022/ Steven Bragg
The percentage-of-sales method is used to develop a budgeted set of financial statements. Each historical expense is converted into a percentage of net sales, and these percentages are then applied to the forecasted sales level in the budget period. For example, if the historical cost of goods sold as a percentage of sales has been 42%, then the same percentage is applied to the forecasted sales level. The approach can also be used to forecast some balance sheet items, such as accounts receivable, accounts payable, and inventory.
The basic steps to follow for this method are:
Determine whether there is a historical correlation between sales and the item to be forecasted.
Estimate sales for the forecast period.
Apply the applicable percentage of sales to the item to arrive at the forecasted amount.
For this method to yield accurate forecasts, it is best to apply it only to selected expenses and balance sheet items that have a proven record of closely correlating with sales. Outside of these items, it is better to develop a detailed, line-by-line forecast that incorporates other factors than just the sales level. This more selective approach tends to yield budgets that more closely predict actual results.
Advantages of the Percentage-of-Sales Method
The advantages of the percentage-of-sales method are as follows:
It is the quickest way to develop a forecast.
It can yield high-quality forecasts for those items that closely correlate with sales.
Disadvantages of the Percentage-of-Sales Method
However, these advantages are more than offset by several major disadvantages, which are:
Many expenses are fixed or have a fixed component, and so do not correlate with sales. For example, rent expense does not vary with sales. Many balance sheet items also do not correlate with sales, such as fixed assets and debt.
Step costing may apply, where a cost is variable but will change to a different percentage of sales when the sales level changes to a different volume level. For example, purchase discounts may apply to purchases once the unit count passes 10,000 per year.
March 06, 2022/ Steven Bragg/
Forecasting future finances is important to running a business. Will you make enough next year to cover costs? Will you be able to expand? Will you have to lay off staff? The percentage-of-sales method is a quick and simple way to make financial forecasts, but it's not as accurate as a slower, more detailed approach.
You can use the percentage-of-sale method to predict budget items that change in relation to sales revenue. If accounts receivable historically runs to 25 percent of revenue, doubling revenue will probably double accounts receivable.
The percent-of-sales method of financial forecasting is a simple concept, explains Accounting Tools. Suppose your spending on raw materials per quarter is around one-third of your net sales revenue. For the past year, net sales – sales revenue less discounts and returns – has been $12 million for the year or $3 million per quarter. Your raw materials spending has been $1 million per quarter. If you anticipate sales going up to $4.5 million per quarter next year, you can project spending $1.5 million a quarter on raw materials.
You can apply the percentage-of-sales method to any account that historically correlates with sales revenue. Typically, this includes the cost of goods sold, accounts payable, accounts receivable and inventory. Your bad debt allowance is usually some percentage of accounts receivable, so that's also correlated, according to Online Accounting.
This doesn't work for everything in your ledgers, though. Fixed payments, such as rent and internet, don't change, regardless of how much or how little you sell. Neither do balance sheet entries such as fixed assets or debt. You also have to watch out for step-costing items. For example, if your supplier gives you a raw materials discount above a certain quantity, that will throw the correlation off when you hit the trigger level.
If you're using the percent-of-sales method of financial forecasting, your sales projections have to be accurate. First, take a look at historical trends: Have sales been steadily increasing over time, staying level or shrinking? Then consider the effect of any planned changes, such as cutting prices or opening new distribution channels. If your sales projections are off, the percentage of sales method won't produce reliable predictions.
If you're looking at your future finances, examining pieces in isolation isn't sufficient. The usual forecasting approach is to draw up financial statements for the next quarter, next year and so on, SCORE notes. A projected income statement calculates how much money will flow in and out of your company over the coming year. The cash flow statement projects the amount of cash on hand. The future balance sheet can show whether your liabilities are rising too high compared to assets.
A forecasted financial statement approach using the percentage of sales offers a quick result but not necessarily a reliable one. That's because of the items on the statements that aren't affected by sales revenue. For a more accurate financial forecast, you have to take the financial statements and go through them line by line. If an item correlates to the percentage of sales, use that method. If it doesn't, look for some other method to project that future expense.
The percent-of-sales method of financial forecastingis more detailed than a cash budget approach.requires more time than a cash budget approach.assumes that balance sheet accounts maintain a constant relationship to sales.provides a month-to-month breakdown of data. 12.The percent-of-sales method of financial forecastingA. is more detailed than a cash budget approach.B. requires more time than a cash budget approach.C. assumes that balance sheet accounts maintain a constant relationship to sales.D. provides a month-to-month breakdown of data.
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