Finance Percentage Of Sales Method

The percentage of sales method, also known as the sales ratio method, is a simple and widely used technique in finance and accounting for forecasting various expense items or balance sheet accounts as a percentage of a company’s sales revenue. It assumes a direct relationship between sales and the account being forecasted; that is, as sales increase, the account in question will increase proportionally.

How it Works:

1. Identify the Account: Determine the specific expense item or balance sheet account you want to forecast. Examples include cost of goods sold (COGS), selling, general, and administrative (SG&A) expenses, accounts receivable, and inventory.
2. Calculate the Historical Percentage: Calculate the historical relationship between the account and sales. This is done by dividing the account’s value by the total sales revenue for a period of time (typically several past periods, such as the last 3-5 years). For example, if COGS was $600,000 and sales revenue was $2,000,000, the COGS percentage of sales is 30% ($600,000 / $2,000,000).
3. Apply the Percentage to Future Sales: Use the historical percentage to forecast the future value of the account. Multiply the projected sales revenue for the upcoming period by the historical percentage. For example, if projected sales are $2,500,000 and the COGS percentage of sales is 30%, the forecasted COGS would be $750,000 ($2,500,000 * 30%).

Advantages:

• Simplicity: It is easy to understand and implement, making it accessible to small businesses and those without extensive financial expertise.
• Speed: It provides a quick and efficient way to generate forecasts, especially when numerous accounts need to be projected.
• Basis for Further Analysis: It serves as a starting point and can be refined with more sophisticated techniques.

Disadvantages:

• Oversimplification: The primary weakness is the assumption of a constant, linear relationship between sales and the forecasted account. This may not always be the case, especially when considering factors like economies of scale, changes in efficiency, or external economic conditions.
• Ignores Other Factors: It neglects other crucial factors that can influence account balances, such as changes in prices, competition, or management policies.
• Potential for Inaccuracy: It can lead to inaccurate forecasts if the historical relationship is not stable or if significant changes are anticipated.
• Static Assumption: It relies on past performance and does not account for future improvements or inefficiencies.

When to Use:

The percentage of sales method is most suitable for:

• Accounts that have a strong, direct, and stable relationship with sales.
• Short-term forecasting when accuracy is less critical.
• Initial estimations before conducting more detailed analysis.
• Businesses with limited resources for sophisticated forecasting methods.

To improve accuracy, consider using multiple years of historical data, identifying and adjusting for any outliers or anomalies, and supplementing the method with qualitative factors and industry insights. While simple, it is crucial to acknowledge the limitations and supplement it with other more refined forecasting techniques for more reliable financial planning.