Percent-of-Sales Method

Definition

The percent-of-sales method is a forecasting technique used to estimate future financial statements, particularly the income statement and balance sheet, based on the relationship between certain account balances and the level of sales. It involves using historical percentages to project future values of accounts that tend to vary with changes in sales volume.

5 Must Know Facts For Your Next Test

1. The percent-of-sales method assumes that certain account balances vary proportionally with changes in sales volume.
2. This method is commonly used to forecast current assets, current liabilities, and certain operating expenses on the income statement.
3. The forecasted values are calculated by multiplying the projected sales level by the historical percentage of that account to sales.
4. The percent-of-sales method is useful for creating short-term financial plans and budgets, as it provides a quick and easy way to estimate future financial statements.
5. Limitations of the percent-of-sales method include the assumption of a linear relationship between account balances and sales, and the potential for changes in the underlying business that may not be captured by historical percentages.

Review Questions

• Explain how the percent-of-sales method is used to generate the complete financial forecast.
  • The percent-of-sales method is used to forecast future financial statements, such as the income statement and balance sheet, by applying historical percentages of certain account balances to the projected sales level. For example, if the cost of goods sold has historically been 60% of sales, the forecasted cost of goods sold can be calculated by multiplying the projected sales by 60%. This process is repeated for other accounts that tend to vary with sales, allowing the creation of a complete set of pro forma financial statements to support the overall financial forecast.
• Describe how the percent-of-sales method can be implemented in Excel to create a short-term financial plan.
  • When using Excel to create a short-term financial plan, the percent-of-sales method can be applied by setting up a spreadsheet with the historical percentages for each relevant account balance. The projected sales level is then entered, and the forecasted values for the income statement and balance sheet accounts are calculated by multiplying the sales projection by the corresponding historical percentages. This allows for a quick and efficient way to generate a comprehensive short-term financial plan based on the expected sales performance.
• Evaluate the strengths and limitations of the percent-of-sales method in the context of financial forecasting and planning.
  • The key strength of the percent-of-sales method is its simplicity and ease of use, making it a popular choice for short-term financial forecasting and planning. By relying on historical relationships between account balances and sales, it provides a straightforward way to estimate future financial statements. However, the method also has limitations, as it assumes a linear relationship between accounts and sales, which may not always hold true. Additionally, it does not account for potential changes in the underlying business that could affect the historical percentages. Therefore, the percent-of-sales method is best used as a starting point for financial forecasting, and should be supplemented with other analysis and forecasting techniques to ensure a more comprehensive and accurate financial plan.

Related terms

Sales Forecast:

A projection of future sales levels based on historical data, market trends, and other factors.

Income Statement:

A financial statement that reports a company's revenues, expenses, and net income or loss over a specific period of time.

Balance Sheet:

A financial statement that reports a company's assets, liabilities, and equity at a specific point in time.