Percentage-of-sales method

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:

  1. Determine whether there is a historical correlation between sales and the item to be forecasted.

  2. Estimate sales for the forecast period.

  3. Apply the applicable percentage of sales to the item to arrive at the forecasted amount.

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.

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.

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.

Related Courses

Capital Budgeting