What is the 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:

Determine whether there is a historical correlation between sales and the item to be forecasted.
Estimate sales for the forecast period. This means extrapolating historical sales forward through the forecast period, and then adjusting this forecast based on inputs from the sales force and others with a knowledge of the market.
Apply the applicable percentage of sales to the item to arrive at the forecasted amount.

Percentage-of-Sales Method Best Practices

For the percentage-of-sales 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.

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Advantages of the Percentage-of-Sales Method

There are several advantages to using the percentage-of-sales method, which are as follows:

Simplicity. The method is straightforward and requires minimal data. Also, by basing calculations on historical sales data, it avoids complex forecasting models and reduces computation time.
Rapid estimations. It provides a rapid way to estimate financial requirements such as expenses, profits, or funding needs. It is especially useful for businesses with stable sales patterns where relationships between sales and expenses are predictable.
Scalability. It adapts easily to changes in business size. If sales projections increase or decrease, the related financial elements are adjusted proportionally.
Useful budgeting tool. It is particularly helpful for setting budgets for departments or projects tied to revenue streams.

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.

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