Say you want to quickly estimate the amount of cash your business will have on hand at the end of next year. You have a picture of how your sales figures are expected to grow and your balance sheet nearby. How would you go about doing that?
Well, one of the more popular, efficient ways to approach the situation would be to employ something known as the percent of sales method.
Let's take a closer look at what the method is, how to use it, and some of its benefits and shortcomings.
The percent of sales method is a financial forecasting model in which all of a business's accounts — financial line items like costs of goods sold, inventory, and cash — are calculated as a percentage of sales. Those percentages are then applied to future sales estimates to project each line item's future value.
The percent of sales method is one of the quickest ways to develop a financial forecast for your business — specifically for items closely correlated with sales. That's its major advantage. If your business needs a very rough picture of its financial future immediately, the percent of sales method is probably one of your better bets.
Even then, you have to bear in mind that the method only applies to line items that correlate with sales. Any fixed expenses — like fixed assets and debt — can't be projected with the percent of sales method.
The method also doesn't account for step costing — when the cost of a product changes after a customer buys a quantity of that product over a discrete volume point. For instance, if a customer buys a product from a business that has a step cost at 5,000 units, then every unit beyond those first 5,000 comes at a discounted price.
Still, despite its shortcomings, it's a useful method worth understanding and being able to apply.
Steps of the Percent of Sales Method
- Determine your estimated growth and most recent annual sales figures.
- Determine if a correlation between sales and specific line items you want to forecast exists.
- Determine the line item balances and their percentages relative to sales.
- Calculate forecasted sales.
- Apply line items' relative percentages to your forecasted sales figure.
For the sake of example, let's imagine a hypothetical businessperson, Barbara Bunsen. She operates a specialty cake, army bed, cinnamon roll shop called "Bunsen's Bundt, Bunk Bed, Bun Bunker" or "B6" for short. We'll use her business as a reference point for applying the percent of sales method.
1. Determine your estimated growth and most recent annual sales figures.
When Barbara started her shop, her friends and family told her to pump the brakes a little. They said, "Barbara, maybe reign it in a bit? People don't want to buy bundt cakes at a shop that also sells military surplus bunk beds." Little did they know that the pastry-loving veteran niche is incredibly lucrative. And she was able to do $50,000 in sales her first year and anticipates sales will increase 40% in the coming year.
She decides she wants to put together a rough financial forecast for the future, so she opts to leverage the percent of sales method. Now that she has the relevant initial figures, she can move on to the next step.
2. Determine if a correlation between sales and specific line items you want to forecast exists.
Before she can put her forecast together, Barbara has to see which financial line items are correlated with her sales figures. These are the accounts the percent of sales method applies to. Those accounts often include:
- Inventory
- Accounts receivable
- Accounts payable
- Cash
- Costs of goods sold
- Net income.
Once she has the specific accounts she wants to keep tabs on, she has to find how they stack up to her overall sales figures.
3. Determine the line item balances and their percentages relative to sales.
Let's say Barbara's accounts have these balances:
- Inventory — $20,000
- Accounts receivable — $10,000
- Accounts payable — $7,000
- Cash — $15,000
- Costs of goods sold — $15,000
- Net income — $35,000
When divided by Barbara's $50,000 in revenue, those figures amount to these percentages:
- Inventory — 40%
- Accounts receivable — 20%
- Accounts payable — 14%
- Cash — 30%
- Costs of goods sold — 30%
- Net Income — 70%
Next, Barbara needs to calculate her estimated sales for the upcoming year.
4. Calculate forecasted sales.
As previously mentioned, she expects to see a 40% increase. To determine her forecasted sales, she would use the following equation.
Barbara Bunsen's Bundt, Bunk Bed, Bun Bunker is expected to see a 40% increase in sales next year. So calculating her forecasted sales would look like this:
50,000 (1+40/100) = 50,000 (1.4) = $70,000
From there, she would determine the forecasted value of the previously referenced accounts.
5. Apply line items' relative percentages to your forecasted sales figure.
Barbara's figures would look like this:
- Forecasted inventory — $28,000
- Forecasted accounts receivable — $14,000
- Forecasted accounts payable — $9,800
- Forecasted cash — $21,000
- Forecasted costs of goods sold — $21,000
- Forecasted net income — $49,000
Ultimately, the percent of sales method is a convenient but flawed process of financial forecasting. It's useful in that it can provide a solid picture of what certain balance sheet items will look like going forward, and should only be applied to specific line items that you can prove have a correlation with your sales figures.
By no means is meant to be hailed as a definitive document of every aspect of your company's financial future. If you want a clearer, more accurate picture of where your company is headed financially, you're better off carefully detailed, line-by-line forecast that considers other aspects beyond your sales level.