Percentage of Sales Method: Definition, Steps and Examples
Updated March 16, 2023
Making accurate financial predictions can help businesses survive and generate profits. Economic forecasting tools like the percentage of sales method allow companies to estimate future cash flow and expenses. Using this method can also help you create more accurate budgets and make more accurate financial decisions.
In this article, we discuss the percentage of sales method, describe how to use it, provide examples and explain its advantages and disadvantages.
What is the percentage of sales method?
The percentage of sales method is a forecasting model that makes financial predictions based on sales. Financial statement items like the cost of goods sold and accounts receivable appear as a percentage of sales. Companies then use this data to assess their financial future.
The percentage of sales method links sales data to company balance sheets and income accounts. It's one of the most efficient methods a business can use to create a detailed financial outlook statement. While a business can't get precise numbers this way, it's still an effective way to learn about an organization's short-term financial future.
How to use the percentage of sales method
Follow these steps to use the percentage of sales method and create a financial forecast based on company data:
1. Find your numbers
Before you can make predictions about your company's financial health, gather data about the sales and business expenses the company produces. You can use other accounting documents, such as financial statements and sales numbers, to provide your desired information. Organizing your numbers and data before beginning your calculations can increase accuracy and make the process more efficient.
2. Determine what you want to forecast
When creating a financial forecast with the percentage of sales method, make a plan and decide which specific accounts to include in the final forecast. Sales can directly influence certain accounts on a financial statement. Affected factors include:
Costs of goods sold
3. Calculate the percentage of sales to expenses
Look at each line item's balance on your company's financial statement and calculate its percentage relative to overall sales. You can do this by following these steps:
Determine your expenses and total sales for the period.
Divide your expenses by your total sales.
Multiply your result by 100.
Here's the formula:
Percentage of sales = (Expenses / Sales) x 100
Here's what this looks like using sample numbers:
Expenses: Costs of goods sold is $5,000 per year; Sales: $20,000 per year
5,000 / 20,000 = 0.25
0.25 x 100 = 25
In this example, this means that 25% of the sales revenue goes to the costs of goods sold account. You can now use this number as a budgeting and forecasting tool. For instance, if the percentage appears much higher next year, you can investigate the reasons production costs have increased faster than your revenue. This data can inform your budgetary decisions and provide short-term financial projections.
Related: How To Calculate Percent
Examples of the percentage of sales method
Here are a few more practical examples of the percentage of sales method:
Example 1: Billy's Brownies
Billy's Brownies is a famous online bakery that sells directly to customers. The cost of flour and eggs is increasing, and the management team wants to know if they need to raise the price of their brownies. To figure this out, the team decides to use the percentage of sales method.
First, they prepare in-depth financial statements. Each line item corresponds to a percentage calculated using the percentage of sales to expenses formula. For instance:
• Total cost of goods sold for the year: $30,000
• Total sales: $100,000
• Cost of goods sold sales percentage: (30,000 / 100,000) x 100 = 30%
If the percentage was 25% last year, management would want to know why baking brownies have become more expensive. It could be because of the increase in flour and egg prices, but it could also relate to a change in the supply chain. The delivery trucks may travel farther to reach the new industrial kitchen.
Ultimately, businesses want revenue to increase proportionately to costs. If this isn't occurring, the management team can determine which costs are increasing and decide what cost-reducing measures are appropriate.
Example 2: Sandra's Loan Company
Businesses can use the percentage of sales method to anticipate future bad debts, which are unpaid receivables owed by customers.
Sandra's Loan Company notices that in years past, 10% of its sales have funded bad debts. As sales increase, so does the amount of irretrievable debt listed in its ledger. If Sandra's management team believes the company aims to report $1 million in sales next year, using the percentage of sales method, it would account for a planned 10%, or $100,000, in bad debt-related expenses.
Example 3: Pizza Planet
Pizza Planet's financial statement shows a monthly sales revenue of $2,000. A school plans to open near the restaurant soon, and the owners predict business might grow by 50% next month, pushing sales to $3,000.
If the business has a $200 balance in its available cash account, using the percentage of sales to expenses formula, Pizza Planet's owners can determine that that number represents 10% of current sales. Here's the formula:
(200 / 2,000) x 100 = 10
To predict how much cash might be available next month after the school opens, Pizza Planet can use the same formula, plugging in $3,000 for the sales data and variable X for the available cash amount. It looks like this:
(X / 3,000) x 100 = 10
Now, the team can solve for X to predict how much cash is available next month. In this case, it's $300.
Advantages of the percentage of sales method
The advantages of using the percentage of sales method include:
Easy-to-define goals: A sales-based model provides measurable company goals related to its core purpose: to make money.
Clear budget: One reason why financial teams use financial forecasting methods is to ensure their budgets are accurate and prepare for future expenses as much as possible.
Focus on profitability: Companies following a percentage of sales business model are apt to focus their investments on directly profitable projects and avoid costs that aren't related to sales.
Disadvantages of the percentage of sales method
The percentage of sales forecasting method provides a rough estimate, not an exact outline, of a company's financial future. Potential disadvantages of this method include:
Missed variables: Companies that rely on the percentage of sales model may ignore business variables with no immediate effect on sales. For example, a customer service team's size influences revenue, yet increasing or decreasing the number of agents may not instantly affect sales.
Relies on past behavior: This forecasting model uses past sales behavior to predict future trends, which can cause inaccuracies, as there's no guarantee that sales behavior stays the same.
Short-term focus: The percentage of sales method focuses on short-term sales and can present a challenge when there's a potential long-term consequence. For example, you can reduce your costs of goods and raise your profit at once by choosing a cheaper supplier, but if the new supplier is unreliable or provides lower quality products, it can damage the business' reputation.
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