Financial management principles and practices

Percentage of Sales Method of Forecasting

In order to effectively anticipate market conditions, predict future sales, and make crucial adjustments to marketing and production strategies, the process of financial forecasting is used by management to ensure a firm enjoys sustainable growth. Financial forecasting methodologies typically begin with the generation of a detailed sales forecast, and while forecasting early-stage ventures is intrinsically more unpredictable than forecasting established firms, it is critical that the correct approach to building an accurate sales forecast is consistently employed. It has been widely established that because "sales forecasts drive the preparation of projected financial statements, the ability to project sales is accurately is crucial to a venture's financial health" (Leach & Melicher, 2011), which is why differentiating between the two primary sales forecasting methods is an important skill to develop. The percentage-of-sales forecasting method works under the assumption that the typical firm's balance sheets and income statement accounts experience fluctuations as sales increase or decrease, while expressing most expenses and balance sheet items as a percentage of total sales. This method of sales forecasting necessarily results in a variant known as the constant-ratio forecasting method, which makes projections based on a constant ratio of expected sales. While the percentage-of-sales method is widely used, both by established firms in major industries and developing ventures, realizing the full potential of the practice requires financial analysts remain capable of recognizing its clear limitations.

One of the primary disadvantages associated with the use of percentage-of-sales forecasting to formulate accurate financial statements is the use of rough approximations rather than precise assessments. The vast majority of research regarding the relative efficacy of percentage-of-sales forecasting has indicated that while this "method of forecasting future financing is not as precise or detailed as the method using a cash budget & #8230; it offers a relatively low-cost and easy-to-use first approximation of the firm's financing needs for a future period" (Keown, 2004). This lack of detail results from the fact that the percentage-of-sales forecasting method is premised on transforming historical data into informed assumptions about future market conditions, and while these assumptions are based on carefully calculated predictive models, multiple external variables routinely result in dramatic and unexpected shifts. Another fundamental weakness is that while the "percent of sales method presumes that the asset or liability being forecast is a constant percent of sales for all future level of sales & #8230; there are instances when this assumption is not reasonable and, consequently, the percent of sales method does not provide reasonable predictions" (Keown, 2004). For example, when economies of scale are involved in the asset being forecast, any increase or decrease in inventories will not be proportionally linked to sales. Another instance of percentage-of-sales forecasting failing to produce accurate predictions comes when a firm's asset purchases are random or extreme, because sporadic multimillion dollar purchases will not remain a constant percentage of sales. Although there are decided advantages and drawbacks to consider, it remains the prerogative of management to balance the cost-benefit impact of utilizing only percentage-of-sales forecasting to guide future financing decisions, or to moderate this inherently risky approach with sales force composites, trend analysis, or executive opinion.