The underlying premise of this method is that most of the items on the income statement and on the balance sheet will vary with sales. In addition to direct variable costs, such as cost of goods sold, indirect costs will also vary roughly in line with sales. These costs include fixed costs such as selling, general and administrative expense, and even fixed assets. As the company grows, the line items will grow in roughly equal proportion.
For example, if in 2008 a firm's cost of good sold is 40% of its revenues, then it would be assumed that the same would hold true in 2009. The revenues themselves would be the one component of the equation that is left to management to determine. They would need to estimate the cost of sales without a set formula, but after that the remainder of the income statement and balance sheet would fall into place based on the established percentages.
It is understood that the percentage of sales method is imperfect. However, it is also understood that all methods of forecasting are imperfect and that this method is the most accurate relative to the amount of effort it requires. Other methods may ultimately be more accurate, but they also require more effort on the part of the management. Percentage of sales, therefore, is the quick and dirty method of deriving future financial statements.
The underlying theory of this method is that the organization scales up its cost structure and balance sheet-based with revenues. In practice, this is only true for the most stable of organizations. Companies in mature industries, not engaged in any merger & acquisition activity, are the most likely to get sound results from this method. There are a number of companies for whom this is reasonable, especially small companies that have stabilized in terms of their size and cost structure. For most public companies, however, there are too many externalities for the percentage of sales method to hold much relevance. It is difficult for firms operating with a number of different products in a number of different environments to effectively utilize this technique -- the structure of their organization is simply in too much flux. Therefore, the percentage of sales method is somewhat limited, in particular for complex organizations and those that may be subject to variability as a result of either the nature of their operations or externalities.
Although the percentage of sales model is by far and away the most popular model for financial planning in corporations, there are other models in use as well. Another important model is the budgeted expense model. This model is especially popular with in public budgeting, but is also useful for corporations whose constituent companies are subject to fluctuating operating conditions, such that the percentage of sales method would be inaccurate. The budgeted expense model expects that the future budgets are based on the compilation of contemporary budgets of constituent agencies or departments. In a top-down scenario, the parent would dictate the budget amount to the agency or department, that would then be compelled to meet that budget. In a bottom-up model, the agencies or departments would set their own budgets based on previous years' spending. The parent would then make its own budget for the next year based on the aggregated agency/department forecasts.
This method is based on the underlying philosophy that the most accurate way to reflect future spending and revenue amounts is by aggregating the constituent budgets of the organization's various components. For many organizations, this is a reasonable approach because future spending levels primarily reflect future spending levels. For many corporations, however, this method is weak. Expense levels are not taken in most corporations as a given -- they fluctuate not only with revenues but also with the organization's cost-control measures. Therefore, this method is most popular in public budgeting rather than with public corporations. It can be effective at the broadest corporate -- conglomerate -- level however. A conglomerate can set its budget on the basis of the budgets turned in by its constituent corporations, but beyond that the constituent corporations must still find their own system of budgeting that will lead to the overall budgeted expense budget.
A third model for financial planning is via a trend analysis model. In this model, the projections of future revenues, expenses and other line items are derived from trends in those items that have developed over the past several years. For example, assume a company has the following income statements. In this situation, a trend analysis...
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