June 17, 2021

Percentage Of Sales Method: How To Apply It?

The percentage of sales method is a technique used to determine the effectiveness of an advertising campaign. You can use this method in various scenarios but its application will always be simple and straightforward. This article will discuss how you can apply the percentage of sales method in real life situations.

Let's say you need a quick estimate of how much cash your company will have at the end of the year. You have a visual representation of how your sales are predicted to increase, as well as a copy of your balance sheet. What would you do if you had to do that?

One of the more popular and effective methods to handle the situation is to use a technique known as the % of sales method. Let's look at what the approach is, and how to apply it. 

What is the Percent of Sales Method?

The percent of sales method, which is also known as the direct proportion method, uses information on past sales to forecast future sales. It's one of several forecasting techniques. When using the percent of sales method, you multiply your current year's or period's total revenue by a percentage to get your projected revenue figure for next year or next period. 

For example, if you expect 10% growth in revenues next year and this year's total revenue was $100,000 then you would expect next year's total revenues to be $110,000 (10% growth x $100k). The advantage of this approach is that it doesn't rely on anyone's income statement account or line item. 

You can apply the percentage to any line item. Another benefit is that it's relatively easy to calculate since the steps are straightforward and don't require much analysis.

What do I need to use for this method?

You will need: 

- Estimated growth from last year for each fiscal period in question.

- Most recent annual sales figures.

- Line item balances and their percentages relative to the most recent annual income statement.

- Amounts owed by customers at the balance sheet date [assuming it is not too far out].

[NOTE: In addition, if you have to estimate accounts receivable or accounts payable numbers, then your estimates should be based on what the company's requirements are going to be on average over previous years]. 

- A systematic approach to updating your balance sheet.

- A systematic approach to matching up each line item in your income statement with its related balance sheet account.

What are the steps of the method? 

Step 1 - Determine estimated growth from last year for each fiscal period in question. This is usually done by taking an average of several years' annual growth. The total of this should equal 100%. 

Dividing 100% by the number of years you took an average for will yield a percentage that is representative of that particular period's expected growth rate. If you have trouble coming up with these estimates, then it may be simpler just to use your company's long-term target rates instead. 

Because there are constantly changing dynamics in accounting standards, the following steps only provide a general framework for your use.

Step 2 - Determine if a correlation between sales and specific line items you want to forecast exists. You must identify the line items most correlated with changes in overall revenue. In other words, what influences or drives most of these changes? 

The following are most commonly used:

- Accounts receivable balances 

- Inventory balances 

- Service Revenue (if your company provides services) 

- Loan Proceeds from Customers (if applicable) 

- Cash receipts from customers 

Also, look at each item's cost relative to its respective contribution to total revenue. This will help you determine which costs have the most influence on changes in income.

Step 3 - Determine the balance sheet accounts that are affected by these line items. They should be similar to the following: 

- Accounts Receivable = Number of Invoices Issued * Average Days Before Payment Is Received \* \* FUTURE VOLUME OF SALES * 100 / 365 

[NOTE: this should only be an estimate] 

- Inventory = Number of Units Receive or Produced * Average Days Between Manufacture and Time of Sale \* \* FUTURE VOLUME OF SALES * 100 / 365 

[NOTE: this should only be an estimate] 

- Service Revenue (if applicable) = Total Sales for The Period * Contracted Percentage of Sales \* \* FUTURE VOLUME OF SALES * 100 / 365 

[NOTE: this should only be an estimate] 

- Loan Proceeds from Customers (if applicable) = Gross Profit Before Interest Expense for The Period * Average Days Between Timing of Sale and Payment Received 

FUTURE VOLUME OF SALES * 100 / 365 

[NOTE: this should only be an estimate] 

- Cash Receipts from Customers = Number of Invoices Issued * Average Days Before Payment is Received \* \* FUTURE VOLUME OF SALES * 100 / 365

[NOTE: this should only be an estimate]

Step 4 - Determine the percentage of each line item's contribution to total revenue. This is done by dividing the line items' contributions to revenue for that specific fiscal period by overall revenue. The following are most common: 

- Accounts receivable = Annual Sales * Average Days Before Payment Is Received \*(1- days) / 365 

- Inventory balances = Annual Sales * Average Days Between Manufacture and Time of Sale \*(1- days) / 365 

- Service Revenue (if applicable) = Annual Sales * Contracted Percentage of Sales \*(1- days) / 365 [NOTE: this should only be an estimate] 

- Loan Proceeds from Customers (if applicable) = Gross Profit Before Interest Expense for The Period * Average Days Between Timing of Sale and Payment Received \*(1- days) / 365 

- Cash Receipts from Customers = Annual Sales * Number of Invoices Issued \*(1- days) / 365

Step 5 - Multiply each line item's relative contribution to overall revenue by the forecasted growth rate (or target growth rate if no accurate historical data can be found). This gives you a compounded annualized rate. 

Add these values together and divide by 100 to determine what your estimated future revenues will be: Revenues = (Line Item Contribution ^ # of Years X Compound Annual Growth Rate) / 100

Final Words

You must know that this formula only provides a rough estimate, as there are a few potential issues. One issue is that the formula only averages the line items' contributions over a certain number of years even if it is less than the actual number of years you have been in business. In other words, if your company has been in existence for 5 years and you decide to use this method, then you will average each year's contribution over those 5 years.

This may not be fair because many businesses grow at different rates for their first few years before achieving significant growth rates. Also, consider using 3 or 4-year figures instead of 1 or 2-year figures (i.e., multiply by 4).


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Spencer Farber

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