Question

Using the simple percent-of-sales method to prepare a pro forma income statement assumes all expenses remain fixed percentages of the sales revenue.

Discuss the pros and cons of this approach. For example, you may discuss the validity of assuming fixed expenses or interest expense as a fixed percentage of sales.

Answer 1

Pros of using Percent-of-sales method:

• Less time consuming
• Simple and easy to create
• Less assumptions as % of sales are usually constant throughout the period
• Highly useful for stagnant companies where cost doesn't varies much
• Employee cost can be used as % of sales for manufacturing industry (as for service industry, increase in employee cost is not proportional to increase in sales)
• Cost of materials where the raw material cost variation is not high can be predicted accurately using % of sales method
• Marketing and admin expenses can be largely predicted using % of sales as these expenses are directly related to sales

Cons of using percent-of-sales method:

• Not useful for new and growing companies as cost varies with time
• % of sales doesn't take in account the increase in efficiency or increase operational efficiency
• Interest expenses can't be used as % of sales method as this expense will get reduce with payment of the principal amount or change in the interest rate
• Depreciation are based on Fixed assets and hence, using it to calculate as % of sales will not be a true value
• Companies having operation in different countries cannot be rely on % of sales method as they will have to consider the changes in foreign exchange rate for projections
• Tax projections are more accurate when based on Profit before tax rather than sales
• Other income projection should be based on investments and other parameters rather than sales as these income are not operational and are not related to sales