Question

Describe the percentage of sales model and its potential pitfalls in the financial planning process .

Answer 1

The percentage of sales model is used in estimating the income statement and balance of the business in future.

In the percentage of sales method, other components of the Income statement like Cost of goods, the selling and admin expenses, etc are increased or decreased in the same proportion of Sales. For example if the sales in the next year is expected to increase by 5% from the current year sales, the cost of goods sold and the admin and Miscellaneous expenses are also increased by 5% (same proportion).

In the balance sheet, the current assets like cash, accounts receivable and inventory as well as the fixed assets are also increased by the same percentage as the sales. On the liabilities side, the current liabilities like accrued interest and accounts payable are also increased in the same proportion.

Pitfalls:

1. it’s a very simple and straightforward method of estimation without considering any abrupt increase/decrease in other costs.

2. It does not take into consideration, the state of the economy, if there is a recession or a boom, the costs may not decrease in proportion to sales or vice versa

3. It assumes interest expense and depreciation to be constant. However, the changes to the macro-economy may result in the change in interest expense and tax rate.

4. Sometimes fixed assets may not be utilized to the full extent and we may not need to increase the fixed assets by the proportional increase in sale as assets are not fully utilized.