Question

When forecasting financial statements, the percentage of sales method of tying forecast variables to sales may not be appropriate when:

	a.	The asset or liability does indeed vary as a constant percentage of sales
	b.	There are economies of scale tied to certain assets such as inventory, where higher levels of sales may be supported with little change in the level of assets
	c.	Property, plant, and equipment expenditures to support growth will be “lumpy” over the planning period
	d.	All of the above
	e.	Both b. and c.

Answer 1

Forecasting financial statements through % of sales method involves assuming all costs and expenses as % of sales. An example would be to assume the next year sales as 1000USD and Cost of goods sold as 10% of sales, Selling general and administration expenses as 20% of sales, etc. Similarly balance sheet items can also be estimated using % sales method. Example: Cash, Debtors, retained earnings, etc. will directly vary with the level of sales.

Answer) Option e) Both b. and c.

This is because both option b) and c) are inappropriate for % of sales method. % of sales method does not work when the level of assets are not correlated with the level of sales. Due to economies of scale, the business is unable to make correct assumptions at higher level of sales. Also, option c) is inappropriate because step costing may apply due to lumpy expenditures where the expenses will change in a different proportion as the sales level changes.

Option a) is incorrect since assets and liabilities vary with the sales level. This means they are highly correlated with sales and is an idle situation for % of sales method.

Option d) is incorrect because option a) is appropriate condition for % of sales method.