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The Percentage of Sales Method: Formula & Example

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  • 0:05 Percentage of Sales Method
  • 1:27 Percentage of Sales…
  • 3:16 Determining the Sales Forecast
  • 3:54 Retained Earning Changes
  • 6:08 Forecasted Financial…
  • 7:49 Lesson Summary
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Lesson Transcript
Instructor: Deborah Schell

Deborah teaches college Accounting and has a master's degree in Educational Technology.

Businesses need to forecast their sales growth on an annual basis and determine their borrowing needs. In this lesson, you will learn about the percentage of sales approach to financial forecasting.

Percentage of Sales Method

Meet Mr. Weaver, owner of the Cushy Carpet Company. He would like to complete his financial forecast for next year and is wondering if he could use the percentage of sales method. He has determined that his sales will increase by 30% next year. Let's see if we can help Mr. Weaver with his forecast.

The percentage of sales method is a financial forecasting method that businesses use to predict their sales growth on an annual basis. They use this information to predict the amount of financing they need to acquire to help accomplish their goal. The key component of this approach is the growth in company sales. Once the sales growth has been determined, the company can prepare pro-forma, or forecasted financial statements.

The two main financial statements used in this approach are the balance sheet and the income statement. The balance sheet shows the company's assets, liabilities, and owners' or shareholders' equity (the amount the owners have invested in the business). In order to balance, we assume that assets = liabilities + owners' or shareholders' equity. The income statement shows the revenue that the business has earned by selling its goods and services, along with the costs it incurred to make those sales. We can use this to find out net income, which is the difference between revenue and costs. Now let's explore how we calculate percentage of sales.

Percentage of Sales Calculations

The first step of the process is to determine the amount by which sales are expected to increase. In Mr. Weaver's case, we determined that this is 30%. The next step is to identify which accounts are closely related to sales. For example, when a sale is made, a customer could choose to pay with cash or credit. Therefore, both the cash and accounts receivable accounts would vary with the amount of sales. The accounts that vary with sales include:

  • Cash
  • Accounts receivable, or the amounts owed by customers
  • Inventory
  • Fixed assets, which includes large equipment and machinery
  • Accounts payable, which is the amounts owed to suppliers
  • Cost of goods sold
  • Net income

Once the accounts have been determined, you make a calculation to determine what percentage of sales the balances represent. Let's assume that Mr. Weaver's accounts have the following balances:

  • $500 in cash
  • $600 in accounts receivable
  • $850 in inventory
  • $1,200 in fixed assets
  • $900 in accounts payable
  • $2,000 in sales
  • $700 in cost of goods sold
  • $1,300 in net income

Mr. Weaver must calculate the balances in relation to sales by dividing each balance by sales, which is $2000. That gives him:

  • 25% for cash
  • 30% for accounts receivable
  • 42.5% for inventory
  • 60% for fixed assets
  • 45% for accounts payable
  • 35% for cost of goods sold
  • 65% for net income

Keep in mind that the financial statements contain other accounts that do not vary with sales, such as notes payable, long-term debt, and common shares. The changes in these accounts are determined by which method the company chooses to finance its growth, debt, or equity.

Determining the Sales Forecast

Now, since many accounts will change based on sales, Mr. Weaver must calculate what his sales are forecast to be in the next year. The formula for calculating forecasted sales growth is:

Forecasted Sales = Current Sales x (1 + Growth Rate/100)

If Mr. Weaver assumes that sales will increase by 30% next year, then when we plug this into our formula: Current Sales x (1 + Growth Rate/100), then we get 2,000 x (1+ 30/100), which gives him the forecasted sales of $2,600.

Retained Earning Changes

Now let's take a look at how to calculate changes in retained earnings. Retained earnings represent the amount of earnings that have been retained in the business since the company started operating. In other words, they represent the earnings after dividends have been deducted. The process for determining the addition to retained earnings as a result of the increased sales is calculated by using the forecasted net income and the percentage of earnings that are kept in the business.

Let's assume that the Cushy Carpet Company has for the current year:

  • $2,000 in sales
  • $700 in cost of goods sold
  • $1,300 in net income
  • $300 in dividends
  • $1,000 in retained earnings

Mr. Weaver can calculate the percentage of net income that dividends and retained earnings comprise by dividing each by the net income. So the percentage of net income that dividends comprise is: Dividends / Net income. When we plug in our values, we get $300 / $1,300, which equals 23.1%. The percentage of net income that retained earnings comprise is Retained Earnings / Net Income. We plug in our numbers to get $1,000 / $1,300, which equals 76.9%.

Now that Mr. Weaver knows that 76.9% of his earnings are retained in the business, he can calculate the addition to retained earnings that he will realize from an increase in sales. The formula for addition to retained earnings is:

Addition to Retained Earnings = Net Income Forecast x Percentage of Net Income That Is Retained Earnings

Net income forecast represents the amount of net income Mr. Weaver expects to generate at his higher sales volume. If his forecast sales are $2,600, then his projected net income will also be 30% higher and so, Original Net Income + 30% = $1,300 x (1.30), which equals $1,690. Using the formula, Mr. Weaver would expect to generate an additional $1,300 ($1,690 x 76.9%) in retained earnings if his sales increase by 30% next year.

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