The first advantage is that it is easy. The math associated with the percentage of sales method is very simple to execute. The underlying premise of this method is that most of the items on the income statement and on the balance sheet will vary with sales. In addition to direct variable costs, such as cost of goods sold, indirect costs will also vary roughly in line with sales. These costs include fixed costs such as selling, general and administrative expense, and even fixed assets. As the company grows, the line items will grow in roughly equal proportion.
For example, if in 2008 a firm's cost of good sold is 40% of its revenues, then it would be assumed that the same would hold true in 2009. The revenues themselves would be the one component of the equation that is left to management to determine. They would need to estimate the cost of sales without a set formula, but after that the remainder of the income statement and balance sheet would fall into place based on the established percentages.
It is understood that the percentage of sales method is imperfect. However, it is also understood that all methods of forecasting are imperfect and that this method is the most accurate relative to the amount of effort it requires. Other methods may ultimately be more accurate, but they also require more effort on the part of the management. Percentage of sales, therefore, is the quick and dirty method of deriving future financial statements.
The underlying theory of this method is that the organization scales up its cost structure and balance sheet-based with revenues. In practice, this is only true for the most stable of organizations. Companies in mature industries, not engaged in any merger & acquisition activity, are the most likely to get sound results from this method. There are a number of companies for whom this is reasonable, especially small companies that have stabilized in terms of their size and cost structure. For most public companies, however, there are too many externalities for the percentage of sales method to hold much relevance. It is difficult for firms operating with a number of different products in a number of different environments to effectively utilize this technique -- the structure of their organization is simply in too much flux. Therefore, the percentage of sales method is somewhat limited, in particular for complex organizations and those that may be subject to variability as a result of either the nature of their operations or externalities.
Although the percentage of sales model is by far and away the most popular model for financial planning in corporations, there are other models in use as well. Another important model is the budgeted expense model. This model is especially popular with in public budgeting, but is also useful for corporations whose constituent companies are subject to fluctuating operating conditions, such that the percentage of sales method would be inaccurate. The budgeted expense model expects that the future budgets are based on the compilation of contemporary budgets of constituent agencies or departments. In a top-down scenario, the parent would dictate the budget amount to the agency or department, that would then be compelled to meet that budget. In a bottom-up model, the agencies or departments would set their own budgets based on previous years' spending. The parent would then make its own budget for the next year based on the aggregated agency/department forecasts.
This method is based on the underlying philosophy that the most accurate way to reflect future spending and revenue amounts is by aggregating the constituent budgets of the organization's various components. For many organizations, this is a reasonable approach because future spending levels primarily reflect future spending levels. For many corporations, however, this method is weak. Expense levels are not taken in most corporations as a given -- they fluctuate not only with revenues but also with the organization's cost-control measures. Therefore, this method is most popular in public budgeting rather than with public corporations. It can be effective at the broadest corporate -- conglomerate -- level however. A conglomerate can set its budget on the basis of the budgets turned in by its constituent corporations, but beyond that the constituent corporations must still find their own system of budgeting that will lead to the overall budgeted expense budget.
A third model for financial planning is via a trend analysis model. In this model, the projections of future revenues, expenses and other line items are derived from trends in those items that have developed over the past several years. For example, assume a company has the following income statements. In this situation, a trend analysis would reveal that the revenue has increased 26.5% on average each year. The COGS has increased 15.4% each year on average. It is assumed that these trends will continue through 2009, such that the 2009 income statement is as follows.
This methodology is based on the underlying theory that past trends are roughly analogous to future ones with the company. This contrasts to the percentage of sales method, which essentially extrapolates the performance of just one previous year to derive estimates of future years' performance. Trend analysis emphasizes using data from multiple years into order to determine the trends. Because the data is derived from multiple years, it is also more likely to be valid over the long-term.
Trend analysis has the benefit of using more data points than other methods to derive its estimates of future performance. As a result, this method tends to be more accurate than other methods that are based on data points from just a single year. In addition, this method is relatively easy to determine. Although slightly more complicated than the percentage of sales method, trend analysis nonetheless relies strictly on basic math in order to derive its projections.
Another method is the zero growth method. This is utilized by firms that operate in mature markets, or by firms that are facing adverse economic or competitive circumstances. In this scenario, the firm assumes that revenue will flatline. The budget may or may not contain expense reductions, but the underlying principle is that the firm cannot count on revenue improvements and must therefore attempt to operate under a cost containment scenario. This method is not accurate to the extent that few firms have sustainable flat revenue growth, but there are years in which the projection of a zero growth scenario would be appropriate. Under such circumstances, this form of estimate will have value.
Another method is to build the financial plan from scratch. This method is highly complex and requires significant input from multiple levels of management. However, these methods can be accurate because of that high degree of input. The underlying principle of this method is that most of the easier methods are ultimately not particularly accurate. They are based on estimates derived more for their practicality than their accuracy. For some firms, that is unacceptable and a more sophisticated method must be used. Building the financial plan from scratch involves consultation with a wide range of managers to derive their estimates of potential revenues and costs. The financial plan is then an aggregate of this information.
This method is perhaps the most realistic, assuming that the managers are capable of relatively accurate foresight. In addition to being subject to the ability of the managers to exhibit accurate foresight of the firm's operations, this method is also subject to the quality of the information available. For example, a manager planning in late 2007 may have made estimates that were logical at the time, but rapid fuel costs in the first half of 2008 may have rendered those estimates inaccurate by a wide margin.
The primary drawback to this method is that it is the most time-consuming. In order to execute this model, managers will need to spend an inordinate amount of time analyzing their organizations in order to derive accurate estimates of future performance. There is a tradeoff that must be evaluated with respect to the quality of the information and the time and effort needed to develop that information in the first place.
In addition, this method is subject to changing environmental factors. The best efforts of managers to build projections from scratch based on their expected actions over the next year can be rendered moot by changes in the external environment, or even the internal environment (for example, a major takeover or a major restructuring). All methods are subject to such changes, but because this method is based entirely on managerial interpretation of the future and because it is so time-consuming, there is more downside associated with such major shifts in the firm's external environment.
Lastly, the combination method takes into consideration both the percentage of sales method and the budgeted expense method (Slideshare, 2009). The combination method considers that for some line items it is reasonable that they will fluctuate largely in line with sales. For these items, the percentage of…