Measuring Forecast Errors in the Percentage of Sales Method

Abstract

The percentage of sales method is commonly used to forecast income statements and balance sheets, assuming that costs change in the same proportion as the change in sales and using the sales forecast as a proxy. Since fixed cost is present in the short run, the percentage of sales method can result in errors when forecasting the short run. This paper derives two equations that quantify the forecast errors inherent in forecasting one-period income statements using the percentage of sales method. As expected, the equations show that errors can be significant when fixed cost or sales growth rate are high. An unexpected result is that profit margin also plays a role in determining the profit forecast error. A table showing forecast errors for a range of the main variables causing the errors is included.