# Percent-of-Sales Method

The percent-of-sales method is a technique for forecasting financial data. When forecasting financial data for strategic planning, budgeting, or for developing pro forma financial statements, analysts can use the percent-of-sales method of forecasting to create reasonable projections for certain key data.

The idea is to see how a financial statement account item relates historically to sales figures. Then use that relationship to project the value of those financial statement account items based on future sales estimates. This method of forecasting requires the items to be estimated based on relations to sales figures, thus it is necessary that movements in the items to be forecast are highly correlated with fluctuations in the sales figures. Forecast that item using a different technique; especially if there is no clear correlation between the item to be forecast and sales figures.

For example, if, after examining and analyzing historical financial statement data, an analyst determines that inventory levels are typically at 30% of sales. Additionally, the sales forecast for the coming year is for \$100,000 dollars in sales. Then according to the percent-of-sales method of forecasting, the analyst can estimate inventory of approximately \$30,000, or 30% of the estimated sales figure.

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## Three Step Process

There are three steps in the percent-of-sales forecasting process. First, use the sales figures to identify the correlated items. Then separate the uncorrelated out. To do this, analyze historical financial statement data. Only the items which are correlated with sales figures can accurately be predicted or forecast using the percent-of-sales method. Estimate items that have no concrete relation to sales figures using a different technique.

Next, forecast sales for the fiscal period in question. Because all projections in the percent-of-sales method of forecasting depend on relationships between financial statement items and sales figures, it is very important to get an accurate sales forecast.

The third step in the percent-of-sales method of forecasting is to forecast the values of certain appropriate financial statement items. You can accomplish this by using the sales forecast from the previous step in combination with the historical relation between the financial statement item and the sales figure.

## Percent-of-Sales Method

1. Analyze historic financial statement data
2. Forecast sales for the fiscal period
3. Forecast financial statement items using sales forecast

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# Forecasting in Accounting

Forecasting in accounting refers to the process of using current and historic cost data to predict future costs. Forecasting is important for planning purposes – it is necessary to estimate and plan for costs that will be incurred prior to actually incurring them. There are several common tools and techniques used for forecasting in the field of cost accounting, including the following:

## Budgeting

Budgeting is the process of preparing a budget in order to plan for revenues and expenses in an upcoming fiscal period.

A budget has five primary objectives. These include the following:

1. Planning for the upcoming fiscal period
2. Facilitating coordination and communication of these plans throughout the organization
3. Allocating resources within an organization
4. Managing financial and operational performance during the fiscal period
5. Evaluating performance and providing goal-based incentives to management and other personnel inside the organization

Budgets are prepared using current and historic data and estimations about future trends. Budgets can also be prepared using the traditional method or the zero-based method. The tradition method of budgeting typically uses the previous period’s budget at a starting point for the upcoming period’s budget. The zero-based budget method essentially requires starting from scratch each period.

### High-Low Method

You can use the high-low method is a technique for cost estimation in forecasting. It is a rather simple technique and it is less accurate than more sophisticated cost estimation techniques, such as regression analysis.

Using the high-low method requires having a set of data relating costs to cost-driver activities. You take the highest cost and the highest cost-driver activity level and the lowest cost and the lowest cost-driver activity level from the data set. Then use these four pieces of data to calculate the slope of the line that connects the two points. Finally, you compute the intercept using the slope and one of the points. This gives you the high-low cost equation for that particular cost-incurring activity.

### Regression Analysis

Regression analysis is a method of relating a dependent variable to an independent variable. The analysis essentially computes how much of the variance in the dependent variable is due to variations in the independent variable. Regression analysis requires having a set of data for both the dependent and independent variables. The best way to do a regression analysis is in a computer program.

Regression analysis can be either simple or multiple. Simple regression analysis uses one independent variable and one dependent variable. Whereas, multiple regression analysis uses several independent variables and one dependent variable. The result of a regression analysis is an equation that can be used to forecast costs based on certain estimates of independent variable activity.

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# Cost Accounting Definition

The common cost accounting definition is accounting which seeks to create then compare a budget to the actual cost of doing business. In cost accounting, budgeting aids in decision making with regards to minimizing costs and increasing profit.

## Cost Accounting Description

Cost accounting is a form of managerial accounting and is used for the benefit of internal managers. Due to this fact reports need not follow GAAPFASB, or other accounting standards and procedures. Cost accounting, ultimately, is focused on reducing costs and increasing profit. Costs, for the purpose of creating uniform reports, are measured in one form of currency.

The purpose of cost accounting is strategic decision making. With effective cost accounting measurements managers can make key decisions on price, product offerings, technologies, and controls for short term and long term planning.

The foundation of this purpose is measurement and analysis. With incomplete records come partial decisions, some managers must take great effort to ensure proper data procedures. After completing this daunting task, managers must then derive accurate decisions based on quantitative and qualitative analysis of internal records and external variables.

## Cost Accounting Techniques

There are many methods for a cost accounting standards guide. Pivotal cost accounting techniques include the following:

Cost accounting is an extensive field. The cost accounting basics, however, are simply described as the following:

These explanations may fall under a different name, however the concept and purpose behind most cost accounting terms will remain similar.

## Cost Accounting Example

For example, Stan is the CFO for a financial services company called Financeco. Stan believes the company is spending too much in total costs for servicing one customer. As a result, he wants to reduce the total cost of servicing one customer to increase the profit received from each one. A trained CFO is an authority for any situations that require cost accounting solutions.

So, Stan begins by looking at the company cost of goods sold (COGS). He sees satisfactory results but wonders if he can do better. While looking at this he realizes that a large portion of these expenses come from processing customer paperwork and monthly reports. He begins to study, measure results, and form a plan of action.

Stan finds that the company makes \$2400 per year off of the average customer. In comparison, he also finds that the company spends a total of \$400 per year in paperwork processing. He studies the experience of the customer and realizes a main flaw.

Financeco uses paper-based record keeping instead of computerized databases. On the front end, by encouraging the customer to apply to Financeco online the company can slash the first half of total paperwork processing by 30% (\$200 X 30% = \$60 cost reduction per customer). To encourage this he suggests waiving the \$25 application fee for clients who apply online.

### Stan’s Plan

On the back end, Stan believes he can convince clients to “go paperless” with monthly reports. By providing clients with an online system to view reports he can completely remove the other half of paperwork processing. To do this, Stan suggests a new portal to their website. With a one time capital expenditure of \$20,000 he can remove \$200 of yearly costs per customer. Stan suggests that the company market this change as “Financeco going Green”. For customers not motivated by the environmental benefits of the new system, give a temporary price reduction. A per client, year-end rebate can be budgeted to each sales agent on an as needed basis.

Stan estimates that this change will cost the company approximately \$40,000 (\$20,000 for web design and an additional \$20,000 for training hr for the transition.). He creates his report and prepares to meet with the company’s Board of Directors.

Stan’s plan is a welcomed change to the Financeco Board of Directors. They embrace the plan and begin making the necessary changes to company processes.

Cost accounting systems, cost accounting software, and other tools will ease the task of the manager. Without a foundation of measurement and analysis, however, Stan would have never experienced success in his project.

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# Capital Budgeting Phases

The phases of the capital budgeting process include the following:

• Description of the need or opportunity
• Identification of alternatives
• Evaluation of the options and the relevant cash flows of each
• Selection of best alternative
• Conducting a post-completion audit of the projects.

## Examples

To identify capital projects, refer to functional needs or opportunities. Although many are also identified as a result of risk evaluation or strategic planning. Some typical long-term decisions include whether or not to:

• Buy new office equipment, cars or trucks
• Add to or renovate existing facilities, including the purchase of new capital equipment/machinery
• Expand plant or process operations
• Invest in facilities for a new product line or to expand services
• Continue or discontinue an existing product line
• Replace existing capital equipment/machinery with new equipment/machinery
• Invest in software to meet technology-based needs or systems designed to help improve process and/or efficiency
• Invest in R&D or intangible assets
• Build or expanding a foreign or satellite operation
• Reorganize assets or services
• Acquire another company.

Refer to capital investment (expenditure) decisions as capital budgeting decisions. They involve resource allocation, particularly for the production of future goods and services, and the determination of cash out-flows and cash-inflows, which need to be planned and budgeted over a long period of time. Because of the complexity of this accounting issues, get involved yourself right from the beginning. Guide them through the whole process.

### Project Evaluation

Develop an objective methodology with the upper management. Then evaluate alternate capital projects on a reasonable basis. Consider both quantitative and qualitative issues and use the whole organization as a resource.

Marketing should provide data on sales trends, new demand and opportunities for new products. Managers at every level should be identifying resources that are available to upper-management that may lead to the use of existing facilities to resolve the need/take advantage of the opportunity. They should also be communicating any needs they/their departments or divisions have that should be part of the capital decision.

Financial analysts should also identify the target cost of capital, the evaluation of startup costs, and the calculation of cash flows for those projects chosen for evaluation purposes. If your financial analysts are absent, then refer to qualified external financial experts. By calculating the appropriate discount rate and calculating conservative cash flows, you are contributing to a critical part of this process. As a result, have an independent accounting firm look at the project/these issues impartially. Estimation bias can be dangerous.

Evaluate (predict) how well each capital asset alternative will do. Then, determine whether the net benefits are consistent with the required capital allocation. When doing this, consider that most firms face the scarcity of resources.

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# Capital Budgeting Methods Definition

Most small to medium sized companies have no idea how to approach capital investments. They treat it as if it were an operating budget decision rather than a long-term, strategic decision that will impact their cash flow, efficiency of their daily operations, income statement, and taxable income for years to come. They need your help understanding the importance of and then making the right capital budgeting decisions.

Capital budgeting decisions relate to decisions on whether or not a client should invest in a long-term project, capital facilities and/or capital equipment/machinery. Capital budgeting decisions have a major effect on a firm’s operations for years to come, and the smaller a firm is, the greater the potential impact, since the investment being made could represent a substantial percent of the firm’s assets.

Managing capital is one of the many ways that a financial leader can improve profitability. Start developing your financial leadership skills!

## Capital Project Examples

A capital project is usually identified by functional needs or opportunities, although many are also identified as a result of risk evaluation or strategic planning. Some typical long-term decisions include whether or not to:

• Buy new office equipment, cars or trucks;
• Add to or renovate existing facilities, including the purchase of new capital equipment/machinery;
• Expand plant or process operations;
• Invest in facilities for a new product line or to expand services;
• Continue or discontinue an existing product line;
• Replace existing capital equipment/machinery with new equipment/machinery;
• Invest in software to meet technology-based needs or systems designed to help improve process and/or efficiency;
• Invest in R&D or intangible assets;
• Build or expanding a foreign or satellite operation;
• Reorganize assets or services; or,
• Acquire another company.

Refer to capital investment (or, expenditure) decisions as capital budgeting decisions. They involve resource allocation, particularly for the production of future goods and services, and the determination of cash out-flows and cash-inflows. Plan and budget the determination of cash out-flows and cash-inflows over a long period of time. Get involved from the beginning. Then, guide them through this process. This is a very complicated accounting issue.

### Capital Budgeting Phases

The capital budgeting phases process include:

• Description of the need or opportunity
• Identification of alternatives
• Evaluation of the options and the relevant cash flows of each
• Selection of best alternative
• Conducting a post-completion audit of the projects

### Identifying Capital Budgeting Needs

The first step is to identify the need or opportunity. Mid-management level employees usually do this. It is the result of a shared vision of company goals and strategies coupled with a “where the rubber meets the road” perspective of “local” clients needs, tastes and behavior. They see a need or opportunity and communicate it to senior management. This is usually done in the form of proposals, which both include:

• Identification of the need or opportunity
• Potential solutions and/or recommendations

Senior management evaluates the merit of each proposed opportunity. Then they make a determination of whether or not to look into it further.

While project need identification is usually a decentralized function, capital initiation and allocation decisions tend to remain a highly centralized undertaking. The reason for this revolves around the need for capital rationing. This is particularly true when funds are limited and upper-management wishes to maximize its returns/benefits from any capital project undertaken.

The information needed to make this determination usually comes from both internal and external sources. It is also based on both financial and non-financial considerations. Interestingly enough, the factors examined in this process can be both firm-specific and market-based in nature. Companies should be seeking qualified financial guidance since the consequences of both a poor decision and of the implementation of a good decision can be far-reaching.

### Capital Project Evaluation

Have upper management develop an objective methodology so that you can evaluate alternate capital projects on a reasonable basis. Consider both quantitative and qualitative issues and use the whole organization as a resource.

Marketing should provide data on sales trends, new demand and opportunities for new products. Managers at every level should identify resources that are available to upper-management that may lead to the use of existing facilities to resolve the need/take advantage of the opportunity. They should also communicate any needs they/their departments or divisions have that should be part of the capital decision. Involve your financial analysts, or in their absence, qualified external financial experts such as your firm, in the following tasks:

• Identifying the target cost of capital
• The evaluation of startup costs
• The calculation of cash flows for those projects chosen for evaluation purposes

Critical part of this process involve both calculating the appropriate discount rate and calculating conservative cash flows. An independent accounting firm can best look at the project/these issues impartially. Estimation bias can be dangerous.

Evaluate (predict) how well each capital asset alternative will do. Also determine if the net benefits to the firm are consistent with the required capital allocation, given the scarcity of resources most firms face.

### Measurements Used in Capital Budgets

The purpose of the evaluation phase is to predict how well a new asset will benefit the firm. Consider the following possible measures, which you should help the firm develop.

#### Net Income

Managers of net income evaluate the incremental increase in accounting net income between alternatives.

#### Net Cash Flow

The most widely used measure is net cash flow. This measure looks at the actual cash flows (out and then in) resulting from the capital investment for each alternative. Evaluate these for both overall value (several techniques will be discussed next) and from the standpoint of the effect on daily cash flow and the ability of the firm to meet its financial obligations in a timely manner. Projects with high projected future returns may not be as attractive when adjusted for the time value of money or the costs involved in borrowing funds to meet operating obligations such as payrolls and accounts payable.

#### Cost Savings

Cost savings are not designed to generate revenues directly. But instead, they are designed to both save costs and increase productivity. Best evaluate these projects on the basis of incremental savings generated.

#### Cash Flows

Equality of cash flows tend to vary from year to year. The timing of cash flows may be an important consideration to the firm.

#### Salvage Value

Salvage value and functionality of an existing asset when replacing it with a new asset while the historical cost of an existing asset is not relevant to a capital budgeting decision, the net proceeds from disposal of the existing equipment is. So is the question of how well existing equipment operates given that capital budgeting decisions are only concerned with incremental costs and incremental savings/profits.

#### Depreciation

Depreciation, earnings and income tax effects need to be considered based on the form of the firm (sole proprietorship, partnership, corporation, etc.). The differences in the financial and tax accounting treatments available to the firm, especially as they apply to salvage value, useful lives and allowed depreciation methods, and, consideration of the marginal tax rate (which may vary from country to country). Most firms fail to consider this cost or choose a tax or financial accounting treatment that does not maximize the firm’s return on invested capital.

#### Inflation

Inflation the effects of inflation need to be considered in estimating cash flows as well, especially if is projected to increase in future periods and varies between capital projects being considered.

#### Risk

Risk considerations political risk, monetary risk, access to cash flows, economic stability, and inflation should all be considered in the evaluation process since all are hidden costs in the capital budgeting process.

#### Interest

Interest and the cost of capital the venture has to have a return that is greater than its cost of capital, adjusted for tax benefits, if any.

#### Subjective Decisions

The firm should also make a subjective decision as to its preferences in terms of characteristics of projects in addition to the regular selection criteria it has set. For example, does the firm prefer:

• Projects with small initial investments? Earlier cash flows? Or, perhaps, shorter payback times?
• New projects or expansion of the existing operations?
• Domestic projects or foreign operations?
• If the firm is risk neutral, would the prospects of additional potential cash flows in riskier investments make a capital project more attractive?

### Evaluating Risk of Capital Projects

Analyze risk carefully, regardless of which valuation method you used to evaluate the project. The more popular risk-assessment techniques include Sensitivity Analysis, Simple Probability Analysis, Decision-Tree Analysis, Monte Carlo Simulations and Economic Value Added (EVA):

Sensitivity Analysis considers what will happen if key assumptions change. It also identifies the range of change within which the project will remain profitable.

Simple Profitability Analysis assesses risk by calculating an expected value for future cash flows based on their probability of success to future cash flows.

Decision-tree Analysis builds on Simple Profitability Analysis by graphically outlining potential scenarios and then calculating each scenario’s expected profitability based on the project’s cash flow/net income. Managers use this technique to visualize the project and make more informed decisions. Although decision trees can become very complicated, consider all scenarios (e.g., inflation, regulation, interest rates, etc.).

Monte Carlo Simulations use econometric/statistical probability analyses to calculate risk.

EVA, which is growing in popularity, is a performance measure that adjusts residual income for “accounting distortions” that decrease short-term income but have long-term effects on shareholder wealth (e.g., marketing programs and R&D would be capitalized rather than expensed under EVA).

Once you have assessed the risk, which valuation method should the firm/you use for a project? The answer depends on considerations such the nature of the investment (the timing of its cash flows, for instance), uncertainty about the economy and the time value of money if it is a very long term capital project.

### Capital Project Evaluation Methods

The four most popular methods are the payback period method, the accounting rate of return method, the net present value method, and the internal rate of return method.

#### Payback Period Method

This method favors earlier cash flows and selects projects based on the time it takes to recover the firm’s investment. Weaknesses in this method include the facts it does not consider:

• Cash flows after the payback period
• The time values of money

Use this method to select from projects with similar rates of return and that were also evaluated using a discounted cash flow (DCF) method. For example, refer to this as the Payback Method based on Discounted Cash Flows or Break-Even Time Method.

#### Accounting Rate of Return Method

The Accounting Rate of Return (ARR) Method uses accounting income/GAAP information. Calculate it as the average annual income divided by the initial or average investment. Compare the projected return to a target ARR based on the firm’s cost of capital, the company’s past performance and/or the riskiness of the project

#### Net Present Value Method

Base the Net Present Value (NPV) Method on the time value of money. It is a popular DCF method. The NPV Method discounts future cash flows (both in- and out-flows) using a minimum acceptable cost of capital (usually based on the weighted average cost of capital or WACC, adjusted for perceived risk). Refer to this as the “hurdle rate.” NPV is the difference between the present value of net cash inflows and cash outflows. And a \$0 answer implies that the project is profitable and that the firm recovered its cost of capital.

#### Internal Rate of Return Method

The Internal Rate of Return (IRR) Method is based on the time value of money. It calculates the interest rate that equates the present value of cash outflows and cash inflows. This calculated rate of return is then compared to the required rate of return, or hurdle rate, to determine the viability of the capital projects.

### Soft Costs and Benefits in Capital Budgeting Methods

Other considerations the firm/you should consider as part of the valuation process are “soft” costs and benefits. Soft costs and benefits are difficult to quantify by are real non-the-less. Soft costs might be a capital investment in a manufacturing process that results in added pollution to the atmosphere. A soft benefit might be the enhancement of a firm’s overall image as a result of investing in R&D for high-tech products. Ignoring soft benefits and costs can lead to strategic mistakes. This is especially true if you are taking about investments in advanced manufacturing technology. Estimate soft benefits and costs. Then include them as part of the method to determine if a capital project is desirable.

### Post Completion Project Evaluation

Once you choose the project and put into operation, a qualified financial services firm, such as yours should undertake a post completion audit of the project. They can evaluate the project objectively. This audit by an independent party will function as a control mechanism to ensure that the capital project is performing as expected. In the event it is not, the audit will make it easier to terminate the project by eliminating any bias of those involved in the project. It will also serve as a learning mechanism for upper management. They will compare actual performance to expected results. In addition, they will improve the processes and estimates they use in future investment decisions.

Control mechanism, which can be expensive, is essential to the success of future capital investment decisions… Especially when considering the long life of most capital projects.

One final word regarding implementation of this control mechanism. Successful post-completion auditing processes require that upper management understand that the purpose of the audit is to learn from past experiences,. Do not penalize managers for the decisions they made. But instead give them the opportunity to learn from them. Learn more of how to becomes a valuable financial leader; download the free 7 Habits of Highly Effective CFOs whitepaper.

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# Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is an equilibrium model that measures the relationship between risk and expected return of an asset based on the asset’s sensitivity to movements in the overall stock market.

CAPM is used to price the risk of an asset or a portfolio of assets. The model is based on the idea that there are two types of risk, systematic risk and idiosyncratic risk, and that the investor should be compensated for both types of risk, as well as, the time value of money. Systematic risk refers to market risk. Idiosyncratic risk refers to the risk of an individual asset. Time value of money refers to the difference between the present value of money and the future value of money. Also, use the model to measure the required rate of return for capital budgeting projects.

The CAPM states that an asset’s expected return equals the risk-free rate plus a risk premium. The risk-free rate refers to the return on an investment without risk, such as a US Treasury Bond, and represents the time value of money. The risk premium represents the incremental return for investing in a risky asset. In the CAPM, it is defined as the market premium, or the overall stock market return less the risk-free rate, multiplied by the beta of the asset. Beta is a factor that measures an asset’s sensitivity to movements in the overall stock market. According to the CAPM, riskier assets should yield higher returns.

## The CAPM Formula

Expected Return = Risk-Free Rate + Beta (Market Return – Risk-Free Rate)

For example, if the risk free rate is 5%, the market return is 10%, and the stock’s beta is 2, then the expected return on the stock would be 15%.

15% = 5% + 2 (10% – 5%)

### Problems with Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is based on assumptions. First, the model assumes that a riskier asset will yield a higher return. But this is not necessarily true. A risky asset could decline in value. Second, historical data determines beta. The model assumes this historical data an accurate predictor of future results. But the asset’s future volatility may not necessarily reflect its past volatility.

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## Budgeting vs Forecasting

Forecasting
Comparison Analysis

# Budgeting vs Forecasting

The budgeting vs forecasting process has been a good discussion between financial professionals. The argument of whether they serve the same purpose or if one is better than the other has lead to some interesting debates. The term has been used several times interchangeably. However let’s explore why this is incorrect by identifying the budget vs forecast difference. When it comes to planning and grading the company’s financial health, they are both tools that can be used by companies. Their managers to do just that. However, the proper way to use them both is in concert with one another and not particularly as a substitute for one another.

## Budgeting

What is budgeting, definition-wise? It is the process used to compose a plan or create an estimate during a prior year or at the beginning of a current year to help manage and control the income and expenditures of the company for that year. Some have even defined a budget to be a road map or financial guide that recognizes the income of the company, while detailing the expense allowances with a not-to-exceed expectation for that given year. Now let’s examine the definition of forecasting to compare the differences between the budgeting and forecasting process.

## Forecasting

Forecasting is another financial tool commonly used to help determine the financial status of a company. The meaning of financial forecasting is quite different from that of budgeting. Where the budget is used as a financial planner, the forecast uses this plan and compares it to the current financial direction of the company. They do this to predict where the company will end up by the end of that year. In other words, use the forecast to see if the company will meet or exceed the expectations from the budget allowing the managers and controllers to set future goals. They also use forecasts to identify trends that are used to grade the company’s financial position. They both seem to be very resourceful tools. Instead of comparing financial forecast vs budget, the more important discussion should be which tool is more effective.

## Which is More Important?

So which tool in the financial forecast versus budget debate is more important? Let’s answer a few questions first. Can a business run productively without a budget, a plan of action for each year? Some do. However, to run a successful business without monitoring your financial status throughout the year to predict its financial grade by the end of the year can be very difficult. Budgeting can be a good tool to use to help plan the future of the business; however a greater predictor of future behavior is past behavior. The purpose of investing time to create a financial forecast is to predict the future based upon certain assumptions. In addition, use the past to defend those assumptions. Both tools are necessary for a business to be successful. In short, a budget sets the company’s goals while a forecast defines its expectations.

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