Gross profits are recorded on a company's income statement and are equal to total sales/revenues minus cost of goods sold (COGS). This metric serves as a basis for calculating a company’s financial performance.
It is different from net income or net profit, usually found at the bottom line of the income statement, which accounts for all expenses a business incurs. However, it helps for small business owners to keep track of the company’s revenue over time and total costs (including direct expenses) over time. While there are other options, the percentage of sales method is one of the most common financial methods used for preparing financial forecasts.
The Percentage of Sales Method
The underlying premise of the percentage of sales method is that a company's historical performance is an accurate indicator of its expected performance. This method involves applying a company’s income statement items (all financial statements can be obtained via the U.S. Security and Exchange Commission's EDGAR – Search and Access tool, expressed as a percentage of sales, to forecast sales, which are derived using trends in the company's past sales growth.
Analyze Historical Sales
Analyze historical sales to obtain historical growth percentages. If historical sales are stable, you can use a simple average. However, if you have reason to believe that the most recent years are more indicative of the future, use a time-weighted average allocating greater weighting to recent years.
Account for any relevant factors, such as if the company operates in a cyclical industry, and analyze those factors to determine what the total sales revenues might be moving forward. Once you select a growth rate, apply it to the most recent year's sales by multiplying sales by 1 plus the growth rate. The result is the forecast for the next year's sales.
Analyze Historical Gross Profit Margins
You should analyze historical gross profit margins much the same way you've analyzed sales, with the goal of obtaining an accurate proxy for projected gross profits. Then, calculate an historical average, time-weighted average and range of results manually or using a gross profit calculator.
Take into account any price changes of raw materials that are included in the cost of goods sold since it is one of the direct costs, as well as the company's inventory levels. Use a historical average gross profit margin as a baseline, and make small upward or downward adjustments based on factors that affect the cost of sales (remember, the COGS also includes direct labor but excludes indirect costs like overhead costs and office supplies).
Apply Gross Profit Margin to Project Sales
Once you've forecasted future gross income using historical sales growth trends, and identified a reasonable gross profit margin, apply the gross profit margin to projected sales to obtain projected gross profits.
For example, if you've forecasted next year's total revenues to be $1 million with a gross profit margin of 35 percent, multiply 35 percent times $1 million, which results in projected gross profits of $350,000.
You can make adjustments to gross profits by adjusting the gross profit margin or by making adjustments in dollar amounts. For example, if you know that the subject company will incur one-time consulting fees related to the cost of goods sold of $30,000, subtract the consulting fees of $30,000 from projected gross profits of $350,000, resulting in updated gross profits of $320,000.
You should create a separate tab in the Excel workbook in which to summarize your assumptions. When you create your projections, link the cells directly to the assumptions tab. This way, if your assumptions change, you will only need to update them once in the assumptions tab, as opposed to every relevant cell within the actual forecast tabs.
Alternatives to the Percentage of Sales Method
Per Harvard Business School Online, the following are some of the alternative ways of calculating gross profit projections.
The straight-line method is a simplified method of calculating the amount of money that a company is likely to make in the future because it assumes its growth rate will remain constant. So, when forecasting, you will use the previous year’s revenue and multiply that by the historical growth rate.
For example, if your business grew by 10 percent and you earned a gross revenue of $2.5 million, then you will assume that this year’s gross sales will be 110 percent x 2.5 million, which is $2.75 million. Assuming your expenses stay the same or you have an estimate, you can deduct the COGS from the revenue to get the gross profit forecast.
Simple Linear Regression
To determine gross profit projections using simple linear regression, you need to have two variables: one dependent and one independent. In this case, the gross profit will be dependent, while an independent value would be the cost of goods sold or revenue.
And with the historical data of your preferred variables, you can plot the graph using that data and use the formula below to forecast gross profit margins:
Y = BX + A
Y = gross profit margin
B = regression line slope
X = independent variable such as COGS
A = y-intercept (where the graph intercepts the y-axis)
Moving Average Method
The moving average method involves predicting future revenue by averaging the previous periods’ revenues. You can also do the same with the direct labor and material costs (COGS), then deduct the latter value from the former to get a gross profit projection.
The moving average method is usually better for short-term forecasting, but it may give inaccurate results for long-term forecasts. However, the percentage of sales method can be quite accurate, but it doesn’t work well for companies that lack historical data.
On the other hand, the straight-line method assumes that your business revenues and expenses are stable, which is not always the case. Also, the simple linear regression may not be accurate if there are multiple variable costs that affect the company’s gross profit.
- Create a separate tab in the spreadsheet workbook in which to summarize your assumptions. When you create your projections, link the cells directly to the assumptions tab. This way, if your assumptions change, you will only need to update them once in the assumptions tab, as opposed to every relevant cell within the actual forecast tabs.
This article was written by PocketSense staff. If you have any questions, please reach out to us on our contact us page.