What Are the Advantages of the Percentage of Net Sales Approach?

Definition

• The percentage of net sales approach involves dividing all the components of the income statement by net sales. These numbers are ratios, which are converted to percentages. Following this approach enables the manager to establish benchmark percentages for cost of goods sold, gross margin, administrative and overhead costs and net profit margin. These percentages can be further broken down into percentages for individual components such as labor, materials cost, administrative salaries, insurance, rent and advertising.
  
  

Budgeting and Variance Analysis

• At the beginning of each fiscal year, a manager prepares a budget based on the expected sales level and identifies the percentage of sales for each expense component. As the year progresses, he compares the company's actual performance to the budget and notes any differences, which are known as variances. A variance can be either favorable or unfavorable. If the manager spots and unfavorable variance, he will investigate to determine its cause. The percentage of sales approach makes it easy for the manager to detect variances and see any negative trends in time to take corrective action before the problems get worse.
  
  

Comparison to Industry Standards

• Business managers, analysts and lenders use the percentage of sales approach to compare the performance of a company with similar businesses in the same industry. For example, if a company reports a gross margin of 38 percent, an analyst would not know if this is good or bad until he made comparisons to the industry standard. Several publications issue surveys of hundreds of businesses in different industries every year. Dun & Bradstreet puts out its "Industry Norms and Key Business Ratios," which reports common percentage of sales figures as medians and upper and lower quartiles. Prentice Hall gathers its information from the Internal Revenue Service to publish the "Almanac of Business and Industrial Financial Ratios."
  
  

Forecasting

• Because managers cannot predict the future, they must rely on historical data to make projections and formulate plans with strategies for controlled and profitable growth. Business managers often use a percentage of sales analysis to make predictions for sales, expenses and profits. In these situations, using the percentage of sales approach assumes that the figures on the income statement will vary in proportion to sales. This pro-forma method also allows the manager to predict the composition of the balance sheet and determine whether future growth can be internally financed or whether outside funds will be needed.