These are two commonly used methods for preparing the pro forma profit and loss account â€“ the percent of sales method and the budgeted expense method.
Percent of Sales Method
The percent of sales method for preparing the pro forma profit and loss account is fairly simple. Basically this method assumes that the future relationship between various elements of costs to sales will be similar to their historical relationship. When using this method, a decision has to be taken about which historical cost ratios to be used: Should these ratios pertain to the previous year, or the average of two or more previous years?
The application of the percent of sales method of preparing the pro forma profit and loss account to Space age Electronics for the year 20X3.In this table historical data are given for two pervious years, 20X1 and 20X2 .For projection purpose, a ratio based ion the average of two pervious years has been used. The forecast value of each item is obtained is obtained as the product of the estimated sales and the average percent of sales ratio applicable to that item. For example, the average percent of sales ratio for cost of goods sold is 65.0percent.Multiplying the estimated sales of 1400 by 65.0 percent, the projected value of cost of goods sold has been calculated. Likewise, the projected values of other items in the profit and loss statement have been calculated. Although in practice some deviation from a mechanical application of this method is unavoidable, for the sake of illustration the projections as shown are based on a strict application of this method, except for dividends and retained earnings. Remember that the distribution of earnings between dividends are retained earnings reflects a managerial policy which is not easily expressible in mechanistic terms.
Budgeted Expense Method
The percent of sales method, though simple, is too rigid and mechanistic. For deriving the pro forma profit and loss account shown , we assumed that all elements of costs and expenses bore a strictly proportional relationship to sales. The budgeted expense method, on the other hand, calls for estimating the value of each item on the basis of expected developments in the future period for which the pro forma profit and loss account is being prepared.
Obviously, this method requires greater effort on the part of management because it calls for defining likely developments.
A combination Method
It appears that a combination of the two methods described above often work best. For certain items, which have a fairly stable relationship with sales the percent of sales methods is quite adequate. For other items, where future is likely to be very different from the past, the budgeted expenses method which calls for managerial assessment of expected future developments is eminently suitable. A combination method of this kind is neither overly simplistic as the percent of sales method nor unduly onerous as the budgeted expense method.
The 20X3 pro forma profit and loss account for Space age Electronics, constructed by using a combination of the percent of sales and the budgeted expense methods. Cost of goods sold selling expenses, and interest on bank borrowings are assumed to change proportionally with sales, the proportions being the average of the two preceding years. All he remaining items have been budgeted on some specific basis.