Organisations have different ways in which they can approach sales budgeting. In this section, we will discuss the most commonly used methods of sales budgeting.
Table of Content
Methods of Sales Budgeting
- Affordability Method
- Percentage of Sales Method
- Competitive Parity Method
- Objective & Task Method
- Zero Base Budgeting
It is the most straightforward method of sales budgeting. In the affordability method, the management develops the sales budget based on its ability to spend on sales functions. The management decides how much it could afford to spend for selling its goods and use this figure as a basis for budgeting.
For example, many small businesses use affordable methods of advertising such as social networking, flyers, online video advertising, or pay-per-click advertising. However, things often end up costing more than what was estimated, and there may not be enough funds in the end.
Percentage of Sales Method
In the percentage of sales method, firms set their sales budget as a specified percentage of current or expected sales. This method is commonly used by firms involved in the mass selling of goods and or those governed by finance.
The percent of sales method is a quick method to develop a sales budget by closely correlating items to sales. However, it is only possible to apply this method to line items that correlate with sales; any fixed expenses cannot be projected using this method.
Steps to Use the Percentage of Sales Method
- Find recent sales figures: Before making predictions about the financial health of an organisation, it is important to know its sales and expense data.
- Determine what is needed to be forecasted: Certain accounts on a financial statement are more likely to be directly influenced by sales. These include:
1. Accounts receivable
2. Accounts payable
3. Costs of goods sold
A plan should be made and it should be decided which specific accounts to be included in the organisation’s financial forecast.
- Calculate the percentage of sales to expenses: Each line item’s balance on the organisation’s financial statement should be looked upon. Thereafter, the percentage relative to overall sales
should be calculated by:
a. Determining expenses and total sales for the period
b. Dividing expenses by total sales
c. Multiplying the result by 100= (Expenses/sales) × 100
Let us understand how to use the percentage of sales method with the help of an example.
Papa Foodiez Inc. is a famous food outlet that sells cinnamon rolls directly to customers. The cost of flour and eggs is increasing, thus the management team wants to know if they need to raise the price of their rolls. To figure this out, the team decides to use the percentage of sales method.
Firstly, in-depth financial statements are prepared. Each line item is linked to a percentage calculated using the percentage of sales to expenses formula.
Total cost of goods sold for the year: ₹20 lakhs
Total sales: ₹50 lakhs
Cost of goods sold sales percentage: (2000000/5000000) × 100 = 40%
If the percentage was 35% last year, management would want to know why making rolls has become more expensive. It could be because of the increase in the prices of flour and eggs, but it could also be related to a change in the supply chain. Perhaps the delivery trucks have to travel farther to reach the new industrial kitchen.
Eventually, organisations want revenue to increase proportionately to costs. If this is not happening, the management team can determine which costs are increasing and decide what, if any, cost-cutting measures are appropriate.
Competitive Parity Method
The competitive parity method is commonly used by firms faced with tough competition. Here, the allocation of the sales budget of a firm is such that it is at par with the sales budget of its competitors. The competitive parity method is appropriate for sales budgeting for an industry that is characterised by a large number of established competitors.
It is a safe strategy in a competitive market: keeping the firm in competition but avoiding a sales budget that is more than needed. This method assumes knowledge of competitors’ activities and resource allocation.
For example, there are two FMCG companies X and Y, which are involved in the business of selling soaps. X is the leader and Y is the follower. If X is spending ₹5, 00,000 per month on the promotion of its flagship soap on a particular channel then Y will try to match it for its competitive offering on the same channel with a similar budget.
The competitive parity method has the following merits:
- It ensures that the budget allocation is always optimum, avoiding both overspending that will lead to unnecessary losses and underspending that will lead the firm to lose to the competition.
- It is a safer approach to budgeting when the firm does not have enough information to determine how it can succeed in the market.
Competitive parity has the following demerits:
- When a firm only follows a competitor, it may never have a competitive advantage in the market.
- In the case of products that have as pacific requirement for additional or lower spending, this approach may lead to incorrect budget allocation.
Objective & Task Method
In the objective and task method, managers develop their budgets by identifying the objectives of the sales function and then determining the sales-related tasks to achieve those objectives. Once this is done, the cost of each task activity is estimated to figure out the total budget. Thus, in this method, the firm allocates funds to its marketing budget based on specific objectives, instead of basing it only on sales forecast.
A typical objective and task method have three steps:
- Identifying objectives: In this step, the firm identifies the sales objectives and results it wants to achieve. For example, a company may set an objective of increasing sales by 20% over the course of the next business quarter.
- Identifying tasks: In the second step, the firm determines the specific tasks that will help achieve the desired objectives. For instance, if a company wants to increase sales by 20% in a quarter, then it may determine that it needs to run weekly ads in some local newspapers in order to boost its visibility.
- Estimating costs: In the last step, the firm determines how much money is needed to complete each task and then allocates that amount to the sales budget. Using the above example, if the company determines that it needs to run an ad each week in four different newspapers at a cost of ₹7,000 per ad, and it needs to repeat those ads every week for 12 weeks, then it needs ₹3,36,000 in its marketing budget.
The main merit of this method is that rather than focussing on previous sales figures, sales forecasts, or competitors’ budgets, the budget focuses on the firm’s key goals.
However, the method can be time-consuming and expensive.
Zero Base Budgeting
In the Zero Base Budgeting (ZBB) method, the sales budget for each year is initiated from scratch or zero base. The managers reassess all the line items in the cash flow statement and then justify the expenses that would be incurred along with the revenue that will be generated by the sales department of the firm.
Thus, zero base budgeting method is used to calculate expenses based on the actual expenses that will be incurred for the new period and not on a differential basis where the incurred expenses are changed based on the modification in the operational activity.
Unlike traditional budgeting methods that expect past trends, sales, or expenditures to continue, zero-based budgeting assumes that no balances are carried forward or no expenses are pre-committed and build the budget from scratch.
Traditional budgeting approaches typically draw up a budget based on the previous year’s budget and adjust it according to various factors such as inflation and updated forecasts but the zero base budgeting method does not automatically transfer any line item from the previous budget to the new budget.
It does not depend on previous budget data and requires justification for every line item. Whilst traditional budgeting lays more focus on controls based on the expenditure, zero-based budgeting lays more focus on the reason behind each expenditure. It focuses on identifying a task and its associated cost and then allocating these expenses regardless of the current expenditure structure.
Let us understand ZBB with the help of an example.
Sandoz Inc. is a company that is involved in the selling of books across Delhi, India. The company had traditional outlets for selling the books. With the outbreak of Coronavirus, all schools and colleges started conducting online classes.
As a result, the company is also growing in the e-commerce space. In year 2021, it has completely migrated to the e-commerce business. Now the company is planning to do ZBB as there is a complete shift in the way of operations.
So, some key expenses it looks into are renting expense, advertisement cost, staff cost, etc.
- Rent expense in prior period is ₹75,000 per month per outlet. They had totally 10 outlets in the city which comes to ₹7, 50,000 per month. Now with the present set up the company hardly needs 2 offices set up for which it used two of its outlets. So, there is a cost savings to the extent of ₹6, 00,000 per month.
- On the other end, the e-commerce business is challenging with a lot of emerging players. So, the company decided to spend a good amount on advertisement in order to attract customers. In the previous period, it had spent only ₹2, 00,000 totally for the advertisement, but now considering the situation they have increased it to ₹5, 00,000 for the year.
Zero-based budgeting has the following merits:
- It helps to minimise costs by keeping expenditures in check and preventing the budget from expanding.
- It encourages the strategic allocation of resources.
Zero-based budgeting has the following demerits:
- It can promote short-term thinking.
- It is more resource-intensive, time-consuming, and complex than traditional budgeting.