Percentage of Sales Method, Definition and How to Calculate
When it comes to recognizing revenue from a contract, one of the many generally accepted accounting rules and practices is to use the percentage of sales method or technique. When a company sells products or services on account, the amount of income that is counted as sales gradually diminishes over time as customers make payments.
Investors can get a clear picture of the amount of money that has been recognized at any given time thanks to the percentage of sales method, which records this information immediately in the financial statements. This recognition model requires an organization to keep track of the total value of sales (measured in monetary units) and the percentage of those sales that have been collected as of the current date.
Neither number shifts in its absolute value; rather, it is recalculated in light of the new information. When utilizing this accounting standard, having a solid grasp of the methodology behind the computation of these values is essential.
What is the Percentage of Sales Method?
The percentage of sales method is a recognition method that uses the percentage of sales method to calculate the amount of revenue an organization has earned. Simply put, it uses the total sales in a contract, the percentage of sales collected to date, and then calculates the amount of revenue earned.
A business that sells services or merchandise to a customer on account may not be able to recognize all of the revenue in the month when the sale is made, but they also don’t want to wait until the entire bill is paid. This recognition model helps accountants determine how much revenue has been earned at any given time.
Why do Organizations Use the Percentage of Sales Method?
A business could choose to record revenue using the % of sales technique for a variety of different reasons. The following are examples of some of these possible explanations:
Easy to Understand
The percentage of sales method is a simple way to convey how much an organization has earned. It doesn’t require detailed analysis or complicated calculations, making it easy for investors to grasp.
No Guesswork
In some cases, an organization may not know the number of units sold, the number of units on hand, or the amount of money owed. This recognition method helps accountants calculate revenue without having to guess the numbers.
Accurate
The percentage of sales method is an accurate way to record revenue. Once the numbers are calculated, they don’t change and don’t require further analysis.
How to Calculate the Percentage of Sales Recognition Model
Let’s look at an example of how the percentage of sales recognition model works. A business sells products on account for $5,000. The percentage of sales recognition model calculates the revenue earned by multiplying the total sales by the percentage the organization has collected to date.
● $5,000 is the total amount of sales
● $500 is the number of sales the organization has collected to date
● $5,000 x $500 = $2,500 represents the amount of revenue recognized under the percentage of sales method
What is the Formula for Calculating the Percentage of Sales?
The formula for calculating the percentage of the sales recognition model is as follows:
Recording Sales under the Percentage of Sales Method
Let’s say the business in the above example is a manufacturer that uses a standard costing system. The standard cost for the product is $1,000, and the sales price is $5,000. Assuming the product is sold on account, the following would happen:
● $1,000 is the product’s standard cost
● $500 is the number of sales the organization has collected to date
● $1,000 x $500 = $500 is the amount of revenue recognized under the percentage of sales method
● $4,500 is the amount of inventory remaining (standard cost of goods sold + sales on account)
The organization’s financial statements would show $2,500 in sales and $2,500 in unearned revenue.
When Should You Use the Percentage of Sales Recognition Method?
The percentage of sales approach is a widely established accounting method. Having said that, you need to exercise caution while employing this strategy because it possibly might not be suitable in all circumstances.
When a company cannot make a reasonable estimate of the number of sales or the end date of the contract, this strategy is appropriate. It is also most effective when there is a big number of transactions on the account, with little probability that any of those sales will be canceled or changed.
Limitations of the Percentage of Sales Recognition Method
There are two significant restrictions associated with using the % of sales method. To begin, it does not take into account the order in which financial flows will occur. To put it another way, it does not take into account the timing of the payments. This system merely records how much revenue has been recognized, which might not represent when the cash is actually in the control of the business.
Second, this method doesn’t account for the time between the sale and the receipt of payment. As the amount of time between the two events increases, the amount of revenue that has been recognized decreases. The percentage of sales method keeps revenue amounts consistent, regardless of the time between the sale and payment.
Conclusion
The percentage of sales method is an accepted accounting method that records the amount of revenue an organization has earned based on sales and the percentage of those sales that have been collected to date. This method is suitable when an organization cannot reasonably estimate the number of sales or the contract’s end date.
This strategy works best when there is a high number of transactions on the account and there is little probability that any of those sales will be canceled or changed. It does not take into consideration the timing of cash flows or the amount of time that passes between making a sale and being paid for the sale.