How Are Expenses Forecasted on a Pro Forma Income Statement?
Build a credible pro forma by applying the correct forecasting method to each expense, whether it's driven by sales, schedules, or fixed agreements.
A pro forma income statement is a financial projection that estimates a company’s future profitability. It serves as a forward-looking tool, distinct from historical financial statements that report past results. Businesses create these projections to inform strategic planning, assess the financial impact of major decisions, and secure external financing from lenders or investors. By outlining anticipated revenues and all associated expenses, the pro forma statement provides a structured view of a company’s expected financial performance. These documents are also used by internal management to model different scenarios, such as a new product launch or a merger, to understand the potential effects on profitability.
Forecasting Variable Expenses Using the Percentage of Sales Method
Variable expenses are costs that fluctuate in direct proportion to a company’s sales volume. Common examples include the Cost of Goods Sold (COGS), which covers the direct costs of producing goods, and sales commissions. A widely used technique for forecasting these expenses is the percentage of sales method. This approach assumes that the historical relationship between sales and a specific variable expense will remain consistent in the future.
The first step is to calculate the historical percentage for each variable expense. This is done by dividing the expense amount from a recent period by the total sales revenue for that same period. For instance, if a business had a COGS of $60,000 on total sales of $150,000 last year, the historical COGS percentage would be 40% ($60,000 ÷ $150,000).
Once this historical percentage is determined, it can be applied to the company’s sales forecast. Continuing the example, if the business projects sales will grow to $180,000, the forecasted COGS would be $72,000 ($180,000 x 40%). The same process is repeated for other variable costs like shipping, each using its own historically derived percentage.
This method’s accuracy depends on the stability of the underlying cost structure and pricing. Significant changes in supplier pricing, production efficiency, or commission structures would require an adjustment to the historical percentage to ensure the projection remains realistic.
Projecting Fixed and Semi-Variable Expenses
Unlike variable costs, fixed expenses do not change with sales volume. These are consistent, recurring costs necessary for operations, such as monthly rent, insurance premiums, and administrative salaries. The standard approach to forecasting fixed expenses is to begin with the historical cost from the most recent period and carry it forward into the projection period.
This baseline figure must be adjusted for any known and quantifiable changes expected in the future. For example, if a company’s lease agreement includes a 5% rent increase, the forecasted rent expense must be adjusted upward. Similarly, if management plans to hire a new salaried manager, that individual’s salary must be added to the projection.
Some expenses contain both fixed and variable components; these are known as semi-variable or mixed costs. A utility bill is a common example, as it might include a fixed monthly service charge plus a variable charge based on consumption. To forecast these costs accurately, they should be broken down into their constituent parts.
The fixed portion of a semi-variable expense is projected like any other fixed cost, by carrying over the historical amount and adjusting for known changes. The variable portion is forecasted using the percentage of sales method. Separating the components allows the forecast to more accurately reflect how the expense will behave as sales levels change.
Calculating Other Key Expense Projections
Certain expenses on a pro forma income statement are not directly tied to sales and require unique forecasting methods. Depreciation is a non-cash expense that reflects the allocation of a physical asset’s cost over its useful life. It is forecasted based on a company’s existing fixed assets and any planned capital expenditures, using a depreciation schedule. The most common approach is the straight-line method, where the asset’s cost, minus its estimated salvage value, is divided by its useful life. For example, a machine purchased for $50,000 with a 10-year useful life and no salvage value would result in an annual depreciation expense of $5,000.
Interest expense is another item calculated independently of sales. This forecast is derived from a company’s debt schedule, which outlines all existing and planned borrowing. The projection is a function of the outstanding debt balances and their associated interest rates. For example, if a company has a $100,000 loan with a 5% annual interest rate, the projected interest expense for the year would be $5,000, assuming the principal balance remains constant.
The final expense to be projected is income tax. This calculation is determined by first finding the company’s projected earnings before tax (EBT), which is done by subtracting all other forecasted expenses from projected revenue. An estimated effective tax rate is then applied to this EBT figure to arrive at the income tax expense. This rate is often based on the company’s historical effective tax rate, adjusted for any known changes in tax law.