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Forecasting Profits in the Short Run: Using a More Reliable Profit Margin Ratio

The percent-of-sales method is a frequently encountered simple approach for estimating cost components and profits in projected income statements. The method assumes that all costs are variable, implying that profit margin is constant. Profit margin ratios are also used to estimate profits directly. This may be reasonable in the long run, but some fixed costs are present in the short-run, resulting in forecast errors. I propose a short equation that incorporates the initial profit margin, the sales growth rate, and the ratio of fixed cost to initial sales that renders more accurate profit estimates while preserving the simplicity of the method.