The strict application of the percent-of-sales method to prepare a pro forma income statement assumes the firm has no fixed costs. Therefore, the use of the past cost and expense ratios generally tends to ________ profits when sales are increasing.

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The strict application of the percent-of-sales method assumes that all costs and expenses vary proportionately with sales, which is not always the case. Therefore, the use of past cost and expense ratios tends to understate profits when sales are increasing because it does not account for fixed costs, meaning that these costs will remain the same despite an increase in sales. As a result, the pro forma income statement will underestimate the actual expenses incurred by the firm, leading to an understatement of profits.

The Strict Application of the Percent-Of-Sales Method to Prepare a Pro