Sales are the ultimate source of revenue for any company. They can quickly change a business’ fortunes and make it a world-beater.
An example is Tesla, the carmaker that won the race to a $1 trillion market cap ahead of mainstays Toyota and Volkswagen.
This achievement can be credited to multiple things, but at the heart of it is a steady year-on-year increase in sales.
But is it enough to boost sales in isolation?
There's a catch — the expenses incurred to make these sales.
You could be making sales worth $1 million, but if expenses add up to the same amount, the business won’t be left with much profit.
This post will explain the Return on Sales formula and how to calculate the real impact of revenues coming in from sales.
What is return on sales?
So, what is ROS, or return on sales?
Return on sales is a financial ratio used to gauge how effectively a business transforms sales into profits.
Companies incur costs to produce and sell commodities. Any business will want to get more gross revenues, but real growth depends on their profit.
The Return on Sales formula tells how much company revenue is used to pay for business operations and what remains as profit. As your business grows, you’ll want to try to improve your return on sales ratio because the higher it is, the more profitable your business is.
How do you calculate return on sales?
The Return on Sales formula is as follows:
Divide operating profit by sales, and express it as a percentage.
Let’s look at some examples so that we can see the formula in action.
Example 1: Company X makes $100,000 in sales and spends $80,000 in expenses for a particular quarter. What's their return on sales?
First, we’ll calculate operating profit, which is sales minus expenses. Company X got $20,000 in operating profit.
Next, we’ll divide operating profit by sales — $20,000 by $100,000 to give 0.2. We have to express this ratio as a percentage by multiplying 0.2 by 100 to give us 20%.
Company X’s return on sales for that quarter was 20%.
Example 2: Company Y makes $50,000 in sales and spends $30,000 in expenses for the same quarter. What's their return on sales?
Following the same procedure, we'll calculate the operating profit. Sales of $50,000 minus expenses of $30,000 gives $20,000 in operating profit.
We’ll divide operating profit, $20,000, by sales, $50,000, to get 0.4. Expressing this ratio as a percentage gives a return on sales of 40%.
These two examples illustrate how to calculate return on sales. The results tell the true story behind revenues generated by a business.
Company X generated a lot more in sales but spent more on expenses. Company Y generated half in sales compared to Company X but spent less on expenses.
Both companies had the same operating profit, but Company Y had better operational efficiency despite their low sales turnover.
Businesses can implement various initiatives to make more sales, but they'll only have a meaningful impact if the return on sales ratio is good. Companies need cash flow to grow, and profits are a reliable way to get it.
As you increase sales, focus on ways to improve operational efficiency so that your business achieves a healthy return on sales.
What is the difference between return on sales and profit margin?
Return on sales and profit margin are used interchangeably in some quarters. This is half true, as profit margin is a broad metric that can be broken down into three different types.
Only one of the three types of profit margin is similar to return on sales.
Gross profit margin
This ratio compares sales revenue to the cost of sales. It's calculated first on the income statement. The cost of sales depends on a company’s business model and the inputs needed to get goods and services to the market.
It shows how effectively a company is producing goods or services.
To calculate it, divide gross profit by total sales.
Here, gross profit is total sales minus the cost of goods sold.
Operating profit margin
This is similar to return on sales. It's calculated second on the income statement.
Operating margin is what a company earns from its business. In addition to the cost of sales — deducted first in the income statement to obtain a gross profit — other expenses that are deducted from sales to obtain it are:
- Sales, general and administrative expenses
Note; Operating profit is also called EBIT(Earnings Before Interest and Tax)
Net profit margin
This ratio compares net profits and sales. It's also known as the rate of return on net sales and is calculated last on the income statement.
To calculate it, divide net profit by sales.
Net income is money that remains after a business deducts ALL expenses. It sits at the bottom of the income statement and is calculated by deducting the following from operating profit:
- Interest expenses for outstanding debt
- One-off expenses like the purchase of an asset
The difference between gross, operating, and net profit margins lie in the different points on the income statement where the amount of profit is calculated.
The sample financial statement above shows how deductions are applied to total revenue to give gross, operating, and net profit. These are what are used to compute the three profitability ratios.
How can you improve your return on sales?
While all industries have different ROS percentages, the bottom line is that a higher ratio signals better business performance. This way, any business should strive to increase its return on sales through the following recommendations.
Increase product price
This is the most straightforward way to increase ROS.
However, it isn't the easiest as it can backfire. A lot goes into product pricing, and simply increasing them might not be the best option. It also depends on the industry and products/services your business sells.
In a highly competitive space, increasing product prices without any justification will push customers to the competition. Customers are always looking to save money, and they won't buy from your business if prices elsewhere are favorable.
If circumstances allow, increasing product prices will boost your return on sales. You'll make more in sales, and get more operating profit.
Example: Company X made $100,000 in sales by selling 1,000 units of a commodity worth $100, with operating expenses of $80,000. What will be their new ROS if they increase product prices by 5%?
A 5% increase in price means the goods are now available at $105. Selling 1000 units of this gives a sales revenue of $105,000. The new operating profit will be $25,000.
Using the Return on Sales formula, we divide $25,000 by $100,000 to give 0.25. This is 25% ROS, 5% higher than the initial 20%.
Reduce operational and production costs
This technique applies to the other part of the ROS formula — expenses. Lesser expenses will yield more operating profit for the same amount of sales.
Example: Company X makes $100,000 in sales with lower operating expenses of $60,000. What's their new ROS?
From the Return on Sales formula, operating profit will be sales minus expenses, giving $40,000. Dividing this by sales gives 0.4, 40% when expressed as a percentage.
It isn't easy to implement initiatives that will reduce costs significantly within a short timeframe. However, strategic initiatives can help cut them in the long run.
Simply increasing sales volume will give your business more money. However, it won’t improve your organizational efficiency, which scales with the business.
As your business grows, identify and remove inefficiencies early on as they can grow as well and become too big to handle. This will improve your ROS and get you more profit per unit sale.
What are some of the limitations of the Return on Sales formula?
Return on sales is a good business metric to measure operational efficiency, but it isn't perfect. It has a few limitations that can cloud the insight it gives.
1. It's niche-specific
Return on sales cannot be used to compare two companies across different industries.
Different business models dictate the nature of operations and expenses for any company, and they can vary wildly.
A simple reselling business where one buys goods and sells them has lower operating costs than a technology company that has a lot of inputs going into their final offering.
Context is key when using ROS to compare your company’s performance against others.
Here are a few ROS values per industry as recorded recently:
- Agricultural production crops: 1.7%
- Oil and gas extraction: – 47.7%
- Food and kindred products: 5.2%
- Furniture and fixtures: 2.6%
- Printing, publishing, and allied industries: –1.2%
- Industrial and commercial machinery and computer equipment: 3.6%
- Transportation services: 3.3%
- Wholesale trade-nondurable goods: 0.2%
- Eating and drinking places: – 2.4%
- Real estate: 12.4%
Note: These values are the median ROS values recorded by companies in that niche.
Notice the negative ROS values for some industries.
Some industries have a lot of expenses and record year-on-year losses, despite still holding their pedigree as global companies. An example is Uber.
The company’s revenue model is structured in a way that it continually makes losses despite year-on-year growth in other aspects. You cannot compare such ROS with your business unless it has the same model.
2. It can be bad for new businesses
Newly incorporated businesses have to invest a lot of money to catch up with others that have been operating for some time.
They have to buy assets, fund more marketing campaigns, and experiment with different channels to know what works and what doesn't. As such, the operation costs and expenses for a newly incorporated business are often high.
Using the Return on Sales formula to analyze these companies’ health can be misleading. Low ROS can demotivate business leaders and make them forget that some of these operating expenses will yield returns in the long run.
For instance, small businesses take time to build a loyal customer base and have to spend more on customer acquisition. Once they gain a solid base, the priority will be retention, which is often lower than acquisition.
3. It can be too simple
The Return on Sales formula compares sales and operating profit.
However, a lot more things can be used to gauge a business besides these two. As such, the ROS formula is too simplistic to accurately describe the big picture regarding how a business is performing.
This is why the ROS formula is often used with other metrics to tell the full story.
External business factors that are out of any business control aren't factored in. Some of these factors affect sales and operating expenses. The formula assumes everything else is constant, which isn't true for any business.
Actionable insights from the return on sales
Businesses can derive a few insights from their return on sales.
Return on sales can help gauge how a business fares against the competition. In a specific niche, companies with a better ROS often have a competitive edge.
You can also compare your ROS against industry benchmarks. If it’s lower than the benchmark, implement some initiatives to increase it. The benchmark should be the minimum threshold that any high-performing business should aim to hit.
By comparing your ROS for a long time, say five years, you'll understand if the business is improving or not. A year-on-year increase in ROS improves a company's profitability since expenses are managed well.
Business owners can benefit a lot from the Return on Sales, as it shows them how the business is performing. However, it isn't a perfect business metric, and businesses should be wary of its limitations.
If you employ measures to manage expenses and increase sales, the business will have a better return on sales and get higher returns. A popular way to improve sales is through promotional marketing.
Take a minute to check out CouponFollow for some inspiration on everything coupons for your next promotional campaign to boost sales.