How to calculate return on sales

Each sale is carried out for the same purpose – obtaining financial profit. At the same time, sometimes companies are faced with the fact that they receive a decent income, but there is no sense in it – almost the entire amount is spent on expenses. Just in order to see and understand what exactly is causing losses to a business, you need to track the return on sales indicator. Without it, it is impossible to give an objective assessment of the effectiveness of business investments and company profits. In this article we will look at what return on sales is, how to calculate and increase it.

What is return on sales

Return on sales (ROS) or return on sales ratio is a financial indicator that reflects the ratio of profit from goods or services sold to the company’s revenue for a certain period of activity without taking into account taxes. Simply put, it shows the profit that the organization receives from each hryvnia earned and is measured as a percentage. For example, a profitability of 35% tells us that the company received 35 kopecks of profit from 1 hryvnia of revenue.

Calculating ROS helps to understand how efficiently an enterprise operates and what actions need to be taken to increase its profitability. For example, if the indicator is negative, this indicates that the business is operating ineffectively.

There is no one standard return on sales indicator for all companies. It is different for every business. And the figure that will be low for one enterprise may be high for another. Therefore, it is more correct to control profitability only in your company, monitor dynamics, analyze the reasons for changes, and based on this, take the necessary measures.

Why determines profitability

1. For an objective assessment of the pace of business development. If the indicator decreases, then the company is missing out on profits (although revenue may increase). In this case, you need to urgently take action (reconsider the correctness of the business process management strategy or pricing policy).
2. For cost recovery analysis. Gives an understanding of whether the enterprise is unprofitable or whether it can be invested and developed.
3. To evaluate the performance of sales managers. If there were various problems in their work (conflict situations or long processing of applications), then it is likely that ROS could decrease because of this.
4. By comparing indicators for individual periods, it is possible to draw conclusions about business performance over time.
5. To verify correct pricing and investment capital analysis. This will help you understand what is currently going wrong in the company and what needs to be fixed.

What affects profitability of sales

There are many factors that influence profitability, but the main ones include revenue and expenses. Let’s look at each in more detail.

Revenue. Sometimes people confuse these concepts. Revenue is the amount for which the company provided services or sold goods. Profit is the amount that remains in the company from revenue after all necessary expenses. Fluctuations in revenue determine the size of a company’s profit.

• If revenue grows and expenses remain the same, ROS also increases.
• If revenue decreases but expenses remain unchanged, ROS also decreases.

Calculated using the formula:

Revenue = Expenses + Profit

It happens that there is revenue, but no profit. Let’s look at an example:

Pavel has an online store for children’s backpacks. In a month he sold 30 backpacks for 1000 UAH. His revenue is 30,000 UAH. And expenses for employee salaries, advertising, taxes and the purchase of goods in the same month amounted to UAH 35,000. It turns out that there is revenue, but no profit. On the contrary, the loss for this month is UAH 5,000.

Expenses. They have a direct impact on return on sales. When expenses exceed revenue, ROS decreases. To better track and analyze them, they are divided into the following types:

• These include: salaries of personnel (those who take part in production), utilities, rent, costs of materials, raw materials and communications.
• This group includes: salaries of administrative staff, office, software, services of financial institutions, expenses for expert advisory services (if required).
• This takes into account: expenses for advertising and promotion, salaries of sales staff.

If you calculate expenses all together, without distinguishing between them, it will be difficult to determine the reason for the change in the profitability indicator. That is why they are counted in these three groups, and then the results are evaluated, the cause is identified and subsequent actions are taken.

How to calculate profitability

There are several types of ROS and each has its own calculation formula. Now let’s look at each of them in detail.

Net profit margin

It shows the overall performance of the business. With its help, they plan revenue for future periods.

Calculated using the formula:

Net profit ROS = Net profit / Revenue × 100%

Net profit is the amount that the business brought in after all expenses (taxes, interest on loans, depreciation).

Example:

The online book store earned 100,000 UAH in a month. Expenses amounted to 80,000 UAH. Net profit = 100,000 UAH – 80,000 UAH = 20,000 UAH. ROS = 20,000 UAH / 100,000 UAH x 100% = 20%. That is, the store receives 20 kopecks of profit from every hryvnia earned.

Profitability by marginal profit

It shows the efficiency of a business’s variable expenses.

Calculated using the formula:

Marginal profit ROS = Marginal profit / Revenue × 100%

Contribution margin is the profit a business makes minus variable costs (raw material purchases, shipping costs, and supplies). Shows the amount that the company received from the sale of the product.

Example:

The ROS for the marginal profit of the flower shop in February was 21%, and in March it fell to 20%. This means that the store’s variable costs have increased. For example, the supplier raised the price of flowers. To return to the previous profitability, you can either increase the price of flowers or switch to another supplier.

Gross profit margin

It shows the effectiveness of a separate direction of the company or a separate branch in the network.

Calculated using the formula:

Gross profit ROS = Gross profit / Revenue × 100%

Gross profit is the profit that a business brings minus production costs (costs of manufacturing goods, packaging, salaries of employees involved in these processes). Shows the amount the company received without the cost of the product.

Example:

The store sells handmade chocolates and cakes. Revenue from the sale of chocolate – 80,000 UAH, gross profit – 30,000 UAH. Revenue from the sale of cakes is 110,000 UAH, and gross profit is 40,000 UAH. ROS for gross profit from the sale of chocolate: 30,000 UAH / 80,000 UAH x 100% = 37.5%. ROS for gross profit from the sale of cakes: 40,000 UAH / 110,000 UAH x 100% = 36.3%. It turns out that the store gets more revenue from selling cakes, but profitability is higher when selling chocolate. This shows that fewer resources are spent on the production and sale of chocolate, which means that this area works more efficiently.

Operating profit margin

It shows whether a business is using its resources effectively to generate profits.

Calculated using the formula:

Operating profit ROS = Operating profit / Revenue × 100%

Operating profit is the profit a business makes after variable and fixed expenses (all costs of selling a product). If the operating profit margin for the month has decreased, then for every hryvnia of profit, material or personnel costs increase.

Example:

The coffee shop sells coffee, tea and cakes. Revenue for the month – 600,000 UAH. UAH 280,000 was spent on food, UAH 210,000 was spent on utilities, rent and salaries. Operating expenses = 280,000 UAH + 210,000 UAH = 490,000 UAH. Operating profit = 600,000 UAH – 490,000 UAH = 110,000 UAH. ROS for operating profit = 110,000 UAH / 600,000 UAH x 100% = 18.3%.

How to analyze profitability indicators

The profitability of sales needs to be analyzed constantly, so you will see the dynamics. The periods must be taken the same (month, quarter, half-year, year). The most correct solution is to calculate this indicator for all of the above types. This will help make it easier to find the strengths and weaknesses of the business.

Consider the following factors during your cost-benefit analysis:

1. A low indicator indicates that mistakes were made in the company’s pricing policy and that it currently has an incorrect competitive position in the market. Sometimes enterprises deliberately adhere to such a policy in order to take a higher position, displacing some of their competitors.
2. If ROS is constantly decreasing, this indicates that it is necessary to reduce costs, change the product range, or remove from sales those goods that do not generate income. It will help you a lot in this process. A/B testing, with the help of which it will be easier to make decisions about changes.
3. If sales volume is increasing but profitability on sales is stagnant, this is a sign that non-manufacturing expenses are too high.
4. A high ratio shows that a company effectively manages costs, has a strong pricing strategy and low costs for providing services or manufacturing goods.

Quite often, large companies with a large range of products or services have lower ROS than smaller businesses. This is also considered the norm.

There is such a gradation of profitability of sales:

• 1–5% – low efficiency;
• 2–20% is the average ratio, which allows the company to operate stably;
• 20–30% is a high result.

Reasons for low profitability

Low ROS can be caused by two reasons:

1. Falling prices. If your business operates in a highly competitive environment and you simply need to keep up with competitors who periodically reduce prices, then this option is quite possible. In this case, expenses do not change, and the company earns less. Accordingly, profit also decreases, and with it the profitability of sales.
2. Rapid growth of the company. If an organization experiences sharp growth, but business processes remain at the same level, then the ROS ratio may drop. At this point, the business becomes less manageable and requires a lot of resources to function. It turns out that with a slight increase in revenue, expenses increase significantly, which leads to a decrease in profitability.

We looked at two main reasons for the drop in the indicator, but there are many more. A low ratio should not be perceived as normal, therefore, if it falls or remains at a low level for some time, it is imperative to take measures to increase it.

How to increase your sales profitability

There are many ways to increase profitability, but you need to choose the one that suits your business. There are the following methods to increase ROS:

1. Sales funnel control

If at every stage sales funnels there will be more potential customers, then there will be an opportunity to make more sales at constant costs. The result is increased profitability. You can, for example, make a new sign for a store, update product cards in an online store, find new advertising platforms (which will bring better results), or come up with an improved script for communicating with customers for employees.

2. Increase in prices for goods or services

Even if you raise the price just a little, this will already improve the financial position of the company. But before increasing, be sure to study competitors’ prices for the same products so as not to provoke an outflow of customers. And in order not to cause a negative reaction from customers to price increases, you can warn about upcoming changes and offer to make purchases at the old prices with a small discount or free delivery of goods for a certain order amount.

3. Cost control

You need to conduct a cost analysis and determine where your business can save money without compromising the quality of the product. This includes costs for logistics, rent, labor costs, and costs for raw materials.

4. Changing the discount system

The higher the discounts, the lower the profitability, so they need to be applied wisely and consciously, understanding what result you want to achieve through discounts. For example, you can introduce a temporary discount to attract new customers. If the results of such an action are successful, then it can be repeated in the future.

5. Staff motivation

If employees are motivated, it affects their performance, which affects ROS. Therefore, do not forget about bonuses, bonuses, education and training at the expense of the company and other methods of motivation. If one of the employees does their job poorly or slows down the process, then this issue should also be resolved.

6. Process automation

You can analyze all business processes and identify those that require a lot of resources to complete. For example, the implementation of a CRM system will help save employees’ time filling out the database and creating contracts and documents. It can be used to make upsells.

7. Launch of advertising

If your ROS rate has decreased due to decreased sales, you need to make changes to your marketing strategy. Competent business promotion will solve several problems at once: increase brand awareness, increase sales and improve relationships with customers.

To summarize

Sales profitability is one of the main and main performance indicators of any company. Its analysis makes it possible to evaluate the efficiency of business activities, sales mechanisms and new technologies introduced into the organization that affect work processes. By constantly monitoring changes in the profitability ratio, you always keep your finger on the pulse, and this allows you to make decisions necessary for the company in a timely manner.

Olha Tyshchenko

Editor

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