Return on Sales

What is Return On Sales?

Return on sales (ROS) is a measure of profitability and operational efficiency. It assesses how much operating profit (earnings before interest and taxes) a company makes from every dollar of its net sales. To calculate ROS, divide the company’s net operating income by total sales revenue for a given period.

ROS is closely related to operating profit margin. A high ROS (at least 5% to 20%) indicates the company is functioning efficiently enough to turn a sustainable profit. On the other hand, a low ROS (below 5%) indicates that the business isn’t making enough money from each sale to stay afloat long-term.

Increasing return on sales requires businesses to focus on improving business results through efficiency. They can accomplish this through reducing costs, improving pricing strategies, finding more profitable revenue streams, or negotiating better terms with suppliers and vendors.

Synonyms

• ROS
• Operating margin
• Operating profit margin
• Operating income margin
• EBIT margin

Importance of Measuring Return On Sales

Return on sales is one of the most important financial ratios. Increasing return on sales (that is, profitability) means earning more revenue without having to invest extra in customer acquisition. This in turn helps businesses grow faster and increase their market share.

For investors, return on sales is an important factor to consider when evaluating the potential of a company. In fact, it’s usually one of the first metrics they’ll consider. Whenever a founder talks about their total sales or revenue, the follow-up natural question is, “How much of that does the business keep?”.

A high ROS indicates that, compared to its competitors, the company is able to keep more of its revenue and is therefore more profitable. Lower ROS can mean the company is over-spending on marketing or production, or has too much debt. That’s why, in many cases, it’s an indicator of future success for both investors and shareholders.

Profit margins aren’t the only indicator of busienss value. There are many companies (including grocery stores, airlines, and car dealerships) that operate with low return on sales. Several well-known companies aren’t “profitable” at all — Uber’s operating margin between 2018 and 2022, for example, was -29%, -66%, and -44%, respectively.

How to Use Return On Sales to Improve Sales Performance

While the return on sales metric is crucial, it isn’t super valuable beyond comparisons to direct competitors of the same size using similar business models. Since operating profits are just one indicator of future value (and they vary wildly from industry to industry), return on sales is best used as an internal metric businesses can use for benchmarking purposes.

Here are some of the ways businesses can use ROS to improve sales performance:

• Conducting internal trends analyses to understand revenue growth from one year/quarter to the next
• Evaluating current pricing strategies and adjusting them to maximize profitability
• Reevaluating costs associated with production, marketing, overhead, etc. to identify areas for improvement
• Tracking changes in customer acquisition cost (CAC) over time to ensure the company is spending wisely
• Identifying products/services that are more profitable than others
• Finding ways to negotiate better terms with suppliers or vendors.
• Benchmarking business performance against direct competitors, industry averages, or best-in-industry.

Suppse Company A has a return on sales of 7%. This means that for every $1 the company makes in net sales, it keeps seven cents as profit. If Company A can identify and reduce costs associated with overhead, marketing, production, customer acquisition, etc., they can increase their ROS.

Limitations of Measuring Return On Sales

While return on sales is a helpful metric for understanding profitability and efficiency, it can be misleading in certain situations.

• Companies with a high return on sales could have low overall operating profits if their sales are too small.
• Non-operating expenses like taxes and interest aren’t considered in the calculation. These can play a huge role when evaluating businesses across state lines or multinational organizations with different areas of operation.
• Subscription-based businesses (e.g., SaaS) often have high ROS compared to a retailer because their costs of selling are considerably lower, especially if it’s a remote company versus a brick-and-mortar retailer.
• Companies may have significantly lower ROS if they’ve invested heavily in long-term projects or initiatives that require high upfront investment (e.g., R&D).
• A business may have high ROS thanks to effective pricing strategies and low production costs, but low customer retention. If customers are not sticking around, it’s not a sustainable business model since new customer acquisition is expensive and less profitable than repeat sales from existing customers.
• High-growth tech startups often prioritize growth over profitability in their early years. They reinvest a significant portion of their revenue and investment capital into marketing, innovation, and talent acquisition. While this leads to a low (or negative) ROS, these investments aim to accelerate growth and capture market share, ultimately generating greater profits in the future.
• Mature and stable industries like utilities and real estate may exhibit a high ROS. These sectors necessitate significant initial investment but can generate substantial revenue with low operating costs, resulting in a higher ROS. However, their growth potential is limited due to market saturation and the nature of their business.

How to Calculate Return On Sales

The steps to find your return on sales ratio are as follows:

1. Find ‘Net Sales’ on your income statement (this could also be listed as ‘Revenue’).
2. Find ‘Operating Profit’ (this could also be listed as Earnings Before Interest and Taxes [EBIT] or Operating Income).
3. Divide Operating Profit by Net Sales to get your return on sales percentage.
4. Multiply by 100.

Return On Sales Formula

The formula for return on sales is as follows:

(Operating Profit / Net Sales) x 100

To illustrate, let’s look at Company A again. Let’s say their revenue from sales is $100,000 and their operating costs are $70,000. Since they spend $70,000 in the time it takes them to earn $100,000, their return on sales is 30%:

(30,000 / 100,000) x 100 = 30%

What does a high ROS mean?

The higher the ROAS percentage, the more profitable a company is. If Company A’s director competitor, Company B, earns $60,000 in sales revenue but its operating costs are only $15,000, Company B would have a return on sales of 75%:

(45,000 / 60,000) x 100 = 75%

In this example, Company B is much more profitable than Company A. It may be a good idea for Company A to evaluate its pricing strategies and operating costs in order to increase its profitability.

What is a good return on sales?

A return on sales between 5% and 20% is considered good in most cases. But considering the limitations of using the ROS formula, there’s no definitive answer to what constitutes ‘good.’ ROS ratios, operating expenses, and margins naturally vary wildly from industry to industry.

Even in the hypothetical example above with two director competitors — Company A and Company B — limitations still exist. If Company B wanted to scale from five to six figures in revenue, that difference of just $40,000 could require additional investments in overhead, marketing, research and development, and staffing costs.

This could drastically reduce Company B’s return on sales ratio. There’s no way to know for sure, which is why companies should focus primarily on incrementally improving their ROS over time. Worrying too much about another organization’s ROS or an industry standard could lead decision-makers to be misinformed.

Tips for Increasing Return On Sales

To increase return on sales is to increase profitability. Businesses become more profitable by operating more efficiently, retaining their customers, and finding better revenue growth tactics.

Here are 12 ways businesses can increase return on sales:

1. Focus on cost control and eliminating unnecessary expenses, especially overhead-related ones.
2. Renegotiate vendor and supplier contracts (e.g., larger price breaks or longer payment terms).
3. Streamline internal operations and eliminate human error through process automation.
4. Raise/lower prices or change the pricing structure to reach price optimization.
5. Adopt a recurring revenue model (if it makes sense).
6. Solicit customer feedback to pinpoint areas of your business model you can improve upon or adjust.
7. Reassess your marketing strategies to verify you’re getting the most value for your money, targeting high-value customers, and converting enough.
8. Invest in customer service initiatives like loyalty programs to improve customer retention.
9. Grow revenue within the customer base by incorporating upselling and cross-selling into your sales strategy.
10. Explore new sales channels or products/services that may offer higher margins than existing ones.
11. Slim down your product mix to only focus on higher-margin products.
12. Improve employee retention to reduce hiring and replacement costs associated with churn.

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