Return on Sales: Definition, Formula, and How to Calculate It
Contents
Revenue is a key focus for sales.
Generally speaking, the more revenue your sales function generates, the healthier your business will be. You’ll be well-placed to grow your teams, invest in your product, and develop your workforce.
However, revenue is far from the only sales metric you need to be monitoring. You could be generating substantial revenues through sales, but still not turning a profit.
That’s where return on sales comes in.
Understanding Return on Sales
ROS (return on sales) measures the efficiency with which your sales are turned into profits, providing a valuable insight into how much profit you earn from every dollar of sales you generate. As such, it closely relates to a company’s operating profit margin.
Expressed as a ratio or a percentage, return on sales helps you understand the health of your company. If that percentage is increasing, your business is growing in a more efficient manner, whereas if it drops, the opposite is true – and substantial financial problems could be looming.
ROS can also be an effective way to assess your performance against your competitors. However, if you operate across multiple industries, it’s important to note that return on sales is only a helpful measure for companies within the same industry, as costs can vary widely from one to another. For instance, tech companies typically have low costs – and therefore achieve a very high ROS – while grocers tend to have high costs and lower ROS figures.
What Can Return on Sales Tell You?
Individual financial metrics only ever tell part of the story about the health of your business, and return on sales is no different.
ROS gives you a clear picture of how efficiently sales transform into profits, which in turn tells you:
- How efficiently you’re producing your core products or services
- How effectively your leadership team is running the business
By tracking ROS over time, you can easily understand whether your business is becoming more or less efficient, and therefore whether you need to tighten your belt or update your processes.
However, return on sales doesn’t tell you whether sales are increasing, where those sales are coming from, or what’s causing any inefficiencies – so as always, you’ll need to do some further digging to get the full picture.
How to Calculate Return on Sales
Clearly, ROS is important. You want to run an efficient business, so you definitely want your return on sales to head in the right direction over time. With that in mind, here’s how to calculate it.
Return on sales formula
The formula is relatively simple:
- ROS = (Revenue – Expenses) / Revenue
Now, let’s see how that looks for a business with:
- Revenues of $200,000
- Fixed costs of $60,000
- Variable costs of $50,000
In this instance, we’d start by adding up the different expenses:
- $60,000 + $50,000 = $110,000
Now, we can subtract those expenses from the top line to calculate the return on sales, as follows:
- $200,000 – $110,000 = $90,000
- $90,000 / $200,000 = 0.45
In other words, this business generated a return on sales of 45%, meaning it earns 45 cents from every dollar sold.
That sounds pretty good – generally speaking, a “decent” ROS is anything over 5%. However, if this business happens to be in an industry with extremely low costs and high revenues, it may simply be average (or even below-par).
What’s the Difference Between ROS and Operating Margin?
As we have already noted, return on sales and operating profit margin are tightly intertwined. However, they are not exactly the same.
As standard, operating margin is calculated by dividing operating income by net sales.
On the other hand, ROS is typically based on earnings before interest and taxes (EBIT). Because operating margins can vary widely for companies with different business models and in different industries, it can be confusing to compare them on an EBIT basis.
How to Improve Return on Sales
By this point, you understand how to calculate your return on sales. But what if you find your ROS is lagging behind that of your competitors? That suggests your business is not operating as efficiently as it could be, which means you need to take action. Here are some ways to improve it:
- Increase your product price: The most obvious way to increase your margins, and therefore make your sales more efficient, is simply to raise your prices. If you have a high-quality product with superb reviews and an excellent reputation, this is definitely worth considering. However, it will not be an option for every company, as it could leave you priced out of the market.
- Produce your product more efficiently: Another option is to make it cheaper to produce your product, such as by sourcing lower-priced materials or speeding up your processes so products can be built in a shorter space of time. However, this may have a knock-on effect on product quality, which could harm your sales down the line.
- Reduce the cost of selling your product: Perhaps you have a much larger sales function than your rivals, yet you are only selling a similar volume of products, meaning you are less efficient. In this case, you may need to reduce the size of your sales team. Again, this is not without its risks, as it could result in fewer sales overall.
Other Business Indicators
ROS is just one metric you can use to glean insights into the efficiency and financial performance of your business. There are dozens (or even hundreds) of others available, including these three:
- Return on equity: This metric defines how much profit a company has generated from its equity – or, in other words, its ability to earn money from the investments of its shareholders. It is also referred to as “return on net worth”.
- Return on assets: A calculation that examines the net profit of a company against the total value of the assets it holds, such as physical buildings, equipment, and intellectual property. As such, banks often use it when deciding whether to approve a loan.
- Return on capital employed: Another measure of efficiency, return on capital employed (ROCE), looks at the profitability of a company against the value of all physical assets that are used to generate revenue, such as factories, vehicles, and machinery. When the cost of capital is higher than the ROCE, the company is operating inefficiently and is not delivering adequate value for shareholders.
Conclusion
Return on sales is a valuable metric that can inform a wide range of actions.
Having calculated your ROS, you might decide to make changes. You might review your prices, increase or decrease the size of your sales force or product team, or reduce your production costs.
These are key decisions that can have a huge impact on the future of your business, so it’s vital you have the necessary data to back them up.
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