Return on Sales Ratio: Formula, Definition & Calculation Guide
You’ve probably heard the term ‘Return on Investment’ before, especially in reference to measuring sales success. While ROI is the most popular buzzword used for measuring business returns, it’s not the only metric you need to know.
Today, we’re focusing on the Return on Sales ratio. We’ll review how it compares to other ratios like ROI and ROE, why it’s important, how to calculate it, and how to use it as part of your sales process.
What is Return on Sales Ratio?
Return on sales, or ROS, is calculated by dividing operating profit by net sales to track profit in relation to sales volume.
This financial ratio indicates how much overall revenue is profit and how much is operating income, being used to pay down operating costs. Therefore, ROS is a statistic you’ll want to keep an eye on. It's related to the ‘net sales’ metric, which examines revenue after expenses are paid.
Put simply, ROS is a measurement that describes how efficiently a company turns sales into profits, and how the company’s operating profit (after operating expenses are removed) compares to total sales revenue.
Calculating the return on sales ratio helps companies identify and determine the logic behind the overall sales strategy and budget. ROS ratios don’t simply rise when more products and services are sold; instead, they gain traction when your organization increases its operational efficiency.
Return on Sales vs. Return on Investment
As mentioned, return on sales is just one of the important ratios used to measure a company’s success. Return on investment (ROI) is another metric, and probably one you’ve heard of frequently.
As the name suggests, ROI is the ratio of net income against the dollars spent to generate that income. It is typically used to evaluate the effectiveness of a specific marketing or sales initiative.
While both involve the net income within a fixed period of time, they measure different things and have unique purposes.
Return on Sales vs. Return on Equity
Similarly, Return on Equity has a different purpose than ROS. Return on Equity (ROE) reflects a company’s net income vs. its shareholders’ equity.
As opposed to tracking sales or invested dollars in specific sales and marketing initiatives, this metric demonstrates the profitability ratio for the company’s investors, who are typically interested in a more efficient operation, as reflected in an excellent operating profit margin, higher returns over time in total revenue, and growing net profit margins.
ROS, on the other hand, aims to measure the impact of sales on overall company revenue, not just shareholder's equity.
How to Calculate Return on Sales Ratio
The return on sales ratio is calculated by dividing operating profit by net revenue, and it's presented as a percentage. The return-on-sales formula is as follows:
Return on Sales (ROS) = Operating Profit / Net Sales Revenue
When using a company income statement, the formula can be drilled down to:
Return on Sales (ROS) = (revenue - expenses) / revenue
Let’s say you’ve just closed out your second-quarter accounting books and see the following data:
- Total Sales Revenue = $300,000
- Total Expenses = $210,000
- Operating Profit = $300,000 - $210,000 = $90,000
- Return on Sales (ROS) = $90,000 / $300,000 = 0.30 or 30 percent
In this scenario, for every dollar in sales revenue you bring in, 30 percent is profit.
ROS Example 1: Spacely’s Sprockets
Here’s how ROS works in practice. Say there is a startup company called Spacely’s Sprockets. This new company has hit the ground running and is the first true competitor to industry leader Cogswell’s Cogs. Sales have been outstanding, bringing in $500,000 in the first quarter. This is much more than Mr. Spacely anticipated. He had to bring in extra staff and pay overtime to employees (like George Jetson) to meet these demands. This lowered operational efficiency and meant that the total expenses for the quarter were $460,000, leaving a net profit of only $40,000.
The Return on Sales for this quarter is $40,000 / $500,000 = 0.08 or 8 percent.
The company made a profit of just eight cents on every dollar of sales it brought in—not a very impressive return.
ROS Example 2: Cogswell’s Cogs
During the same period, Cogswell’s Cogs knew that the entry of Spacely’s Sprockets into the market meant they needed to adjust operations, so they pushed their sales team, and delivered on new enterprise contracts. They also cut anticipated operational expenses by delaying the launch of a new initiative during the same quarter.
This frequently improves the efficiency ratio part of ROS. Improving the efficiency ratio changes only the numerator of the ROS ratio; the total sales revenue stays the same, but net profits increase.
Even with Spacely’s launch, their total sales during the first quarter were $600,000 and expenses were just $400,000, making a profit of $200,000.
The Return on Sales for this quarter is $200,000 / $600,000 or 0.33 or 33 percent.
If these companies were to just look at overall sales, they might not see the true impact and return of their sales efforts.
Are EBITDA / EBIT Better than ROS?
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and EBIT (Earnings Before Interest and Taxes) sometimes provide a slightly more accurate description of a company’s value than other calculations can.
These formulas remind analysts that the metrics provided don’t take into account additional adjustments, such as funds set aside for interest expenses, income taxes, or the other factors a ratio analysis fails to consider.
EBITDA is sometimes used as a proxy for ‘operating cash flow’ because it excludes non-cash expenses, such as depreciation. But EBITDA does not equal cash flow, since it doesn’t adjust for any increase in working capital, or account for capital expenditures needed to support production.
In some cases, tracking these numbers in addition to ROS makes sense—depending on your company. When comparing your company to a similar company in the same industry, ROS works well.
What is a Good Return on Sales Rate?
When calculating and tracking ROS, always remember that any positive ROS is a good start. The first time you calculate ROS, you’re establishing a benchmark or comparison ratio.
Generally, a higher ROS indicates that a company is generating a higher profit from sales. But on average, what is a good ratio for return on sales?
That number can depend on industry, but typically, an ROS of between 5 to 10 percent is excellent for most businesses. Of course, if your industry average is 15 percent—you'll want to aim above that number.
The problems arise when you have a decreasing ROS. This signals decreasing profits and can be caused by a variety of factors (including rising product or employee costs, reduced operational efficiency, and so on.) Obviously, in general, you want an upward trend in your ROS—which is why you need to monitor and optimize.
How to Use Return on Sales Data
Return on sales data can be incredibly useful in determining company profitability and healthy, scalable growth. Here are a few productive ways companies use ROS:
- Use the ROS value to compare your company’s performance with a competitor, if the competitor is in the same industry and same scale as you. For example, comparing a small independent hardware store’s ROS to Home Depot's is a poor comparison—it just isn't relevant.
- Compare the ROS value from one reporting period over another. But first, figure out the best periods to compare. You may wish to compare successive months during consecutive peak sales months. Or, if your industry’s sales experience seasonal peaks, consider year-over-year comparison months.
- As your ROS increases, the company’s profitability will increase as well. This means that more of the revenue coming in has reinvestment potential as you add new products and services and grow the company overall.
Example: Effectively Using ROS Data
Let’s revisit our example above.
At Spacely Sprockets, the company’s investors and stakeholders were initially excited about the dollars brought in during their first quarter. But in reviewing Q1 financial statements, they noticed those impressive sales figures were overpowered by production costs.
The board tasked Spacely with doubling the ROS ratio from 8 percent to 16 percent in the next quarter. To make this work, they’ll need to reduce operating expenses— and of course, increasing sales revenue at the same time wouldn’t hurt. After a quick brainstorming session, Spacely decides to do the following:
- Hire highly qualified, highly efficient sales reps, provide training to those who could benefit, or provide job reassignment to those who aren’t fit for the role.
- Identify and remove unnecessary or duplicated work processes.
- Source high-quality materials at better rates for product manufacturing.
The next quarter, Spacely’s total revenue from sales dropped to $400,000, but the lean workforce and operating processes cut overall operating costs to $325,000, resulting in a ROS ratio of 18.75 percent. The board is happy and pushes Spacely to stay on track and get the ratio to 20 percent by next quarter.
How to Improve Return on Sales Ratio
We’ve talked about how a 1980’s cartoon character successfully increased his ROS—but how do business owners do it in real life? Good news. There are several ways you can improve the return on sales ratio for your company:
- Review ROS over several months, analyze profit trends (growing or declining), and look for ways to stabilize them.
- Use ROS to determine if there are more sales on less profitable products, then prioritize the sale of items with higher gross profit margins.
- Increase prices while maintaining or lowering the cost of production and core operations.
- Reduce the cost of goods by looking for discounts, new vendors with better pricing, or less expensive supplies.
- Drive sales revenue and cash flow by pushing sales reps, marketing teams, and customer support agents to shorten the sales cycle, increase quantity, and drive upsells.
- Analyze business operations and reduce non-operating activities.
- Add ROS to the key metrics you review regularly.
And finally, consider using a robust CRM like Close to improve your sales team’s efficiency. We’ll help you cut operational costs while boosting sales potential.
