Return on Sales Ratio: Formula, Definition & Calculation Guide
You’ve probably heard the term ‘Return on Investment’ before, specifically 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.
For this article, we’re focusing on the Return on Sales ratio. We’ll review how it compares to other ratios like ROI, 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.
Closely monitoring 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 is related to the ‘net sales’ metric, which examines revenue after expenses have been paid.
Put simply, ROS is a measure that determines 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 a company identify and determi
ne the logic behind the overall sales strategy and budget. ROS ratios don’t simply rise the 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 I mentioned, Return on Sales is just one of the key ratios used to measure a company’s success. Return on investment is another metric entirely, and probably one you’ve heard of the most.
As the name suggests, ROI is the ratio of net income compared to the dollars spent to generate that income. It is typically used to evaluate the effectiveness of a specific marketing or sales initiative or team.
While both involve the net income in a fixed period of time, they measure different things and have other 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 shows 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 the 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 from sales. 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 first 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%.
In this scenario, for every dollar in sales revenue you bring in, 30% is profit.
ROS Example: Spacely’s Sprockets
Here’s how ROS works in practice. Say you own 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. Unfortunately, this is much more than Mr. Spacely anticipated. He had to bring in extra staff and pay overtime costs to employees like George Jetson to meet these demands. This lowered the operational efficiency and meant 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%.
That means that the company made a profit of just eight cents on every dollar of sales it brought in — not a very impressive return.
ROS Example: Cogswell’s Cogs
During the same period, W.C. Cogswell, president of Cogswell’s Cogs, knew that the entry of Spacely’s Sprockets into the market would mean he needed to adjust operations, so he pushed his sales teams, and they delivered on new enterprise contracts. He also cut anticipated operational expenses by delaying launching a new initiative during the same quarter.
This is frequently seen as improving 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 the net profit increases.
Even with Spacely’s launch, his total sales during the first quarter were $600,000, and expenses were just $400,000, making his profit $200,000.
The Return on Sales for this quarter is $200,000 / $600,000 or 0.33 or 33%.
If these companies were just looking at overall sales, they might not see the true impact 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) can sometimes provide a slightly more accurate description of a company’s value than other calculations.
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 named factors a ratio analysis fails to take into account.
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 baseline or comparison ratio.
Generally, a higher percentage of ROS indicates more profit a company is generating from sales. Here are a few ways companies use ROS:
- You can use the ROS value to compare your company’s performance with a competitor, ensuring that the competitor is in the same industry and same scale as you. For example, comparing your numbers to a bargain shoe company may not be relevant if you are a designer shoe company. Or comparing a small independent hardware store’s ROS to Home Depot or Lowe’s may provide a poor comparison.
- You can use the ROS value from one reporting period over another. It will take some figuring to determine the best periods to compare. For example, you may wish to compare successive months during consecutive peak sales months. If your industry’s sales go through seasonal peaks, consider looking at 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.
Making Use of Return on Sales Data
ROS data can be incredibly useful in determining company profitability and healthy, scalable growth. Let’s revisit our out-of-this-world 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 followed by production costs.
The board tasked Spacely with doubling the ROS ratio from 8% to 16% in the next quarter. To make this work, he’ll need to reduce operating expenses— 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 and highly efficient sales reps; provide training to those who could benefit from it; 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 his lean workforce and operating processes cut overall operating costs to $325,000, resulting in a ROS ratio of 18.75%. His board is happier and pushes him to stay on track and get the ratio to 20% the 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 that you can improve the return on sales ratio for your company. These include:
- Look at ROS over several months, analyze trends of growing or declining profits and look for ways to stabilize them.
- Use ROS to determine if there is a higher amount of sales on products that are less profitable than others, then prioritize the sales 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 sold 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.
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