Perhaps you’re seeking an investor for your firm and want to demonstrate your achievements compared to other organizations. Or maybe you’ve decided to estimate how productive your firm was last month compared to the previous one. Either way, you should learn how to estimate return on sales (ROS).
This parameter helps business owners to estimate the firm’s financial position and growth opportunities. Below, we’ll discuss the primary components of the ratio and how to evaluate it.
What is Return on Sales (ROS)?
It is a parameter that reflects the efficiency of transforming income into profit. ROS shows the share of revenue remaining after covering primary expenditures, including both manufacturing and indirect costs.
Return on sales is an optimal indicator to evaluate operational health because it contains all spending necessary to manage the firm: the cost of goods sold (COGS) and all indirect expenditures. A high or rising ratio signals effective management and a solid spending system.
Furthermore, the ratio shows stakeholders how many cents of income the firm retains for every dollar of earnings. If a firm has a ROS of 15%, it means 15 cents of every 1 USD in commercial activity is operating income.
It is critical to distinguish between return on sales and other parameters, such as return on equity (ROE). ROS evaluates operating profit relative to revenue, while ROE measures profit in relation to partners’ investment. The distinction between gross profit vs ROS is that the former is evaluated based on gross margin, while the latter is estimated considering total earnings.
Why ROS is Important for Businesses
ROS is a critical parameter that pinpoints valuable facts about a firm’s position. Below are several reasons why you should analyze this indicator.
- Assessing the performance. Return on sales demonstrates how effectively management controls expenditures in relation to profit. A high or rising ROS confirms the firm is effectively keeping its spending low and maximizing its return on commercial activity.
- Comparing profitability across intervals or other organizations. Management can track return on sales quarter by quarter to identify trends. A declining ROS indicates a drop in operating activity. You may also compare the productivity of other firms in the same field. ROS gives a more accurate picture than gross sales alone.
- Supporting pricing, investment, and sales planning decisions. ROS provides useful information that helps make essential decisions. A low return on sales ratio means that prices are set too low and do not cover spending. A parameter also enables the analysis of the success of past investments.
- Demonstrating to potential partners and interested parties the real situation. ROS is crucial information for all parties interested in a firm’s stable activity. Management utilizes such a ratio to set operating goals and analyze performance. Investors rely on it as a quick characteristic of a firm’s productivity. Lenders analyze this parameter to assess a firm’s ability to service its loans.
Do not forget that the ROS calculation relies on accrual accounting. It does not reflect the effectiveness of cash spending or the conversion of working capital into cash during the chosen period.
How to Find Return on Sales
The return on sales formula is based on two main components:
ROS = (Operating Profit ÷ Net Sales) × 100%
The parameter displays the money a firm earns after expenditures, but without paying off obligations.
Let’s study the primary stages to define the parameter.
- Define operating margin. We’re dealing with earnings before interest and taxes (EBIT). It is the firm’s residual income after deducting COGS and selling, general, and administrative expenses (SG&A).
- Define net sales. It is earnings excluding the deductibles, e.g., returns and discounts. The parameter displays your commercial proceeds and is typically reported on the income statement.
Once you have all the listed numbers, put them in the formula to define profitability. Let’s analyze the example.
Let’s imagine a firm’s earnings for the three months were $1,000,000. Expenditures for the specified interval were $400,000. How do we define ROS?
Let’s calculate the business’s net profit. We must subtract expenditures from proceeds: $1,000,000 – $400,000 = $600,000.
Divide profit by full revenue: ($600,000 / $1,000,000) × 100% = 60%. It means the organization gets 60 cents profit per $1 of sales.
Factors Affecting ROS
The return on sales doesn’t exist in isolation; several environmental and internal elements affect it. Recognizing these factors will enable you to boost productivity and make rational decisions.
- COGS efficiency. COGS is the direct spending connected with manufacturing commodities or services (materials, production labor). Reducing COGS directly boosts gross profit. It allows for increased revenue to cover operating expenditures and, consequently, enhances sales productivity.
- Day-to-day spending management. You should utilize expenditures such as wages, materials, and overhead to enhance profitability. Firms that implement a comprehensive cost management estimation approach and AP automation may boost commercial profitability and generate more considerable earnings.
- Pricing tactic and commercial volume. Improving procedures, cutting expenditures, and streamlining resource management are crucial to ensure efficiency. Efficient firms may control spending and maximize the value of every USD earned.
- Industry-specific benchmarks and market conjuncture. Firms in competitive industries face pricing pressure, which impacts their capacity to maintain significant profitability. Realizing market tendencies and adapting tactics may mitigate these problems.
Profitability metrics vary by area. So, SaaS businesses often demonstrate higher profitability than retail firms.
How to Improve Return on Sales
If you want to improve return on sales, think of it as an average performance indicator: the higher it is, the more successful your commercial activity is. Below, we’ll analyze several practices to enhance your ROS.
- Lower operating spending without changing quality. Examine your manufacturing procedures, supply chain, and cash flow statement to define cost-cutting opportunities without compromising quality.
- Optimize pricing strategies and product mix. Spending isn’t just a number. It demonstrates the price of your goods. You can explore various pricing algorithms that reflect the value of your commodities and the actual market conditions.
- Increase commercial productivity. Efficiency drives profitability. Optimizing commercial activities, from inventory control to client cooperation, helps decrease expenses and enhance customer satisfaction.
- Streamline commercial procedures and control spending. Create a plan to perform key internal processes (order fulfillment, invoicing, service) to define and eliminate bottlenecks. We recommend implementing and maintaining an internal control hierarchy to ensure strict accountability and prevent unnecessary spending.
- Track and adjust regularly based on performance data. Evaluate your return on sales as a continuous cycle. Track key performance indicators (KPIs), such as gross profit and the operating expenditures’ ratio, monthly. Compare your parameters with sector benchmarks and use this information to adjust pricing, spending levels, and operational strategies.
Remember that only motivated, qualified specialists can drive sales activity. You may invest in professional development to raise productivity and adopt innovative instruments.
Bottom Line
ROS allows business owners and counterparties to estimate the company’s efficiency. The parameter is necessary to define sectors for earnings increase and compare them with similar-sized firms.
BooksTime is ready to help you track critical parameters like ROS and make sound financial decisions. Estimating your return on sales and how to enhance it will enable you to retain more of your well-deserved money.
