What is Return on Sales (ROS) and how to calculate it
The main goal of sales is to generate financial profit. True, somewhere it can be millions of rupees, but somewhere only a couple of thousand. And it is not a fact that in the first case the business will pay off more - it depends on the volume of expenses. To understand exactly how effective these metrics are and how to correlate them correctly, a ROS calculation is used.
I will talk about what the return on sales is, what formula is used to calculate it, and what is it for at all.
Return on sales is...
... a ratio that shows how much a company receives for each unit of a product or service sold. The parameter is called Return on Sales, therefore the abbreviation is also available - ROS. This indicator does not reflect the profit in relation to the invested funds, but rather shows what is the percentage of profit from each earned rupee. To be more precise and expressed in formulas, this is the ratio of net income to total revenue.
Basic types of calculation
Depending on the scope of the company and the goals set, there are three main methods for calculating profitability:
- For goods and services. Here, for the calculation, the funds spent on the implementation of the project are taken, as well as the profit received from it. Such an analysis can be carried out not only for certain categories or product lines, but for the entire company as a whole.
- For businesses. Business owners or investors in this case conduct an appropriate assessment showing the return on investment of the company.
- For assets. This view shows how efficiently it is to introduce certain resources. For example, whether it is necessary to attract additional investments or whether the available investments for development will be enough.
What percentage is considered normal
The profitability ratio can be considered high and low at very different values. But if you try to establish average values, the thresholds for an objective assessment will be as follows:
- 5% and below - low profitability. This means that at some point the costs are too high, and it is advisable to take measures to reduce them.
- From 5 to 20% is the average mark. Shows that the company is working steadily and quite efficiently.
- 20 to 30% is a high value. The company not only pays off, but also accumulates profit, which can then be used for its own development.
- More than 30% - over-profitability. This happens very rarely, when the costs are very small, and the profit grows at the same time in arithmetic progression.
What is the meaning of the profitability indicator
The return on sales clearly shows whether the company is able to make a profit in the current format of activity. This ratio helps to understand the nature of the implementation of the organization's main products, as well as whether its actions are effective under various scenarios, both positive and negative. This makes it possible to predict effective management measures. This indicator is also used in the financial modeling of the company and its assessment. To get a real picture, investors often start evaluating a business by looking at this ratio, and only then explore deeper data.
IMPORTANT! The profitability of sales alone is not enough to determine the real performance of the firm.
If this ratio is quite high, it means that the organization competently controls its costs or offers goods and services on the market at prices that significantly exceed their cost. A high ratio can arise for several reasons, including efficient enterprise management, low costs in the production of goods and services, and the presence of a strong pricing strategy.
If this indicator is low, then the company does not monitor cost efficiency or has not worked out its pricing strategy insufficiently. Also, a low value can arise for some other reasons, for example, with ineffective management, as well as a high level of costs.
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Why ROS Matters
This indicator is used in different situations and to assess the nature of business activities of various sizes - from a small point in a shopping center to an organization that has placed its shares on the stock exchange. In addition to individual businesses, calculating this ratio can be useful for calculating the profitability potential of larger projects at a regional or national level.
An example is investors who assess the profitability of a startup based on various criteria, including return on sales. It is also indicated in important quarterly reports, during the preliminary valuation of the company's shares in the initial public offering (IPO) or when issuing loans to small businesses.
This characteristic does not always guarantee high revs. Well, for example, in the retail segment, product turnovers are usually very high, but these large volumes make up for relatively low profit margins. Or, conversely, as with jewelry - sales can be sporadic, but the profit for each sold product compensates for the small sales volumes.
The formula for calculating the profitability of sales
To calculate the profitability of sales in general, the following formula is used:
FIRST EXAMPLE. A seller in a certain marketplace sold goods worth 4.5 million rupees. The purchase, packaging and delivery costs cost him 3.6 million rupees. It turns out that the net profit in this case is 0.9 million (4.5-3.6). Next, we calculate the profitability ratio as follows:
(900 000 / 4 500 000) * 100% = 20%
EXAMPLE TWO. The hairdresser earned 56 thousand rupees in a month, but having paid all taxes, bills and compensating for other expenses, he had only 7 thousand left - this is his net profit. To calculate the required coefficient, we proceed as follows:
(7,000 / 56,000) * 100% = 12.5%
EXAMPLE THREE. Last year, Vasya sold sports equipment in his store for 6.5 million rupees, and after deducting all costs, his net profit came out to 2 million. And this year, Vasya sold already for 4.7 million, but the profit was 1.4 million. You can see that the coefficient has changed over the year. To do this, of course, we first calculate both profitability indicators.
P1 = (2,000,000 / 65,000,000) * 100% = approximately 30.7%
P2 = (1,400,000 / 4,700,000) * 100% = approximately 25.5%
Now, in order to find out the difference, it is necessary to calculate the last year's result from the value of the current year. It looks something like this:
P2 - P1 = 25.5% - 30.7% = -5.2%
This figure means that this year the payback of Vasya's store has decreased by 5.2 percent.
Factors affecting the profitability of sales
There are a huge number of factors that affect the increase or decrease in the value of profitability of sales. It is even easier to list what exactly does not affect it - the size and type of the company, marketing strategy, economic situation, financial results, sources of funding, as well as the tax policy of the company. Characteristics such as a decrease in the cost of production, an increase in cost rates, or a change in the range of products have a direct impact.
There are several specific cases in which the ROS is guaranteed to decrease:
- The increase in costs outstrips the growth in revenue. This can happen when prices decrease, the assortment changes, or the company's expenses increase.
- The decrease in revenue outstrips the reduction in costs. This is possible with a drop in sales.
Here we can conclude that the investigated ratio decreases when costs change, and the profit does not increase.
Ways to Increase Your ROS
If the profitability indicator goes down, it does not always mean that the situation is going to get worse. At the very least, it is quite possible to fix it by taking some measures. For instance:
- Price increase. This is the easiest way to increase income, but it is not always justified.
- Reducing the cost of goods. Payback often rises when the costs of the firm in the production and sale of goods or services are too high. Here, it is important to reduce the volume of costs without harm to quality - you can optimize logistics, rebuild production, or reduce personnel.
- Changing the purchasing principle. If the prices of raw material suppliers rise, it is quite justified to start looking for new contractors offering the same quality, but at a lower price.
- Increase in the share of promising products. Here you can analyze the market and identify the main development trends at the moment. Based on the collected data, it is worth releasing a new product that meets the requirements of consumers.
- Launch of an advertising campaign. The payback can also decrease with a decrease in customer demand, and the reason for this may be people's ignorance of the company's presence in the market. Fortunately, this is fixable, because you can use inexpensive promotion methods, such as promotions or discounts.
- Employee motivation. The amount of profit is strongly influenced by how competent the people working in the company are and are generally interested in development. For them to understand that they are hired for a reason, it is necessary to clarify what goals the organization is striving to achieve and how their achievement will affect wages. You can additionally revise the method of remuneration, introduce bonuses or bonuses, conduct trainings or training courses, if necessary.
- Service improvement. The better the service, the higher the likelihood that the customer will be satisfied and will definitely return for a second purchase. Things like free shipping or having a bonus system, it turns out, still have a big impact on how people feel about a firm. True, it is not worth taking measures at random - you need to research production cycles, sales channels, analyze the work of the company as a whole.
- Market research. It is likely that competitors in the market have become more dodgy or implemented a new, more efficient distribution scheme. In order not to miss the moment, you need to observe the activities of competitors and, if necessary, adopt some of their practices.
In general, in order not to waste such a "turning point" as a decrease in profitability, it is necessary to constantly analyze the work of the organization and study the environment of its activity. It’s not that difficult - today you can collect and process data using special programs, so you don’t have to calculate anything on your own. And the effect of this approach is worth the time spent.
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