It happens that revenue grows and profits too, but profitability suffers – accordingly, it is too early to talk about growing business efficiency. In the article, we explain what profitability means in commercial activities, what formula is used to calculate it, how profitability is divided into different types depending on the type of profit, what is net profit margin and whether there is a profitability rate.
Return on Sales: What is it?
Return on sales (ROS) is an important indicator in the world of finance, allowing to evaluate how successfully a company converts its income into profit after deducting expenses. Do not confuse return on sales with other types of profitability: production, assets, products, return on fixed assets, return on investment funds, project payback, etc.
How is profitability calculated in business? The formula for return on sales is the ratio of profit to total revenue from the sale of goods or services:
The profitability and its formula are influenced by different types of profit that you take as a basis, we will talk about this below.
Is there an accounting rate of return?
It is important to note that there is no single answer to the question of what profitability is considered normal. Each company should analyze its own profitability indicators and compare them with previous periods – this will show whether things are going well or badly. If profitability has increased according to the results of the next reporting period, then this is normal, and if it decreases or remains at the same level with growing profits, then action must be taken. For a more accurate assessment of business efficiency, it is recommended to take into account the specifics of the industry, the size of the company, goals and development strategy.
Why Know Your Return on Sales
Let’s say that the company’s revenue and profit increased based on the results of the last year. It would seem that such a result is a reason for optimism, but when analyzing financial indicators, it turns out that the profitability of net profit has decreased compared to the results of the previous period. This may be due, for example, to an increase in the cost of production or services, changes in pricing or the competitive environment.
We calculate this using specific figures, which are initially expressed in monetary amounts:
- Revenue in 2023: $1,000,000
- Revenue in 2024: $1,200,000 (+20%)
- Profit in 2023: $200,000
- Profit in 2024: $230,000 (+15%)
Here’s how to calculate profitability for both periods (the indicator is expressed as a percentage):
- Profitability in 2023: (200,000) / (1,000,000) × 100% = 20%
- Profitability in 2024: (230,000) / (1,200,000) × 100% ≈ 19.17%
So, despite the increase in revenue and profit, profitability, as we calculated, ultimately decreased.
Let’s list point by point why it is necessary for companies to calculate ROS:
- Performance measurement : Measure how well an organization converts its operating income into profit.
- Making strategic decisions . Once calculated, you will be able to determine the effectiveness of various strategies for marketing, pricing, cost management, and other aspects of your business.
- Process optimization . Identify bottlenecks in business processes where costs can be reduced or profits increased.
- Planning and forecasting : Calculate more accurate forecasts of revenue, expenses and profits, which leads to more competent management of resources.
- Assessing the financial health of an organization . Investors, creditors, and other stakeholders gain insight into the company’s financial strength and prospects.
Profitability in sales: types
Before calculating profitability in your company, decide what profit to start from. Below we describe different types of profitability of commercial activity and their characteristics.
Return on sales in business by net profit
The net profit margin of a business shows how much of its revenue remains as profit after all expenses, including interest, taxes, and depreciation, have been deducted.
Net profit margin should be calculated as follows:
Net Profit Margin = (Net Profit) / (Revenue) x 100%
Commercial profitability by marginal profit
When calculating profitability based on marginal profit, only the profit remaining after covering variable costs is taken into account – raw materials, consumables, employee salaries, delivery to customers.
The profitability ratio for marginal profit should be calculated as follows:
Contribution Margin Return = (Contribution Margin) / (Revenue) x 100%
High profit margin indicates effective management of variable costs.
Commercial profitability by gross profit
Reflects the share of revenue that remains after deducting both variable and fixed (rent, equipment depreciation, etc.) expenses.
The indicator should be calculated as follows:
Gross Profit Margin = (Gross Profit) / (Revenue) x 100%
In this case, the profitability indicator is used to calculate the productivity of individual areas of the company’s work – certain goods or production lines, branches of the organization.
Operating profit margin
Operating profit is the difference between total revenue and all expenses for the sale of goods and services.
The indicator should be calculated as follows:
Operating Profit Margin = (Operating Profit) / (Revenue) x 100%
In this case, the profitability indicator is used to calculate the operational efficiency of the company – what return it receives from using its resources. This indicator is often used to compare similar business models.
Reasons for the decline in profitability
Here are some common reasons:
- Increase in variable costs, including increased costs for raw materials, production, transportation, etc. Insufficient efficiency in managing variable costs can negatively affect the overall profitability of the business.
- Excessively high inventories of goods, which lead to additional costs for their storage.
- If competitors offer similar products at lower prices, a company may be forced to lower its prices to maintain market share.
- Increased costs associated with rent, equipment, salaries, marketing activities and other expenses. The best way to monitor the return on your marketing campaigns is through advertising analytics .
How to increase profitability
All recipes come down to two components – cost optimization and profit increase. There are several ways to increase the commercial profitability ratio.
Price increase
Increasing the price tags on goods and services can be one of the ways to increase the level of commercial profitability. However, to take such a step, the brand must have a high reputation and trust from customers. In addition, customers need to correctly and convincingly explain the reasons for the price increase. It is worth starting to increase prices with the goods and services that are most popular with the audience.
While warning of future price increases, you can also offer a short-term discount to further soften the transition to new prices.
Cost reduction
Reducing the cost of producing goods or providing services can lead to an increase in overall profits:
- Reducing material costs. Finding alternative (less expensive) suppliers or purchasing materials in bulk, using more efficient materials or recycling them, and controlling losses in the production process.
- Optimization of production processes. Increased production efficiency, improved logistics, equipment, reduced production cycle time and improved quality of work processes.
Motivation of managers
Well-motivated and trained salespeople are able to generate higher sales volumes and increase overall business profitability. We wrote about this in more detail in the article “How to motivate OP staff” . A virtual PBX with call recording helps control the quality of communication with clients .
Increase in customer receipt
The fight for a higher customer check is another possible way to increase sales profitability. Two popular methods can bring you closer to the goal – upselling and cross-selling.
Increase in demand
Improving your marketing leads to successful engagement of new audiences and increased sales. Perhaps you haven’t yet used all the promising promotion channels for your industry. It wouldn’t hurt to use social networks, content marketing, PR, and media advertising if these formats are suitable for your type of business. Create and promote loyalty programs. Analyze the return on your current advertising campaigns using end-to-end analytics , identify the most successful practices, and maximize your results.
Business Process Automation
Perhaps your bottleneck is routine tasks that your employees spend a lot of time on. Using a CRM system allows you to automate a number of routine tasks: sending emails, tracking deals, scheduling meetings, creating reports. Automating business processes with a CRM speeds up the entire sales cycle, from attracting a client to closing a deal.
How to calculate profitability: briefly about the main thing
Return on sales requires a very simple formula – it is the ratio of profit to the company’s revenue. If your company’s profitability indicators are growing, this means development, and if revenue and profit are growing, but profitability is falling, this indicates a problem.
There are different types of profitability – they depend on the type of profit.
There is no general accounting standard for the profitability indicator – each company has its own. It is necessary to strive to ensure that the profitability indicator does not decrease in comparison with previous reporting periods.