Ever ordered something online that showed up broken or drastically different than expected? Don’t worry, you’re not alone. Sales returns are a common and inevitable part of business. But how should companies account for these returns? And how can they minimize the financial impact? This comprehensive guide has the answers. We’ll also explore strategies for boosting your return on sales (ROS) – a key ratio revealing how efficiently your business converts revenue to profit. Learn how to calculate ROS, interpret it, and make improvements. Mastering sales returns and return on sales is critical to running a profitable operation. Let’s dive in!
What are Sales Returns?
Buying something online or in-store and then returning it later is a common practice for many shoppers. In fact, statistics show that around 20-30% of products purchased online are returned, with even higher return rates during the holiday season. But what happens on the seller’s end when a customer brings an item back to the store or ships it back after an online purchase? This is where the concept of sales returns comes in.
Definition and Overview
A sales return refers to any merchandise that is returned by a customer to the original seller or retailer. This return is usually initiated because the customer found some issue with the product and wants to exchange it for a new item, get a refund, or receive a credit to their account.
Common reasons for returns include:
- The item arrived damaged or defective
- The product’s specifications or features were inaccurate
- The customer simply changed their mind and no longer wanted the item
- The seller shipped the wrong quantity or sent the wrong item altogether
Regardless of the reason, the seller or retailer will need to accept the return and process some type of refund or exchange in line with their return policy.
For the seller, a sales return means taking back ownership of inventory they had already considered sold. It can also represent lost profit, especially if the returned item cannot be resold at full value. So accounting properly for these returns is an important financial process.
Reasons for Sales Returns
As a seller, being aware of the most common triggers for returns can help your business minimize them proactively. Some top reasons customers initiate returns include:
- Product defects or damage – No customer wants to receive a broken, defective, or damaged product. Careful quality control before shipping products can reduce returns.
- Incorrect or misleading product information – If the product’s listing or description is inaccurate, customers will be disappointed and return the item. Ensuring marketing materials are truthful is key.
- Impulse purchases – Especially common for online shopping, buyers may experience “purchase regret” and change their mind about a discretionary item. Limiting impulse shopping can help, like not offering deep discounts that spur rash decisions.
- Customer simply changed their mind – Even without a misrepresentation or defect, customers may just decide they don’t like an item after purchasing. Relaxed return policies can satisfy customers, but lead to more returns.
- Wrong item shipped – Another frustration for customers, getting a totally different product from what was ordered results in an automatic return. Double-checking shipments prevents headaches.
- Excess quantity shipped – Retailers can mistakenly send extra units, which customers will return. While it increases sales initially, it leads to inflated return rates later.
- Product was late or damaged during shipping – Late deliveries past promised dates, or items damaged in transit, lead to guaranteed returns. Working with reliable shippers reduces this risk.
Understanding these pain points can allow retailers to improve processes and minimize avoidable returns. But even with the best precautions, some amount of sales returns will always be inevitable.
Types of Sales Returns
When a customer decides to return an item they purchased, there are a few potential options for their refund:
Cash Refunds
The most straightforward type of return is a cash refund, where the customer brings or ships back the unused product and receives their full purchase price back in cash or via refund to their original payment method. This essentially reverses the original transaction.
Cash refunds are common for major product categories like electronics, appliances, furniture, and other big-ticket items. For inexpensive impulse buys, a cash refund may not be worth the hassle for the customer, so they opt for other return types instead.
Credit Memos
Instead of immediately refunding the purchase price, retailers can issue a credit memo or gift certificate equal to the value of the returned item. This credit can be used toward the customer’s next purchase.
Credit memos allow retailers to keep the original sale while satisfying the customer’s desire to return an item. The customer feels compensated but may end up spending even more with the store later to use up the credit.
Store Credits
A store credit offers a similar incentive to a credit memo, but has some key differences. Store credits are mainly used for product returns without receipts, or situations where the original purchase details can’t be verified.
Rather than granting a credit equal to the item’s exact purchase price, retailers offer a store credit approximating its current resale value. This allows for depreciation and protects against fraud.
Store credits also tend to expire after a shorter period, unlike credit memos. And they are normally issued in the form of a gift card or in-store voucher.
The Bottom Line
Sales returns are simply a fact of life in retail. Even when sellers do everything right, a certain percentage of returns will occur. By understanding why customers return items and properly accounting for refunds or credits, businesses can minimize the revenue impact of returns.
No retailer wants to deal with the headache of processing excessive returns. But keeping return rates reasonable and customers satisfied with the process is crucial to long-term success. Analyzing return trends and fine-tuning policies allows retailers to strike the right balance.
Accounting Treatment of Sales Returns
Recording sales returns properly in a company’s financial records is an important accounting process. Sales returns directly impact revenue and inventory figures, so handling them incorrectly could misstate profits and asset balances.
Let’s examine how retailers and sellers should enter sales returns in their books, along with the resulting impact on financial statements.
Journal Entries for Sales Returns
When a customer returns a product, the business needs to record the transaction in their accounting system. This is done by making one of the following journal entries:
1. Return of an Item Originally Sold on Credit
If the returned item was originally purchased on credit by the customer, the sales return is recorded by:
- Debiting the Sales Returns and Allowances account
- Crediting the Accounts Receivable account
For example, if a customer returns $100 worth of merchandise that they originally bought on 30-day terms, the journal entry would be:
Sales Returns and Allowances $100
Accounts Receivable $100This entry increases the Sales Returns and Allowances account (contra-revenue) and decreases Accounts Receivable, reflecting that the customer’s account now owes $100 less.
2. Return of an Item Originally Sold for Cash
When a customer returns an item that they originally paid for in cash, the entry is slightly different:
- Debit the Sales Returns and Allowances account
- Credit the Cash account
If a customer returns a $500 product originally bought with cash, the journal entry would be:
Sales Returns and Allowances $500
Cash $500 The Cash account is reduced instead of Accounts Receivable in this case, showing that the firm now has $500 less cash on hand.
In both cases, the Sales Returns and Allowances account appears, serving to reduce revenues. But the offsetting credit impacts either cash or A/R depending on the original purchase type.
Impact on Financial Statements
Recording sales returns properly is critical because of how they directly hit a company’s top and bottom lines on financial statements.
On the income statement, sales returns lower the net revenue or net sales figure, since the Sales Returns and Allowances account is a contra-revenue account. For example:
Gross Sales $1,000,000
Less: Sales Returns & Allowances ($50,000)
Net Sales $950,000The $50,000 in returns directly reduces net sales, lowering reported revenue for the period.
On the balance sheet, sales returns decrease either cash or accounts receivable, depending on the original purchase method.
- For returns of items bought on credit, A/R is reduced on the balance sheet.
- For returns of cash purchases, cash itself is decreased.
Finally, on the statement of cash flows, cash refunds for sales returns are tracked and deducted from net income in the cash from operations section:
Net income $200,000
Plus:
Depreciation $50,000
Less:
Sales returns ($5,000)
Net cash from operations $245,000Careful tracking of returns ensures all financial statements reflect accurate profitability and asset balances after factoring in refunds.
Real-World Examples
To see sales returns accounting in practice, let’s walk through two examples:
Company A
Company A had $10 million in gross sales last year. Of this amount, $2 million worth of purchases were later returned by customers. All items were originally sold on 30-day credit terms.
The journal entry to record these returns would be:
Sales Returns and Allowances $2,000,000
Accounts Receivable $2,000,000On Company A’s income statement, net sales would be reported as $8 million after deducting the $2 million returns. And on the balance sheet, accounts receivable would be $2 million less than before the returns.
Company B
Company B had $500,000 in gross sales last quarter. Of this amount, $20,000 of cash purchases were returned by customers requesting refunds.
The journal entry would be:
Sales Returns and Allowances $20,000
Cash $20,000Company B would report $480,000 in net sales after the returns. And on the balance sheet, cash would decline by the $20,000 refunded to customers.
Properly recording sales returns is key to accurate financial reporting. And minimizing returns helps improve the bottom line.
Controlling and Minimizing Sales Returns
While some amount of returns are inevitable in business, excessive or growing return rates can hurt a company’s bottom line. Here are some tips retailers can use to proactively control and minimize the number of sales returns they process.
Quality Control and Inspections
One of the top triggers for returns is customers receiving defective, damaged, or faulty products. Instituting strong quality control measures can reduce these types of returns.
Inspect merchandise at various stages:
- Evaluate products when they are received from suppliers to catch issues early
- Do random spot inspections of orders before shipment
- Make final checks of each item just prior to packing orders
Test products rigorously:
- Put samples from each manufacturing batch through extensive stress testing
- Check for durability, proper functioning, and conformity to specifications
Implement process controls:
- Document detailed protocols for production processes and equipment operation
- Track unit output and defect rates to identify problem areas
- Require sign-offs at each process stage to ensure procedures were followed
Train employees diligently:
- Educate staff on inspecting products and identifying defects
- Emphasize importance of following protocols and focusing on quality
- Incentivize finding and flagging defective units before shipment
A rigorous quality program takes effort but reduces costly returns and protects the customer experience.
Accurate Product Descriptions
Another top return trigger is customers receiving a product that doesn’t match what was advertised. Ensuring marketing and sales information is accurate and transparent can help minimize these situations.
Verify product specs and features:
- Fact-check against engineering and product databases
- Test advertised capabilities for truthful representation
- Compare to samples from latest production runs
Show representative photography:
- Take shots of actual product, not prototypes or renderings
- Photograph all angles and call out close-up details
- Video demonstrations can provide added realism
List precise dimensions and materials:
- Avoid vague or exaggerated descriptions
- Quantify product size, weight, ingredients etc.
- Disclose if refurbished parts are used
Update regularly:
- Specs can change across product revisions
- Ensure latest info is always shown
- Proactively notify customers of changes
Accurate technical descriptions, detailed photos, and realistic depictions reduce the chance of customer disappointment.
Product Return Policies
A company’s official return policy can also influence customer behavior and return volume. Optimizing policies can maintain flexibility for customers while protecting the business from excessive returns.
Allow reasonable time limits:
- 30 days is common for many non-durable goods
- Permit 45-90 days for major appliances, furniture, etc.
- Restrict beyond 3-6 months to prevent indefinite returns
Impose restocking fees if necessary:
- Charge 10-15% on returns without receipts or for buyer’s remorse
- Helps offset administrative costs of returns
- Discourage “free rentals” without banning returns entirely
Set eligibility requirements:
- Require all original packaging, parts, manuals etc.
- Mandate proof of purchase with receipts
- Exclude final sale or closeout items
Highlight key parts up front:
- Ensure customers understand before buying
- Increased transparency reduces return surprises
With the right policy balance, companies maintain flexibility for customers while avoiding excessive return abuse.
Open Communication with Customers
Finally, proactively communicating with customers and soliciting feedback can identify issues early before they result in products being returned.
Monitor reviews and complaints:
- Issue surveys after purchase and delivery
- Track ratings, reviews and feedback online
- Identify common complaints and remedy systemic issues
Interact on social media
- Engage customers sharing feedback publicly
- Provide support and issue resolution in a transparent forum
Make it easy to contact support:
- Offer phone, email, and chat contact options
- List means of contact prominently on packaging, sites, etc.
- Empower reps to immediately resolve and de-escalate issues
Learn from returns data:
- Dig into reasons for returns and needed improvements
- Adjust policies, products, and processes accordingly
- Closed-loop corrective action minimizes recurring returns
Proactive outreach and responsiveness to customers provides visibility into potential problems before they amplify.
The bottom line is that some sales returns will always get through, but retailers are not helpless. While returns can never be fully eliminated, implementing strong quality control, accurate marketing, optimized policies, and customer engagement can significantly minimize their volume over time. This benefits customers, who receive higher quality products and service, as well as the company’s profitability. A little prevention goes a long way.
What is Return on Sales (ROS) Ratio?
Now that we’ve covered the ins and outs of sales returns, let’s shift gears to a related sales metric – the return on sales ratio.
Return on sales (ROS) is a popular financial ratio used to evaluate a company’s operational efficiency and profitability. Here is an overview of what the ratio measures, how it is used by analysts, and what insights it can provide.
Definition
The return on sales ratio indicates how much profit is generated for each dollar of sales revenue. It is calculated by dividing a company’s net operating profit by its net sales over a given time period.
Return on Sales Ratio = Operating Profit / Net Sales
For example, if a company has $2 million in operating profit and $10 million in net sales, its ROS would be:
$2,000,000 / $10,000,000 = 0.2 = 20% ROS
The ratio is expressed as a percentage, revealing how many cents of profit are derived from each dollar of sales.
A higher ROS percentage indicates a company is more efficiently converting their sales revenue into bottom line profits. It demonstrates how well management controls operating expenses and pricing strategies.
Measures Operational Efficiency and Profitability
The return on sales ratio offers insights into both a company’s profitability and operational efficiency.
From a profitability standpoint, ROS shows what percentage of sales revenue flows through to operating profits after covering the cost of goods sold and operating expenses.
It indicates how effectively a company is generating earnings from their sales activities. Higher ROS suggests greater profit potential, holding all else equal.
Regarding operational efficiency, ROS reflects how adept management is at controlling costs and extracting profits from their sales. Improvements in production processes, supply chain management, and pricing discipline would likely increase ROS over time.
In summary, the return on sales ratio reveals how well a company converts sales to profit both in absolute terms and relative to its own operating expenses.
Useful for Trend Analysis and Peer Benchmarking
Analyzing ROS over time and comparing against peer company benchmarks are two primary ways financial analysts utilize the ratio.
Looking at ROS trends over quarters or years spots positive and negative momentum. Growing ROS indicates improving profitability, while declining ROS suggests potential problems. Comparing current ROS to historical norms helps diagnosis what is driving changes.
ROS can also be used to compare companies within the same industry. The most revealing analysis looks at ROS ratios across direct competitors, identifying leaders versus laggards in operational efficiency. Industry average ROS serves as a benchmark to evaluate individual companies against.
However, comparisons between highly disparate industries using ROS can be less insightful due to major differences in business models and cost structures. But among peers, ROS provides a standardized profitability metric.
Overall, examining both ROS trends over time and versus peer set benchmarks provides helpful perspective on a company’s financial performance.
The Bottom Line
In summary, the return on sales ratio is a simple but powerful metric that condenses a company’s profit generation efficiency into a single percentage. It quantifies how much profit is derived from each dollar of sales revenue after accounting for the costs required to generate those sales.
Tracking ROS over time and benchmarking against peers spots positive and negative momentum in operational profitability. For any business, maximizing ROS is a primary pathway to amplifying earnings and company value over the long-term.
How to Calculate Return on Sales
Now that we know what the return on sales ratio represents, let’s walk through the mechanics of how to actually calculate it step-by-step.
The good news is that the ROS formula is straightforward once you understand which income statement figures are needed. With a little practice, anyone can learn to quickly calculate a company’s return on sales.
ROS Formula
The return on sales calculation requires two key figures from a company’s financial statements:
Net Sales – This refers to total sales revenue minus any returns, discounts, or allowances. It represents the net amount of sales dollars actually retained by the company.
Operating Profit – Also called operating income, this is a company’s profit after subtracting COGS and operating expenses from net sales. But before interest and taxes are deducted.
With these two inputs, the ROS formula is:
Return on Sales = Operating Profit / Net Sales
To state the ratio as a percentage, simply multiply the decimal result by 100.
For example, if a company’s operating profit was $1 million and net sales were $5 million, the calculation would be:
$1,000,000 / $5,000,000 = 0.2
0.2 x 100 = 20% ROS
So this company generates a 20% return on sales, meaning for every $1 of net sales, it retains $0.20 in operating profit.
This simple ROS formula can be applied to any company with an income statement.
Using Income Statement Figures
To gather the data needed for the ROS calculation, you simply pull the required numbers directly from a company’s income statement report.
For example, consider the following abbreviated income statement:
Revenue
- Gross sales: $50,000
- Less: Returns & allowances: ($5,000)
Net Sales: $45,000
Less: Cost of goods sold: $20,000
Gross profit: $25,000
Less: Operating expenses: $10,000
Operating profit: $15,000
Here we see that the company achieved $45,000 in net sales after deducting returns and allowances from gross sales of $50,000.
The operating profit was $15,000 after subtracting COGS and operating expenses.
Plugging these figures into our ROS formula:
Operating Profit = $15,000
Net Sales = $45,000
$15,000 / $45,000 = 0.33 = 33% ROS
So for this company, their return on sales was 33% for the reporting period.
Extracting the two required income statement figures makes calculating ROS quick and easy.
Examples and Walkthrough
Let’s take a look at one more example to solidify the process:
Company XYZ reported the following income statement results for the year:
Gross sales: $85,000,000
Less returns: ($4,000,000)
Net sales: $81,000,000
Cost of goods sold: $45,000,000
Gross profit: $36,000,000
Operating expenses: $14,000,000
Operating income: $22,000,000
Given this income data, what was Company XYZ’s return on sales for the year?
Step 1) Identify Net Sales = $81,000,000
Step 2) Identify Operating Profit = $22,000,000
Step 3) Calculate:
Operating Profit ($22,000,000) / Net Sales ($81,000,000) = 0.27
Step 4) Multiply ratio by 100: 0.27 x 100 = 27% ROS
So for the year, Company XYZ achieved a 27% return on sales. This means 27 cents of every sales dollar flowed through to operating profits after COGS and operating expenses were covered.
This example demonstrates how quickly the ROS ratio can be calculated with two key figures from a company’s income statement. With a little practice, finding any company’s return on sales takes just minutes.
Analyzing and Interpreting ROS
Once the return on sales ratio is calculated, the next step is interpreting what that ROS figure means for a business.
By analyzing trends over time, comparing to industry benchmarks, and linking ROS to overall financial health, key insights can be uncovered.
ROS Trends Over Time
One of the most useful applications of return on sales is tracking how the ratio changes from period to period. Monitoring ROS trends spots positive and negative momentum.
For example, here is a company’s ROS over the past 5 years:
| Year | Return on Sales |
|---|---|
| 2018 | 18% |
| 2019 | 19% |
| 2020 | 21% |
| 2021 | 23% |
| 2022 | 24% |
This shows steady improvement, with ROS increasing from 18% to 24% over the 5-year span. This indicates the company is becoming more operationally efficient and converting a higher percentage of each sales dollar to profit.
However, a declining ROS over time could signal potential trouble ahead. For example:
| Year | Return on Sales |
|---|---|
| 2017 | 21% |
| 2018 | 18% |
| 2019 | 17% |
| 2020 | 16% |
| 2021 | 15% |
Here we see ROS declining year-over-year, from 21% down to 15%. This means each sales dollar is driving less and less profit. Management would want to diagnose the cause before the trend continues.
Regularly monitoring ROS trends is an early warning indicator of whether business performance is improving or degrading. Sustained momentum in either direction demands further analysis to understand root causes.
Comparing to Industry Benchmarks
While analyzing ROS trends within a company is useful, broader industry benchmarking provides critical perspective. Comparing a company’s ROS to competitors and industry averages reveals relative performance.
For example, an automotive manufacturer with a 10% ROS might appear to have room for improvement. But if the industry average ROS is 8%, it is actually outpacing competitors.
Likewise, a software company with a 22% ROS could seem very solid. But if leading competitors in the space are achieving 30%+ ROS ratios, it actually lags peers.
Some useful benchmark sources include:
- Public financials of competitors
- Industry research reports
- Business valuation resources
- Financial database tools
Shooting for ROS at or above the top quartile of one’s industry demonstrates operational excellence. Falling in the bottom quartile flags potential issues versus competitors.
Linking ROS to Business Health
Ultimately, the return on sales ratio links closely to the overall financial health and prospects of a business.
For example, a company with a high and/or improving ROS likely has advantages such as:
- Pricing power
- Lean operations
- Cost discipline
- Efficient sales processes
This indicates potential for strong profit margins and free cash flow going forward.
Conversely, a company with chronically low and/or declining ROS may suffer from:
- Poor pricing strategy
- High expense structure
- Operating inefficiencies
- Low barrier to competition
Without an intervention, ongoing weak ROS predicts challenges in maintaining profitability.
While no single metric can determine a company’s business prospects, analyzing return on sales ratios in the proper context provides a valuable perspective on financial performance.
Strategies for Improving Return on Sales
For most businesses, maximizing return on sales is a constant focus. Here are some proven strategies companies can use to improve their ROS ratio over time:
Increasing Revenue with Better Sales Processes
One effective way to improve return on sales is to drive more revenue using sales best practices:
Refine lead generation – Ensure your sales team has a strong pipeline of qualified leads to pursue. Refine lead gen efforts to target ideal buyer profiles.
Increase sales conversions – Boost win rates by optimizing the sales process. Offer demos, trials, or pilots to shorten the evaluation stage. Address objections methodically.
Upsell and cross-sell – Identify opportunities to sell higher-value solutions to existing clients. Expand share of wallet.
Implement sales incentives – Structure programs to reward new deals, renewals, expanded purchases, and referrals.
Leverage marketing campaigns – Support sales efforts with multi-channel campaigns. Align messaging and promotions.
Expand sales territories – Enter promising new geographies or segments. Localize offers and collateral.
Automate sales tasks – Use technology to handle repetitive administrative work, saving seller time for actual selling.
Improve seller efficiency – Analyze sales metrics to identify gaps. Coach low performers. Perfect pitches and decks.
Pilot new offerings – Test innovative products/services with focus groups and early-adopter customers. Refine and scale what resonates.
With more effective sales execution, companies generate more revenue to cover their fixed costs, increasing ROS.
Lowering Operating Costs and Overhead
In parallel with driving greater revenue, companies can improve ROS by decreasing expenses:
Renegotiate supplier and vendor contracts – Use increased volume and competition for price leverage. Commit to longer terms in exchange for discounts.
Insource vs outsource – Evaluate outsourced functions to determine if bringing in-house would be more cost effective.
Eliminate unused subscriptions and services – Cancel subscriptions no longer delivering value. Avoid automatic renewals.
Rightsize real estate footprint – Downsize offices and facilities to match current team size. Renegotiate leases.
Reduce energy consumption – Install LED lighting, program thermostats down, power down equipment when not in use.
Negotiate credit card fees – With higher processing volume, push providers for lower rates.
Automate manual processes – Identify repetitive administrative tasks to eliminate with workflow automation.
Streamline org structure – Remove unnecessary layers of management and redundant roles.
Offer remote work flexibility – Allowing remote work lowers real estate and overhead costs.
Controlling operating expenses reduces costs as a percentage of sales, freeing up additional profit.
Optimizing Pricing and Product Mix
A detailed examination of pricing strategies and product lines can also influence return on sales:
Perform customer segmentation – Categorize customers based on profitability and willingness to pay. Set pricing accordingly.
Vary pricing by region – Charge based on local market conditions, competitor pricing, and customer buying power.
Implement tiered pricing – Provide entry-level, standard, and premium options. Upsell customers to higher tiers.
Offer product bundles – Bundle related products into discounted packages with higher profit margins.
Test promotional pricing – Run time-bound discounts and promotions to attract new business while protecting base pricing.
Rationalize product portfolio – Eliminate underperforming products dragging on margins. Refocus on profitable offerings.
Modify package sizing/volumes – Adjust volumes and units per package to influence order sizes. Avoid steep discounts for bulk.
Implement minimum order sizes – Require larger minimum purchases for distributors to qualify for volume discounts.
Pricing optimization, disciplined discounting, and product mix management boosts profitability of each sale.
Enhancing the Customer Experience
Building loyalty through an excellent customer experience can also lift revenue and reduce returns:
Invest in product quality – Deliver consistent, defect-free products with rigorous QA. Reduce safety stocks by improving quality control.
Resolve issues proactively – Identify customer problems early and resolve immediately. Empower support teams to retain customers.
Surprise and delight – Randomly upgrade service levels and offer credits or promotional pricing to spark delight.
Make it convenient – Offer speedy fulfillment options. Provide self-service account management and online support.
Communicate transparently – Set proper expectations upfront. Notify customers of changes. Be transparent in advertising.
Collect feedback – Ask for ratings and reviews. Poll customers regularly on needs, pain points, and new feature requests.
Cultivate brand advocates – Turn loyal customers into references and ambassadors. Seed user communities.
Building a highly satisfied and loyal customer base boosts sales, lowers costs, and improves return on sales over time.
The combination of driving more high-value sales and reducing operating costs and overhead is the ultimate 1-2 punch for maximizing a company’s return on sales ratio. And the higher the ROS, the greater profit potential the business enjoys.
Return on Sales vs. Profit Margin
When evaluating a company’s profitability, the return on sales ratio is often used alongside various profit margin metrics.
While they may sound similar, there are some important distinctions between return on sales and the different types of profit margins.
Key Differences Between ROS and Profit Margins
The main difference lies in the numerator of the ratios – the profitability figure being compared to sales.
Return on sales uses operating profit in the numerator. This is a company’s profit after subtracting COGS and operating expenses from revenue.
Whereas profit margins use different measures of profit in the numerator:
Gross profit margin – Uses gross profit as the numerator, which is revenue minus COGS. It excludes operating expenses.
Operating profit margin – Uses operating income as the numerator, the same as return on sales. The terms are often used interchangeably.
Net profit margin – Uses net income as the numerator, which is profit after all operating and non-operating expenses and taxes.
So while return on sales and operating margin use the same numerator (operating profit), gross margin and net margin compare different levels of profit to sales.
Gross Profit Margin
The gross profit margin compares a company’s gross profit, or revenue less COGS, to its net sales revenue.
Gross Profit Margin = (Revenue – COGS) / Revenue
It measures the percentage of net sales remaining after paying direct production costs. A higher gross margin means a company retains a greater portion of each sales dollar for other operating costs and profit.
For example, if a company has:
Revenue = $1,000,000
COGS = $600,000
Its gross margin would be:
($1,000,000 – $600,000) / $1,000,000 = 40%
Gross margin is useful for benchmarking profitability before operating expenses, which can vary greatly depending on factors like company size, industry, and accounting methods utilized. It can reveal trends in production costs and pricing power over time.
Operating Profit Margin
The operating profit margin compares a company’s operating income to net sales to show the percentage retained after operating expenses are covered.
Operating Margin = Operating Income / Revenue
This is the same formula as return on sales. The terms operating margin and return on sales are often used interchangeably.
For example, if a company has:
Revenue = $1,000,000
Operating Income = $150,000
Its operating margin would be:
$150,000 / $1,000,000 = 15%
The operating margin reveals how efficiently a company can deliver its core product or service after accounting for production and operating costs. It is commonly used for performance comparisons over time and against competitors.
Net Profit Margin
Finally, net profit margin compares net income to net sales.
Net Profit Margin = Net Income / Revenue
Net income is a company’s bottom line profit after ALL expenses, including operating and non-operating costs like interest and taxes.
For example, if a company has:
Revenue = $1,000,000
Net Income = $100,000
Its net margin would be:
$100,000 / $1,000,000 = 10%
The net margin reveals how much pure profit is retained per dollar of sales after all costs, interest, and taxes. It provides a clear picture of overall profitability and is a common benchmark used by investors.
Limitations of Using ROS
While return on sales is widely used, it does have some limitations to be aware of.
ROS doesn’t account for differences in capital intensity. Companies requiring large investments in assets and inventory may have lower ROS ratios strictly due to their business model, not performance.
It also doesn’t consider differences in accounting treatments of expenses like depreciation and amortization. These non-cash costs lower operating profit and thus ROS.
Finally, operating profit excludes financial structure factors like interest costs and tax rates. So ROS may be less useful comparing companies with vastly different capital structures or across global jurisdictions.
For these reasons, other profitability ratios like gross margin and EBITDA margin also have an important role in financial analysis. ROS is just one indicator of many to incorporate.
FAQs about Return on Sales Ratio
Let’s wrap up our comprehensive guide on return on sales by answering some frequently asked questions. These common FAQs highlight key takeaways for putting ROS into practice:
What is a good return on sales ratio?
While it varies by industry, a return on sales between 5-10% is generally considered a healthy range for the average business. Specific benchmarks should be based on a company’s peers and historical norms.
For example, software companies often achieve ROS ratios in the 20-30% range, while grocery stores are typically in the low single digits. Comparing a company’s ROS to competitors and industry averages provides the best benchmark.
It’s also important to measure ROS trends over time. The priority is maintaining and ideally improving ROS each year, not just reaching an arbitrary static target. Even a 1-2% ROS increase over time can have a meaningful impact on bottom line profitability.
How often should ROS be monitored?
For most businesses, calculating and analyzing return on sales quarterly is sufficient. Comparing ROS quarter-over-quarter and year-over-year spots positive and negative trends.
Companies should also update ROS benchmarks against peer/industry data annually, or whenever reporting periodic financials, to maintain an apples-to-apples perspective.
If sales are highly seasonal, it may also be helpful to monitor ROS monthly to account for fluctuations across the year. But for most companies, a quarterly cadence balances data recency with time required.
What are limitations of ROS?
While return on sales is an insightful efficiency metric, key limitations include:
- Variability across industries due to different business models
- Influence of accounting treatments for non-cash items like depreciation
- Exclusion of capital structure factors like interest and taxes
- No adjustment for investment intensity or capital expenditure needs
For these reasons, ROS should be analyzed in conjunction with other profitability ratios when evaluating financial performance. It does not paint a complete picture on its own.
How to interpret a low ROS ratio?
For most companies, the ideal is to achieve and sustain a ROS ratio above the industry average. Consistently landing in the bottom quartile versus peers signals issues that likely need addressing.
Potential root causes of a chronically low return on sales include:
- Lack of pricing power or discipline
- High production costs and operating expenses
- Bloated overhead structure
- Excess capacity and low utilization
- Defective products driving returns
- Inferior sales and marketing execution
If the ROS ratio falls below historic norms or lags competitors, management should diagnose the major drivers. Then initiatives can be implemented to improve operational efficiency and boost profitability per dollar of sales revenue.
What are common ways to improve ROS?
Some proven strategies to increase return on sales over time include:
Driving more revenue – Refine lead generation, boost conversions, upsell clients, offer new products, expand to new segments or geographies.
Lowering costs – Renegotiate supplier contracts, reduce overhead, streamline processes, right-size real estate footprint.
Improving pricing – Perform customer segmentation, implement tiered pricing, test promotions, rationalize product portfolio.
Optimizing sales – Automate repetitive tasks, provide sales training and coaching, analyze performance metrics.
Enhancing customer experience – Invest in product quality and support, resolve issues quickly, collect feedback and reviews.
Benchmarking competitors – Identify industry leaders in ROS and study their strategies and advantages.
Even marginal ROS improvements have an exponential impact on profitability over time.
What is the difference between net sales and gross sales?
Net sales refers to the amount of actual revenue retained by a company after deducting returns, discounts, allowances, and any other contra-revenue accounts.
Gross sales is the absolute dollar total of all products shipped and services rendered to customers. It does not account for any potential deductions or credits back to the client.
For example:
Gross sales = $1,000,000
Less: Returns = ($50,000)
Less: Discounts = ($20,000)
Net sales = $930,000
The net sales figure represents the real retained revenue, while gross sales reflects the total booking value prior to adjustments.
Should COGS be deducted when calculating ROS?
No, cost of goods sold should NOT be deducted from sales revenue when determining the return on sales ratio.
ROS specifically measures the company’s operating profit in the numerator. COGS is already backed out of operating profit on the income statement, along with other operating expenses.
The numerator should only be the final operating income/EBIT line reported on the financials. COGS is deducted further up the income statement when calculating gross profit, but does not get subtracted again for ROS.
How does inventory impact return on sales?
There isn’t a direct correlation between inventory and return on sales. ROS measures profit generated per dollar of sales revenue in a given period. Inventory fluctuations don’t necessarily impact current period sales being measured.
However, there are indirect ways inventory levels influence return on sales over time:
- Excess inventory can lead to liquidation sales at lower margins
- Lean inventory ensures production keeps pace with demand
- Low turnover of obsolete inventory drags on cash flow
- Stockouts from insufficient inventory result in lost sales
While inventory doesn’t directly factor into the ROS formula, strategic inventory management does impact sales, costs, and margins that ultimately flow through to a company’s return on sales.
Should non-cash expenses be included in ROS?
Non-cash expenses like depreciation, amortization, stock-based compensation, and impairment charges should be EXCLUDED from the operating profit figure used to calculate return on sales.
The goal is to isolate true operating cash flow, so non-cash accounting expenses that do not actually impact cash balances are normally backed out.
For comparison purposes, metrics like EBITDA that explicitly add back non-cash costs may be used. Comparing ROS to EBITDA margin can reveal the impact of different accounting treatments.
But in general, the purest ROS ratio uses EBIT or operating income excluding all non-cash costs that don’t affect cash flow.
How does sales mix impact ROS?
The mix of products and services sold impacts return on sales, as profit margins vary by product line and category. As sales shift toward higher margin offerings, a company’s overall ROS will increase.
For example, a 50/50 sales mix of Product A (25% margin) and Product B (75% margin) would yield:
(0.25 + 0.75) / 2 = 50% Average Margin
If the mix shifted to 80% Product B, the overall margin would increase:
(0.25 * 20%) + (0.75 * 80%) = 70% Margin
Multiplying sales mix percentages by product margins reflects the overall profit on total company revenue.
This highlights the importance of monitoring sales trends and profitability by product line or division – not just at the corporate level. Focusing sales on the highest ROS categories lifts overall performance.
Should ROS be used to compare different industries?
As discussed earlier, return on sales has limitations when comparing vastly different industries and business models. The ratio can vary significantly between, for example, a software company and a retailer.
The most relevant ROS comparisons are made within the same industry, ideally among direct competitors. This controls for major structural differences across sectors.
That said, some insight can be gained from industry-level ROS benchmarks. While the absolute ratios may differ, relative performance versus industry norms is telling. A company lagging its peers in ROS warrants a closer look regardless of industry.
How does customer retention impact return on sales?
Increasing customer retention and loyalty improves return on sales in several ways:
- Existing customers tend to purchase more over time
- Higher retention means less churn that must be backfilled
- Loyal customers will pay a premium for products
- Satisfied clients refer new business via word-of-mouth
The key is retaining customers efficiently. If excessive discounts or account perks are required, the boost to ROS may be diminished. But in general, keeping customers engaged, satisfied, and buying more correlates to higher lifetime value and return on sales.
Should ROS be calculated monthly or annually?
For most businesses, return on sales should be monitored quarterly. Monthly calculations could be skewed by seasonal or timing quirks. And annual may not be frequent enough to spot trends.
Quarterly ROS tracking balances data recency and continuity. It allows year-over-year and latest quarter comparisons to identify positive and negative momentum.
Exceptions could include highly cyclical or transactional businesses that warrant monthly monitoring. Or small private firms focused just on annual performance. But quarterly is ideal for typical companies.
How does number of sales transactions impact ROS?
The number or frequency of sales transactions doesn’t directly change the return on sales ratio. ROS measures the total profit generated on total revenue dollars, regardless of order frequency or volume.
However, an increasing number of sales could indirectly lift ROS in several ways:
- More transactions spread fixed costs over larger revenue base.
- Higher sales volume improves production efficiency.
- Upsells and cross-sells boost order values.
- Referrals and repeat sales cost less to fulfill.
So while transaction volume isn’t part of the core ROS formula, more sales certainly support higher profitability over time.
Should ROS be calculated at gross or net revenue?
Return on sales should always be calculated based on net revenue, which is gross sales minus any returns, credits, discounts, or allowances. The net sales figure represents real retained revenue dollars.
While gross revenue indicates total booking value, net revenue reflects how much ultimately flows to the bottom line. Since ROS measures profit generation relative to sales, using net ensures an apples-to-apples comparison on the income statement.
What are some tools to calculate and monitor return on sales?
While ROS can be calculated manually in Excel, many tools exist to automate tracking:
- Financial modeling – Build a profitability forecast model with formulas to monitor projected ROS.
- Accounting software – Solutions like QuickBooks, Sage, and NetSuite track ROS across past periods.
- Business intelligence – BI tools like Sisense, Domo, and Tableau visualize ROS trends and drill-downs.
- Performance management – Dashboards in Gtmhub, Datarama, and Klipfolio centralize key metrics.
- CRM/ERP systems – Many contain accounting modules to calculate ROS from data.
The right tool depends on the use case. For frequent monitoring, a dashboard or BI tool adds automation. For ad-hoc analysis, financial models and reporting functions may be preferable. The optimal tool will surface insights while minimizing manual processes.
How often should return on sales be benchmarked?
Industry and peer ROS benchmarking should occur annually to maintain a current view of relative performance. Financial data lags by months, so annual updates ensure your targets reflect the latest competitor results.
Benchmarking more frequently than annual is often impractical since it requires published financials. But annual checks are essential – many companies adjust their pricing, segment focus, etc. each year. Keeping ROS benchmarks current is key.
What is a better metric – return on assets or return on sales?
Return on sales is generally a more insightful operational metric than return on assets (ROA) for most businesses. While ROA has uses in capital efficiency analysis, ROS better isolates profit generation efficiency.
Since ROS excludes capital structure factors like assets and leverage, it allows for performance comparisons even across very different business models. ROA comparisons can be skewed by differences in asset mix and capital intensity between companies.
However, asset-heavy companies like manufacturers may incorporate both ROS and ROA to get a complete picture. For most service-based businesses, ROS has greater relevance to profitability and performance.
How to calculate ROS in Excel?
Calculating return on sales in Excel requires a simple formula:
=Operating Profit / Net Sales
Where operating profit and net sales refer to cell references where those income statement figures are entered.
To state as a percentage, use:
=Operating Profit / Net Sales * 100
For example, with operating profit in cell B2 and net sales in B3, the formula would be:
=B2/B3
And to convert to a percentage:
=B2/B3*100
This basic Excel formula allows ROS to be updated each period as new financial data is entered. Automating the calculation ensures it remains current.
How is return on sales different from gross margin?
While often conflated, return on sales and gross margin have distinct differences:
- ROS uses operating profit in the numerator. Gross margin uses gross profit.
- Operating profit deducts COGS and operating expenses. Gross profit only deducts COGS.
- ROS measures efficiency generating operating income. Gross margin measures initial profit after production costs.
So in summary, gross margin excludes operating expenses while ROS incorporates a company’s complete expense structure to measure holistic operating profitability.
Can a negative return on sales occur?
Yes, it is possible for a company to report a negative return on sales. This indicates the business is operating at a net loss.
A negative ROS means operating expenses for the period exceeded net sales revenue, resulting in negative operating income. The company spent more across COGS, payroll, admin, etc. than it generated in sales.
Sustained negative ROS represents a money-losing operation. It signals a need for urgent interventions to slash costs, boost sales volume, or raise prices.
Turning around a negative ROS requires increasing revenue, decreasing operating expenses, or both. Simply attaining a positive ROS should be the initial goal. Then focus on optimizing it over time.
What is a good ROS target by industry?
While specific return on sales benchmarks vary, here are rough targets by sector:
- Technology – 20-30%+
- Pharmaceuticals – 15-20%
- Business Services – 10-15%
- Financials – 15-25%
- Industrials/Manufacturing – 10-20%
- Retail – 2-10%
- Transportation – 5-15%
- Utilities – 5-10%
Of course, the same principles apply: compare to direct competitors and baseline against historic company averages. Set goals based on realistic improvement potential over time.
Can ROS be manipulated or inflated artificially?
Unfortunately yes, a company could artificially boost return on sales metrics through misleading accounting or financial engineering.
Tactics like:
- Delaying expense recognition
- Accelerating revenue before completion
- Inflating margins on inventory
- Under-reserving for bad debt
- Overproducing finished goods to lower COGS
All have the potential to inflate operating profit and ROS in the short term. For this reason, investors must scrutinize factors behind ROS changes and watch for patterns of manipulating key ratios around reporting cutoff dates.
Key Takeaways on Sales Returns and Return on Sales
- Sales returns refer to merchandise that is sent back by customers to the seller, usually due to defects, damage, shipping errors, or other issues.
- Companies account for sales returns by recording a debit to the Sales Returns and Allowances contra-revenue account. This reduces reported revenue and accounts receivable or cash accordingly.
- Though inevitable, excessive sales returns can hurt profits. Companies should proactively implement quality control, accurate marketing, and competitive return policies to minimize returns.
- The return on sales (ROS) ratio measures a company’s operational efficiency by calculating how much operating profit is generated per dollar of net sales.
- ROS is calculated by dividing operating income by net sales revenue. It reveals how well a company controls costs and converts sales into bottom line profit.
- Analyzing ROS trends over time and benchmarking against competitors’ ratios provides important insights into a company’s financial performance and health.
- Strategies for improving ROS focus on driving more high-value sales, reducing operating costs, optimizing pricing structures, and enhancing customer experience.
- While ROS has limitations, monitoring it over time and targeting industry-leading benchmarks gives companies a valuable way to measure and improve profitability.
The key is to thoroughly understand what drives both sales returns and return on sales, and implement strategies to optimize both for long-term success.
Here are some frequently asked questions about sales returns and return on sales:
What are some common reasons for sales returns?
Some top reasons for sales returns include damaged/defective products, inaccurate product descriptions, impulse purchases and buyer’s remorse, shipping errors, product obsolescence, and general customer dissatisfaction.
How do returns impact a company’s financials?
Sales returns directly reduce reported revenue and accounts receivable/cash balances. They also decrease profits and can impact inventory valuation. Tracking returns is critical for accurate financial statements.
What is a contra-revenue account?
A contra-revenue account, like Sales Returns and Allowances, reduces the amount of sales revenue reported. It is a deduction from gross sales to derive net sales revenue.
How is return on sales calculated?
Return on sales equals a company’s operating profit divided by its net sales. Operating profit is revenue less cost of goods sold and operating expenses. The ratio shows profit per dollar of sales.
How can companies minimize sales returns?
Strategies to reduce returns include quality control, accurate marketing, competitive return policies, proper staff training, studying product trends, and open communication with customers.
What is a healthy return on sales ratio?
A return on sales between 5-10% is generally considered reasonable, but targets vary widely by industry. The priority is improving ROS over time, not an arbitrary static goal.
What does a high or low ROS indicate?
A high and rising ROS suggests efficient operations and strong profitability. A low and/or declining ROS indicates potential issues with costs, pricing, overhead, or sales processes that management should address.
What are limitations of using return on sales?
ROS limitations include variability across industries, influence of accounting treatments, exclusion of capital structure factors, and no adjustment for investment intensity. It should be analyzed alongside other ratios.
How can companies improve their return on sales?
Strategies to boost ROS include increasing sales revenue, lowering operating costs, enhancing pricing and product mix, improving customer retention and loyalty, and benchmarking competitors.