Using 'Return on Sales' Measurement to Guide Purchases
Let’s look at two hypothetical tire and service stores, in the same town, a few miles from each other. Both stores do about $1.2 million in sales with about a third of their business in tires, the rest in service. Both see business is up and getting even better. It’s time to hire another salesperson. My advice to one of the owners is, “Go ahead, you need the extra help,” to which he thanks me for my expert opinion. To the other owner, I say, “It will make you lose money,” and he quickly tells me how wrong I am.
Why would one store get the green light and the other a bright red one? Return on sales. Return on sales is the measurement of profitability on the stuff a business sells. Mathematically it is net profit divided by total sales.
In the store that was given the green light, there is $100,000 in net profit. That is an 8% return on sales. When a business is deciding if it should purchase something (a machine, an addition to its labor force, or another expense) a good guide is to divide the cost of said thing by the return on sales. In this instance, let’s say a new salesperson costs $50,000 a year in gross payroll. If you take the $50,000 and divide by 8% (.08), you get $625,000, which is what that salesperson needs to sell in addition to the existing $1.2 million. That’s a tall order, but it’s in the realm of possible.
Let’s look at the store that was given the red light. Its net profit was $40,000 — 3% of total sales, which is common in the industry. If we take the same salesperson payroll, $50,000, and now divide by 3% (.03) we get $1.66 million needed in increased sales just to keep net profit the same (break even). That’s a very scary difference.Why such a difference? Using return on sales shows us what the minimum increase in sales is needed to not make the store worse financially. If the red light store were to hire the new salesperson, even with improving sales, it would lose profit by the end of the year. What should they do then? It would be OK if they had a plan to specifically increase net profits, outside of the plan of increasing sales. If the business focused on getting from 3% net profit to 8% or 10%, the business then could afford the added expense.
This exercise is useful when determining the purchase of new equipment. Say the business is looking for a new balancer. Road force or regular? Well, let’s look at those stores again.
Green light store, at 8%, needs to generate $100,000 in additional wheel balance revenue to buy an $8,000 road force balancer ($8,000/.08). The other store? $8,000/.03 is $266,000. Looks like they need to get the standard balancer. Or they could wait, improve profits, and then get the more expensive one.
As a side note, but very importantly, this exercise should never be used in determining purchases when employee safety or bringing a business up to code. Nothing is more important than the safety of your employees.
We can also look at this from an expense perspective. Let’s say your salesperson “borrowed” a stamp from the office to mail out an overdue personal bill. He was in a jam, it had to get out today or he’d have to pay another fine. And his credit would take a huge hit!
Let’s do the math on what additional sales are needed to offset that stamp. I’ll wait while you do the math. Yup, our green light store needs to sell $6.13 worth of additional goods and services to offset that “borrowed” stamp. Red light store needs to sell $16.
I’m not saying a total ban in office supplies is in order or if an employee honestly forgets to pay for a stamp you should salt their land, burn down their home and tarnish their family name for centuries. What I am saying is that return on sales is a powerful tool in business that can help guide good decision making processes instead of relying on a “gut-feeling.” This is another reason to strive for 10% net profit annually. ■
Dennis McCarron is executive director of Dealer Strategic Planning Inc., a company that manages multiple tire dealer 20 Groups in the U.S. (www.dsp-20group.com). To contact McCarron, email him at email@example.com.
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