Ratios can be Tricky Just because one sounds true doesn’t make it so!

Ratios can be TrickyJust because one sounds true doesn’t make it so! Ted Mitchell

Four PossibilitiesThe Scenario … • 1) Sounds True and it is True • 2) Sounds False and it is False • 3) Sounds True but it is False • 4) Sounds False but it is True

Rewarding Return on Sales • You have two stores. One in Reno and one in Sparks. You want to reward the store manager who is most efficient at converting sales revenues (inflow) into profits (outflow) • The performance measure is • ROS = Return on Sales • ROS = Net Profit Returned on Sales Revenue • ROS = Net Profit Margin

Return on SALES REVENUE • In 2010 Roy has $20 million in sales and has made a profit of $2million in your Reno store. • What is Roy’s return on sales, ROS? • ROS = PROFIT/REVENUE • ROS = $2/$20 = 0.10 = 10%

Reno Store ROS = 10% Profit $4 Reno ROS = 10% $2 $20 $40 Sales Revenue

In general we see that • Profit Returned on Sales Revenue = Profit/Sales Revenue • The key equation is • Profit = Return on Sales x Sales Revenue • Profit = (Profit/Sales Revenue) x Revenue • Z = ROS x R • Z = (Z/R) x R • An increase in our efficiency (ROS) implies an increase in profitability

Return on Sales • In 2010 Sam has $20 m in sales revenue and has made a profit of $4 m in your Sparks store. • What is Sam’s Return on Sales? • ROS = PROFIT/REVENUE • ROS = $4/$20 = 0.20 = 20%

Sparks Store ROS = 20% Profit Sparks ROS = 20% $4 Reno ROS = 10% $2 $20 $40 Sales Revenue

Conclusion • In 2010 the Sparks store with a 20% ROS was more efficient at converting Revenues into profits than the Reno store with a 10% ROS. • Sam with the store in Sparks got the bonus for being more efficient than Roy’s Reno store. • Does this scenario sound Plausible? • A) True • B) False

Sounds True and Is True • The conclusion is consistent with the information given. • The 2010 scenario sounds plausible and is true.

A Different Scenario • The Next Year for Sam and Roy

In 2011 Sam in the Sparks store maintained his 20% Return on Sales. Roy in the Reno store improved his Return on Sales to 25%. • Roy got the bonus for being more efficient in converting revenues into profits than Sam. • However, Roy made less profit than Sam this yearand he made less profit in 2011 than in 2010. • Does this scenario sound plausible? • A) True • B) False

The scenario sounds inconsistent and implausible

The scenario sounds False but it can be True. • In 2011 Sam in Sparks had revenues $20 million and with a 20% ROS earned a profit of $4 million. • In 2011 Roy in Reno had revenues of $6 million and with a 25% return on investment earned a profit of $1.5 million compared to his profit of $2 million in 2010.

Why did it sound false or implausible? • The reader or the audience assumes that both stores had the same revenues as in 2010. • We expect to be comparing like-things! • However, the denominator in the ROS changed. Roy had less sales revenue.

As a manager you must be very sensitive to comparing performance ratios. • 1) Watch out for the implied consistency of the context. Are you comparing apples and oranges. • 2) Your brain wants it easy to compare and so it will fill in the blanks.

Return on Sales • In 2010 you made a ROS of 10% in Reno and a ROS of 20% in Sparks. Your average return per store is 15%. • Does the scenario sound true or plausible? • 1) Yes • 2) No

Average ROS = 15% Profit Average Rome = 15% Sparks ROS = 20% $4 Reno ROS = 10% $2 $20 $40 Sales

Average ROS = 15% Profit $6 ROS= 15% ROS = 20% $4 ROS = 10% $2 $20 $40 Advertising

The scenario having an average ROS per store of 15% sounds consistent and plausible.

NEXT YEAR’S AVERAGE • In 2011 Sam in Sparks had a 20% ROS with profits of $4 million and Roy in Reno had a 25% ROS with a profit of $1.5 million. The average ROS is 22.5% per store. • Does the scenario sound plausible? • 1) Yes • 2) No

Profit Reno ROS = 25% Sparks ROS = 20% $4 $1.5 $20 $40 Sales $6

The average ROS in the 2011 scenario sounds very plausible but it is NOT True • The average ROS per store was NOT 22.5% • The average ROS per store was 21.15%

Profit ROS = 5.5/26 = 21.13% Reno ROS = 25% 5.5 $4 Sparks ROS = 20% $1.5 $20 $26 Sales $6

The average ROS per store is the total profit of the business divided by the total sales divide by 2 stores • Average ROS per store is the average profit per store divided by the average sales revenue per store = (5.5/2) / (26/2)= 21.15%

In other words the ROS for the whole of the two store business is the average ROS for each store. • BE VERY CAREFUL when calculating the average performance rates, ratios

Summary • ROS is a popular performance ratio for measuring overall efficiency • It should not be used in isolation • It is best remembered as Profit is the product of efficiency and revenue • The more revenue the more profit • The more efficiency the more profit • Profit = ROS x Revenue • A change in profit implies that efficiency or sales or both have changed • ∆Profit = ∆ROS + ∆Revenue

Any Questions on ROS? • Do NOT rely on ROS as a measure of efficiency • It is a rule of thumb for efficiency but IT can be very misleading

Ratios can be Tricky Just because one sounds true doesn’t make it so!