Is Anything as a Percentage of Sales Meaningful?

If I’m not mistaken, the overall financial goal of a for-profit organization is to generate the best possible return on investment (ROI) for its owners. That’s a basic assumption on which the profitability analytics framework has been built. With ROI being the appropriate measure of an organization’s overall “value,” wouldn’t if follow that the “value” of any segment of that organization’s business (e.g., customer, product, market) also be measured by its ROI?

PACE’s recent poll indicates otherwise. 81% of the respondents indicated that their organization’s measure of business segment profitability is based on a percentage of sales, not ROI. Any percentage of sales measure ignores one of the factors in ROI; the investment. Could a customer, product, or market with a higher profit, margin, or contribution percentage to sales actually be less valuable than one whose percentage is lower?

Consider the case of a manufacturer with a $9 million investment that manufactures two products; Product A and Product B. Both have sales of $10 million. Product A’s cost is made up of $7 million of material and $2 million of activity costs – the costs of running the business to convert the material into the product. As a result, it has a 10% profit as a percentage of sales. Product B’s cost consists of $4.5 million of material and $4 million of activity cost. It’s profit as a percentage of sales is 15%. Based on the profit as a percentage of sales measure, it would appear that Product B is more valuable to the company than Product A.

But how about the investment? Since two-thirds of the company’s resources are dedicated to the production of Product B, isn’t it reasonable to assume that two-thirds of its investment is also dedicated to Product B? If that’s the case, Product A’s ROI is 33% ($1 million /$3 million) while Product B’s ROI is 25% ($1.5 million/$6 million). Product A is actually more valuable to the company than Product B.

Ideally, a cost of capital, which incorporates the company’s targeted ROI, would be included in development of each product’s cost. That would enable management to assess each product’s return against the company’s target. But few, if any, organizations go so far in their costing practices. A measure that incorporates already available information is needed.

One option would be to use profit as a percentage of activity cost as a measure. Using that method, Product A would generate a 50% rate and Product B a 37.5% rate. More in line with each product’s relative ROI. Another option would be use profit as a percentage of value added. That would give Product A a rate of 33.3% and Product B a rate of 27.3%. Again, more in line with the relative ROIs of the two products.

If ROI is the ultimate financial goal of a company, any measure as a percentage of sales falls short in measuring the relative value of various segments of the business, whether customer, product or market. I’ve suggested a few alternatives. Do you have any to suggest?