Operating Ratio Definition

Operating ratio measures the relationship of expenses to sales. It is also known as an expenses-to-sales ratio. The expense can be an individual expense or a group of expenses like cost of goods sold, labor costs, material expenses, administrative expenses, or sales and distribution expenses. The ratio is expressed in percentage. The relationship can be represented mathematically as follows:

Operating Ratio = {Expense (or group of expenses) / Net Sales} * 100

Expense Ratio

Operating Ratio Example

Let’s consider the following income statement for understanding expense ratio computation:

Income Statement
Revenue:
Revenue earned from operations $102,000
Expenses:
Salaries expense $40,000
Supplies expense $2,000
Rent expense $8,000
Insurance expense $750
Advertising expense $450
Depreciation expense – equipment $1,000
Interest expense $400 $52,600
Income before tax $49,400
Income tax $17,290
Net income $32,110

In such a scenario, the following operating ratios or expense ratios can be computed (rounded-off to the first decimal):

Salaries expense ratio = (40,000 / 102,000) * 100 = 39.2%

Supplies expense ratio = (2,000 / 102,000) * 100 = 2%

Rent expense ratio = (8,000 / 102,000) * 100 = 7.8%

Insurance expense ratio = (700 / 102,000) * 100 = 0.7%

Advertising expense ratio = (450 / 102,000) * 100 = 0.4%

Equipment depreciation expense ratio = (1,000 / 102,000) * 100 = 0.9%

Interest expense ratio = (400 / 102,000) * 100 = 0.4%

All these will add up to the total expense ratio, which in this case is:

Overall expense ratio = (52,600 / 102,000) * 100 = 51.5%

Operating Ratio Explanation

Operating ratio helps in understanding which expense head is causing the biggest impact on overall expenses of the company. Also, a study of these ratios across time periods can show which head has undergone the largest variation over the period so that management can decide on the fate of that expense and how that needs to be dealt with.

Importance of Expense Ratio

Operating ratio is important from the point of view of controlling and monitoring expenses. When these ratios are monitored every month, it is easy to find out the trend of such ratios. If only a particular expense ratio is increasing, it is a preliminary sign of some inefficiency in that area. Similarly, if a particular ratio is showing a downtrend, there could be an effective management in that area or it could simply be because of increase in revenues.

Operating Ratio Behaviour

Normally, the behavior of these ratios can be very well estimated by bifurcating the expenses between fixed and variable by their nature. If the expense is mainly comprised of variable expenses, the % ratio of these expenses would not change much due to increase or decrease in revenues. If that happens, its a sign indicating further investigation. Similarly, if the expenses in a particular operating expense comprise mainly of fixed expenses, which should remain fixed irrespective of change in revenues, the % operating ratios should decrease with increase in revenues.

Conclusion

Although operating ratios are good indicators of operating efficiency, it is advisable to look at other metrics also and not to solely depend on these ratios. Some expenses could increase or decrease with happening or non-happening of an event.

References:

Last updated on : March 7th, 2018
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About The Author

Sanjay Bulaki Borad
Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of training100.ru. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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