Operating Ratio

The operating ratio is a type of profitability ratio. It is the comparison of an operating expense to the revenue of a business. Operating expense could be an expense or a category of expenses like selling and distribution, administration, depreciation, salaries, etc. It is an important determinant of the operational efficiency of an organization.

Operating Ratio Definition

The 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 the cost of goods sold, labor costs, material expenses, administrative expenses, or sales and distribution expenses. The ratio is expressed in percentages. 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

The operating ratio helps in understanding which expense head is causing the biggest impact on the company’s overall expenses. 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

The 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 determine the trend of such ratios. If only a particular expense ratio increases, it is a preliminary sign of some inefficiency in that area. Similarly, if a particular ratio shows a downtrend, there could be effective management in that area simply because of an 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 comprises variable expenses, the % ratio of these expenses will not change much due to an increase or decrease in revenues. If that happens, it’s a sign indicating further investigation. Similarly, if the expenses in a particular operating expense comprise mainly fixed expenses, which should remain fixed irrespective of change in revenues, the % operating ratios should decrease with an increase in revenues.

Read about other types of PROFITABILITY RATIOS.

Conclusion

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



Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. 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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