The operating ratio is a type of profitability ratio. It is the comparison of an operating expense to the revenue of a business. Operating expenses 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 between 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
Operating Ratio Example
Let’s consider the following income statement for understanding expense ratio computation:
| Income Statement | Amount (USD) | Amount (USD) |
|---|---|---|
| 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.
Also Read: Profitability Ratios
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.
