Operating RatioDefined along with Formula & How to Calculate
What is the Operating Ratio?
The Operating Ratio measures the business operating efficiency through the company’s generated sales against the total Operating Expense.
It is the ideal method for monitoring a company’s day-to-day operations and helping the company in its decision-making processes related to cost management.
A smaller Operating Ratio indicates that the company has efficient operations to achieve a high-profit margin percentage.
How Does the Operating Ratio Work?
The formula for Operating Ratio is:
A step-by-step computation of the Operating Ratio is shown below:
- Determine the Cost of Goods Sold (for manufacturing industries), Cost of Sales (for retail companies), or the Cost of Service (for service industries).
- From the Income Statement, compute the total operating expenses.
- Take the sum of the Cost of Goods Sold and the Operating Expense. This shall be the numerator.
- Divide the numerator (Total Cost) by its denominator (Net Sales).
- Some companies combine the Cost of Goods Sold and Operating Expenses as a single account title, while others recognize it separately.
What Does the Operating Ratio Tell You?
The most popular method investment analysts use is the operating ratio as it provides a more accurate measurement of the company’s day-to-day operations.
When the ratio is used over different accounting periods, an analysis will be done to monitor the efficiency or inefficiency of the business operations during those periods.
A higher operating ratio indicates a high amount of operating expense incurred in one period as compared to the net sales is considered unfavorable for the company.
In contrast, when the operating ratio is low, it could either be because the net sales have increased or the operating expenses have gone down or both.
When the operating ratio is in an upward trend, the management can look at cost control methods to improve the overall profit margin of the business.
Components of Operating Ratio
Operating expenses are so-called indirect costs of production or costs that are not primarily included in the production process but are significant to fulfill the whole business operations.
Examples of these are general and administrative expenses, marketing expenses, etc.
These are also called overhead costs like office employee salaries, etc.
Other recognizable office expenses are:
- Sales and Marketing Expense
- Bank Charges and other fees
- Non-capitalizable research and development cost
- Accounting and legal fees
- Office Expenses
- Utility Expenses
- Salaries and Wages
- Repairs and Maintenance expense
Some companies record the Cost of Goods Sold and Operating expenses into only one line item while others recognize the two accounts separately.
That is why it’s vital to get the sum of the two account titles before dividing it by the net sales.
The components of the Cost of Goods Sold are:
- Direct Materials
- Direct Labor
- Rent of production facility
- Wages and benefits of production workers
- Repair and maintenance of equipment
The first line item seen in the Income Statement is the Net Sales.
It is recognized as net sales because there are still deductions related to the sale process and is the amount computed before the expenses are deducted.
The net sales and expenses are all listed in the Income Statement and for companies to be able to accurately determine the efficiency of their operations, the operating expenses must be clearly stated.
Example of Operating Ratio
Apple Inc.’s Income Statement Report for the period ended June 27, 2020 shows the following details.
- Net Sales – $59.8 billion
- Cost of Sales – $37 billion
- Operating Expense – $9.59 billion
The sum of the Cost of Sales and Opex is $46.59 billion.
To Calculate the Operating Ratio:
Operating Ratio = Cost of Goods Sold + Operating Expenses / Net Sales
Operating Ratio = $46.59 billion / $59.68 billion = 0.78 or 78%
The computed ratio means that 78% of Apple’s Net Sales is comprised of the total operating expenses for the period.
Since it’s just a one-quarter analysis, an investor must monitor the entire four quarters of Apple Inc.’s financial performance to attain more relevant information.
Also, investors may do a separate cost analysis of the company’s management of its two main costs: Cost of Goods Sold and Operating Expenses.
Operating Ratio vs. Operating Expense Ratio
The Operating Expense Ratio (OER) is a ratio that measures the operating efficiency of the Real Estate Industry.
It is a method used to determine the cost to operate the business against the income generated through its real estate operation.
The formula to get the OER is:
OER = (Operating Expense – Depreciation) / Gross Operating Income
The Operating Ratio is a comparison between the total expense and the total generated revenue across companies of different industries while the OER is only used for the Real Estate Industry.
Limitations of the Operating Ratio
The only drawback of the Operating Ratio analysis is that it does not recognize the acquisition of the company’s debts.
Since debts are one form of capital financing, many companies are enticed to acquire long-term debt which requires paying interest.
Such interest payments are omitted in the operating ratio computation.
While several industries from the same industry show almost similar operating expenses, they can have varying levels of debt.
Investors must be able to also compute the debt ratio of these companies to make a sound investment decision.
Investors must also do comparative analysis over several periods to accurately identify if there is a trend present in the company.
Monitoring a company’s cost management is a must to compare the cost performance of each period because there are cases where a company strategically cut its expense to present high earnings.
For a better performance evaluation, the investor must compare the company’s operating ratio to another company within the same industry.
A low operating ratio as compared to its competitors means that a company operates efficiently.
But as with the analysis of a company’s operations, it is always better to not use just a single analysis to make financial decisions but instead employ a full ratio analysis.
FundsNet requires Contributors, Writers and Authors to use Primary Sources to source and cite their work. These Sources include White Papers, Government Information & Data, Original Reporting and Interviews from Industry Experts. Reputable Publishers are also sourced and cited where appropriate. Learn more about the standards we follow in producing Accurate, Unbiased and Researched Content in our editorial policy.
University of North Carolina "Key Financial Indicators: Operating Ratio" Page 1 . August 29, 2022
Michigan State University "Financial Ratios Part 18 of 21: Operating-Expense ratio" Page 1 . August 30, 2022