The operating ratio compares production and administrative expenses to net sales. The ratio reveals the cost per sales dollar of operating a business. A lower operating ratio is a good indicator of operational efficiency, especially when the ratio is low in comparison to the same ratio for competitors and benchmark firms.
The operating ratio is only useful for seeing if the core business is able to generate a profit. Since several potentially significant expenses are not included, it is not a good indicator of the overall performance of a business, and so can be misleading when used without any other performance metrics. For example, a company may be highly leveraged and must therefore make massive interest payments that are not considered part of the operating ratio. Nonetheless, this ratio is commonly used by investors to evaluate the results of a business.
To calculate the operating ratio, add together all production costs (i.e., the cost of goods sold) and administrative expenses (which includes general, administrative, and selling expenses) and divide by net sales (which is gross sales, less sales discounts, returns, and allowances). The measure excludes financing costs, non-operating expenses, and taxes. The calculation is:
(Production expenses + Administrative expenses) ÷ Net sales = Operating ratio
A variation on the formula is to exclude production expenses, so that only administrative expenses are matched against net sales. This version yields a much lower ratio, and is useful for determining the amount of fixed administrative costs that must be covered by sales. As such, it is a variation on the breakeven calculation. The calculation is:
Administrative expense ÷ Net sales
Significance and interpretation:
The operating ratio is used to measure the operational efficiency of the management. It shows whether or not the cost component in the sales figure is within the normal range. A low operating ratio means a high net profit ratio (i.e., more operating profit) and vice versa.
The ratio should be compared: (1) with the company’s past years ratio, (2) with the ratio of other companies in the same industry. An increase in the ratio should be investigated and brought to attention of management as soon as possible. The operating ratio varies from industry to industry.
Components of the Operating Ratio
Operating expenses encompass all costs except interest payments and taxes. Organizations do not factor in non-operating expenses, such as exchange rate costs, into the operating ratio, as these are extra expenses unrelated to core business activities.
Operating expenses include overheads such as general sales or administrative costs. Examples of overhead include expenses accrued because of owning a corporate office since, although it is necessary, it is not linked to the production process. Operating expenses include:
- Legal and accounting fees
- Banking charges
- Marketing or sales costs
- Office costs
- Wages or salaries
In some instances, operating costs include the cost of goods sold (COGS). Such expenses are directly related to the production process. That said, some companies prefer to keep operating costs and direct production costs separately. The direct product costs can include:
- Material costs
- Labor cost
- Wages and benefits for production workers
- Machine repair and maintenance costs
Total sales or revenue usually appears at the top of an income statement as the sum total that an organization generates.