Operating ratio
When calculating the operational ratio, production and administrative costs are weighed against net revenues. The ratio provides information on the amount of operating expenses incurred for each dollar of revenue. The lower the operating ratio, particularly when the ratio is low in relation to the same ratio for rivals and benchmark businesses, is a solid sign of operational efficiency.
Only for the purpose of determining whether or not the primary business can really turn a profit can the operating ratio be of any help. Because it does not take into account a number of costs that might be quite important, it is not a reliable predictor of the entire success of a company. As a result, it can be deceiving if it is used alone in the absence of any other performance indicators.
For instance, a corporation can have a large level of debt and hence be required to make enormous interest payments, which are not included into the calculation of the operating ratio. Nevertheless, investors often use this ratio as a tool for analysing the outcomes of a company’s operations.
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.