Operating ratio

Operating ratio (also known as operating cost ratio or operating expense ratio) is computed by dividing operating expenses of a particular period by net sales made during that period. Like expense ratio, it is expressed in percentage.

Formula:

Operating ratio is computed as follows:

operating-ratio-img1

The basic components of the formula are operating cost and net sales. Operating cost is equal to cost of goods sold plus operating expenses. Non-operating expenses such as interest charges, taxes etc., are excluded from the computations.

The following example may be helpful in understanding the computation of operating ratio:

 Example:

The selected data from the records of Good Luck limited is given below:

Net sales: $200,000

Cost of goods sold: $120,000

Administrative expenses: $20,000

Selling expense: $20,000

Interest charges: $10,000

Required: Compute operating ratio for Good Luck limited from the above data.

Solution:

= (160,000* / 200,000) × 100

= 80%

The operating profit ratio is 80%. It means 80% of the sales revenue would be used to cover cost of goods sold and operating expenses of Good Luck limited.

*Computation of operating cost:

Cost of goods sold + Administrative expenses + Selling expenses

= $120,000 + $20,000 + $20,000

= $160,000

Notice that the interest charges have not been included because they are not operating expenses.

Significance and interpretation:

This ratio is used to measure the operational efficiency of the management. It shows whether the cost component in the sales figure is within normal range. A low operating ratio means high net profit ratio i.e., more operating profit.

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. The operating ratio varies from industry to industry.

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9 Thoughts on Operating ratio

  1. Nyombi Thembo

    Excellent defintion and good example-thanks.

  2. Accounting for Management

    Welcome Nyombi Thembo.

  3. Abi

    It is useful ratio.

  4. Rajesh Poudel

    Can we say, the operating cost is other than financial cost(interest, dividend…)?

  5. Disha modi

    Actually i want to know the main reason behind earning high operating ratio for a business…?

  6. alfred

    great I am pleased with this way of explanation through website

  7. regen-degen

    since operating ratio + operating profit ratio = 100%,
    does this imply that when the operating profit ratio is negative; operating ratio will be > 100%?

  8. Lindo

    what is the rule of thumb for this ratio

  9. dawit

    it is interesting explanation and more useful for everyone

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