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.
Operating ratio is computed as follows:
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:
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.
= (160,000* / 200,000) × 100
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
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.