Expense ratio (expense to sales ratio) is computed to show the relationship between an individual expense or group of expenses and sales. It is computed by dividing a particular expense or group of expenses by net sales. Expense ratio is expressed in percentage.
The numerator may be an individual expense or a group of expenses such as administrative expenses, sales expenses or cost of goods sold.
The following information has been extracted from the income statement of Beta limited:
- Net sales: $750,000
- Cost of goods sold: $487,500
- Administrative expenses: $30,000
- Sales expenses: $45,000
Required: Compute the cost of goods sold ratio, administrative expenses ratio and sales expenses ratio.
1. Cost of goods sold ratio:
(Cost of goods sold /Net sales ) × 100
= ($487,500 / $750,000) × 100
The cost of goods sold is 65% of net sales.
2. Administrative expenses ratio:
(Administrative expenses /Net sales ) × 100
= (30,000 / 750,000) × 100
The administrative expenses are 4% of net sales.
3. Selling expenses ratio:
(Selling expenses /Net sales ) × 100
= (45,000 / 750,000) × 100
The selling expenses are 6% of net sales.
Significance and Interpretation:
Expense ratio shows what percentage of sales is an individual expense or a group of expenses. A lower ratio means more profitability and a higher ratio means less profitability.
Analyst must be careful while interpreting expense to sales ratio. Some expenses vary with the change in sales (i.e variable expenses). The ratio for such expenses normally does not change significantly as the sales volume increases or decreases. For fixed expenses (rent of building, fixed salaries etc.), the ratio changes significantly as the sales volume changes. The ratio is helpful in controlling and estimating future expenses.