Expense ratio (also referred to as expense to sales ratio) is computed to show the relationship between an individual expense or a group of expenses and net sales. It is computed by dividing a particular expense or group of expenses by net sales revenue generated during the reporting period. Expense ratio is expressed and communicated in percentage form.
The numerator may be an individual expense or a group of expenses such as administrative expenses, sales expenses or cost of goods sold etc. The denominator is the net sales revenue i.e., the total gross sales less sales returns and allowances.
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 selling 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 an individual or a group of expenses is. 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 (e.g., rent of building, fixed salaries etc.), the ratio changes significantly as the sales volume changes. Expense ratio analysis might be helpful in controlling and estimating future expenses of a business entity.