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 Company limited is given below:
- Net sales: $400,000
- Cost of goods sold: $160,000
- Administrative expenses: $35,000
- Selling expense: $25,000
- Interest charges: $10,000
Required: Compute operating ratio for Good Luck Company Limited from the above data.
= (220,000* / 400,000) × 100
The operating profit ratio is 55%. It means 55% of the sales revenue would be used to cover cost of goods sold and other operating expenses of Good Luck Company Limited.
*Computation of operating expenses:
Cost of goods sold + Administrative expenses + Selling expenses
= $160,000 + $35,000 + $25,000
Notice that the interest charges of $10,000 have not been included because they are categorized as financial expenses, not operating expenses.
Significance and interpretation:
The operating ratio is used to measure the operational efficiency of a company’s management. It shows whether or not the cost component in the sales number is within the normal range. A low operating ratio means a high net profit ratio (i.e., more operating profit). A high operating ratio, on the other hand, indicates a low net profit ratio (i.e., less operating profit).
The ratio should be compared with (i) the company’s own past years’ ratio and (ii) the ratio of other similar companies. An increase in the ratio should be investigated and brought to the attention of management as soon as possible so that corrective steps can be taken. The operating ratio varies from industry to industry; hence, the firms selected for performance comparison must belong to the same industry.