# 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:

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 Company limited is given below:

• Net sales: \$400,000
• Cost of goods sold: \$160,000
• Selling expense: \$25,000
• Interest charges: \$10,000

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

### Solution:

= (220,000* / 400,000) × 100
= 55%

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
= \$220,000

Notice that the interest charges of \$10,000 have not been included because they are categorized as financial expenses, not operating expenses.

A D V E R T I S E M E N T

## Significance and interpretation:

The operating ratio is used to measure the operational efficiency of the management. It shows whether or not the cost component in the sales figure is within the normal range. A low operating ratio means a high net profit ratio (i.e., more operating profit) and vice versa.

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 as soon as possible. The operating ratio varies from industry to industry.

More from Financial statement analysis (explanations):
A D V E R T I S E M E N T
1. Nyombi Thembo

Excellent defintion and good example-thanks.

2. Accounting for Management

Welcome Nyombi Thembo.

3. 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. 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%?

1. Smoky RT

You misunderstood. The operating ratio would be 80% but the profit ratio is NOT 20% !! Remember that the 20% had to cover TAXES and INTEREST. Both of those usually eat up MOST of the 20% (Corporate tax rate is 50%!!). Usually companies make about 3 to 4% after taxes and interest, not the 20% that you have deduced from this Operating Ratio analysis.

8. what is the rule of thumb for this ratio

9. it is interesting explanation and more useful for everyone

10. bunilal

Where can i include depreciation ? in operating exp or non operating exp ?

1. Accounting For Management

Depreciation is an operating expense because it is incurred as a part of normal business operation.

11. Manpreet sodhi