Running a business involves carefully managing expenses to ensure profitability. Most business owners would agree that controlling overhead costs is critical, but often struggle to optimize operating budgets.
Using a simple accounting formula called the operating expense ratio provides valuable insights to trim expenses. Mastering this financial metric can lead to improved profit margins and financial success.
In this post, you'll learn the definition of operating expenses, the formula to calculate the operating expense ratio, how to benchmark against industry averages, and actionable strategies to reduce overhead costs for a healthier bottom line.
Introduction to Operating Expense Ratio in Corporate Finance
The operating expense ratio measures a company's operating expenses as a percentage of its net sales. This key financial metric provides insight into a company's operational efficiency and profitability.
The formula for calculating operating expense ratio is:
Operating Expense Ratio = (Operating Expenses / Net Sales) x 100
Where:
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Operating Expenses include overhead costs like rent, utilities, and administrative expenses required to run the business. It does not include expenses directly tied to production like raw materials or direct labor.
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Net Sales refers to total revenue generated from sales of products and services, minus returns, allowances, and discounts.
Analyzing a company's operating expense ratio over time can reveal trends in efficiency. As a company grows, operating expenses should not grow at the same pace as sales. A decreasing ratio indicates the company is improving efficiency as sales increase. An increasing ratio could signal reducing profit margins.
Benchmarking a company’s ratio against industry averages also provides context into operational performance. For example, retail companies tend to have higher operating expense ratios than manufacturing companies.
Overall, the operating expense ratio is a useful indicator of a company’s financial health and ability to convert sales into profits. Monitoring this metric helps managers control costs, increase efficiency, and ultimately boost the bottom line.
What is the operating cost ratio in accounting?
The operating ratio shows the efficiency of a company's management by comparing the total operating expense of a company to net sales. It measures how much operating expense is incurred for each dollar of sales revenue earned.
A lower operating ratio indicates that a company is better at keeping operating expenses low relative to net sales. An increasing operating ratio over time means that operating expenses are becoming a larger portion of net sales, reducing profitability.
Key things to know:
- Operating ratio = Total Operating Expenses / Net Sales
- Shows how well a company controls operating expenses relative to sales
- Lower ratio = more efficient management and higher profit margins
- Ratio will vary significantly by industry
Most analysts want to see an operating ratio well below 1.0, often between 0.4 and 0.8 depending on the industry. Ratios above 1.0 mean operating expenses exceed sales, indicating inefficiency and low profits.
The operating ratio doesn't indicate the profitability of non-operating income and expenses though. So it's best used together with other metrics like return on assets (ROA) or return on equity (ROE) to assess overall company performance.
What is the formula for operating expenses?
The operating expense ratio is an important financial metric that measures a company's operating expenses as a percentage of its net sales. Here is the formula:
Operating Expense Ratio = (Operating Expenses / Net Sales) x 100
Where:
- Operating Expenses include things like:
- Salaries
- Rent
- Utilities
- Marketing
- Research & Development
- Net Sales is total revenue minus returns, allowances, and discounts
This ratio gives insight into how efficiently a company can control costs and turn revenue into profits. A higher ratio means operating expenses make up a larger portion of net sales, leaving less profit. Most healthy companies target an operating expense ratio below 80%.
Tracking this metric over time and comparing to industry benchmarks helps assess operational efficiency and cost management. Taking steps to streamline operations or cut unnecessary spending can help improve profitability.
Key things to monitor include:
- Salary expenses as a percentage of revenue
- Overhead costs relative to production
- Selling, general and admin costs trends
Overall, keeping close watch on operating expenses ensures more revenue flows to the bottom line as net income.
How do you calculate operating ratio in accounting?
The operating ratio is an important financial metric used to evaluate a company's operational efficiency and cost management. Here is a step-by-step guide to calculate operating ratio in accounting:
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Add Operating Expenses and Cost of Sales
The first step is to add up all operating expenses, including things like:
- Selling, general and administrative (SG&A) expenses
- Depreciation and amortization
- Research and development (R&D) expenses
Next, add the company's cost of goods sold (COGS). This represents the direct costs to produce products or services.
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Divide Costs by Net Sales
Take the total operating costs calculated in step 1 and divide it by the company's net sales or revenue. This measures costs as a percentage of sales.
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Multiply by 100 (optional)
Some analysts multiply the result by 100 to convert it into a percentage rather than a decimal. This makes it easier to understand and compare across companies.
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Evaluate and Compare
An operating ratio below 1.0 or 100% signals greater operating efficiency and profitability potential. Compare the ratio to competitors, industry benchmarks, and past performance to contextualize it.
In summary, the operating ratio formula is:
Operating Ratio = (Operating Expenses + COGS) / Net Sales x 100
Monitoring this metric over time and comparing to industry averages can provide meaningful insights into a company's operational efficiency. The goal is to minimize operating costs as a percentage of revenue.
How do you calculate expense ratio in accounting?
An expense ratio is a financial metric used to measure a company's operational efficiency by comparing its operating expenses to its net sales. The formula is:
Expense Ratio = Operating Expenses / Net Sales
Operating expenses refer to the day-to-day expenses incurred in running a business, such as:
- Cost of goods sold
- Selling, general and administrative expenses
- Depreciation and amortization
- Research and development costs
Net sales refers to total revenue generated from business operations after sales returns, allowances for damaged/missing goods and any discounts offered.
A lower expense ratio indicates greater operating efficiency as the company is able to generate more sales revenue relative to the operating expenses. For example:
- Company A has $2 million in operating expenses and $10 million in net sales. Its expense ratio is 0.2 or 20% ($2 million / $10 million).
- Company B has $1 million in operating expenses and $5 million in net sales. Its expense ratio is 0.2 or 20% ($1 million / $5 million) as well.
Although both companies have the same 20% expense ratio, Company B is less efficient as it is generating less sales revenue relative to operating expenses.
The expense ratio provides useful insights into factors influencing profitability. Companies aim to lower this ratio by optimizing operations to reduce costs and boost sales. Tracking the metric over time shows improving or worsening operating efficiency.
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Defining Operating Expenses and Their Role in Financial Ratios
Overview of Operating Expenses
Operating expenses are the day-to-day expenses incurred in the normal business operations of a company. They are expenses tied directly to the core operations and production of a business's goods or services. Common categories of operating expenses include:
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Cost of Goods Sold (COGS): Direct costs attributable to production of goods sold by a company. This includes raw materials, direct labor, and overhead costs.
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Selling, General & Administrative Expenses (SG&A): Expenses incurred in the selling, marketing, and delivery of products/services and managing overall business operations. This includes salaries, rent, utilities, office supplies, insurance, advertising costs, etc.
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Depreciation/Amortization: Allocating the cost of fixed assets like property, plant, and equipment over their expected useful lifespans. This reflects wearing out over time.
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Research & Development Costs: R&D expenses related to development of new products and services. This is an investment in innovation and future operations.
Operating vs. Non-Operating Expenses
Non-operating expenses are expenditures not directly tied to central business operations:
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Interest Expense: The cost of borrowing money and interest payments on debt. Considered non-operating as it's tied to financing decisions rather than core operations.
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Taxes: Corporate income taxes levied on net earnings. Non-operating as it's not an expense related to sales/production.
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One-Time Expenditures: Infrequent, unusual losses from events like lawsuits or asset write-downs. These are typically excluded from operating expenses.
Categorizing Overhead Expenses
Overhead expenses like rent, utilities, insurance, security costs, administrative salaries, depreciation of non-manufacturing assets, etc. are operating expenses. They support general business operations even if not directly involved in production. Overhead is categorized under Selling, General & Administrative Expenses on the income statement.
Research and Development Expenses
Research and development (R&D) spending is essential for business growth and innovation. All R&D costs are operating expenses, including salaries of research personnel, cost of materials/testing, intellectual property registration fees, and amortization of R&D-related intangibles. Tracking R&D spending is vital, as high R&D expenses can significantly impact a company's operating expense ratio.
Calculating the Operating Expense Ratio
Formula Overview
The operating expense ratio measures a company's operating expenses as a percentage of its net sales. It is calculated by dividing operating expenses by net sales.
The formula is:
Operating Expense Ratio = Operating Expenses / Net Sales
Where:
- Operating Expenses = Selling, General & Administrative Expenses + Depreciation & Amortization
- Net Sales = Total Revenue - Returns - Allowances - Discounts
This ratio shows what percentage of net sales is consumed by operating expenses. A lower ratio indicates greater operating efficiency.
Walkthrough of Formula Calculation
Here is an example calculation of the operating expense ratio based on the income statement below:
Revenue = $1,000,000
COGS = $600,000
Gross Profit = $400,000
Operating Expenses
- Selling & Marketing = $100,000
- General & Administrative = $200,000
- Depreciation = $50,000
Total Operating Expenses = $350,000
Net Sales = Revenue - Returns & Allowances
= $1,000,000 - $20,000
= $980,000
Plugging this into the formula:
Operating Expense Ratio = Total Operating Expenses / Net Sales = $350,000 / $980,000 = 35.7%
So 35.7 cents out of every dollar of net sales goes towards operating expenses.
Incorporating Net Sales into the Calculation
Net sales, rather than total revenue, is used in the formula to account for returns, allowances and discounts which reduce the amount actually collected. Using net sales provides a more accurate picture of the operating expense ratio. Companies with higher returns and allowances will have lower net sales, resulting in a higher operating expense percentage.
Adjusting for Cost of Goods Sold
The calculation focuses specifically on operating expenses, so cost of goods sold (COGS) is excluded. COGS is deducted from revenue to arrive at gross profit on the income statement. Operating expenses are then deducted from gross profit to determine operating income. Removing COGS isolates the operating expenses to analyze their ratio against net sales revenue.
Interpreting the Operating Expense Ratio
Ratio Analysis and Insights
The operating expense ratio measures a company's operating expenses as a percentage of net sales. It gives insight into how efficiently a company is managing costs and generating profits.
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A high ratio over 80% can indicate excessive operating expenses that are eating into profits. It may signal inefficient operations or an unfavorable cost structure compared to competitors.
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A low ratio under 40% suggests the company is tightly controlling operating costs and keeping overhead expenses in check. This leaves more net sales available as operating income.
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Ratios between 40-80% are average for most industries. Within that range, lower is generally better from an operational efficiency standpoint.
Industry Benchmark Comparisons
Comparing a company's operating expense ratio to industry averages provides useful benchmarking to assess operational efficiency:
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If the ratio is well above the industry average, it indicates higher operating costs than competitors. There may be opportunities to streamline operations.
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A ratio below the industry average suggests above-average cost control and operating efficiency. Maintaining lower overhead costs than peers leads to higher profit margins.
For example, the average operating expense ratio in the retail industry is around 65%. A retailer with a 50% ratio likely has better cost controls than competitors.
Impact on Return on Assets and Equity
The operating expense ratio directly impacts return on assets (ROA) and return on equity (ROE):
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A higher ratio leads to lower ROA and ROE, since more sales revenue goes towards operating expenses rather than net income.
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A lower ratio increases ROA and ROE, as the company converts more sales into profits with tighter overhead cost control.
Considering Bank Charges in Ratio Interpretation
Bank charges like monthly account fees can artificially inflate the operating expense ratio. When comparing ratios:
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Exclude bank charges from operating expenses to avoid distortion. This provides a more accurate picture of core business operating costs.
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If bank charges cannot be excluded, note comparisons may be less meaningful if one company incurs significantly higher charges.
Strategies to Optimize the Operating Expense Ratio
Identifying Areas for Reduction
Analyzing the income statement and balance sheet can reveal opportunities to reduce operating expenses without sacrificing quality or output. Specifically, business owners should scrutinize:
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Overhead costs: Expenses like rent, utilities, and office supplies that support business operations. Consider renegotiating contracts, switching providers, or cutting back on unnecessary spending.
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Payroll: Evaluate if staff levels align with current workload. Consider cross-training employees or leaving vacant positions open.
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Cost of goods sold: Review production and distribution processes for inefficiencies. Identify ways to cut material, labor, or logistics expenses.
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Discretionary spending: Cut back on non-essential expenses like travel, entertainment, and excess marketing.
Increasing Sales Revenue
While lowering operating expenses improves the ratio, boosting the denominator (net sales) has an even greater positive impact. Businesses can focus on:
- Marketing campaigns and promotions to attract new leads.
- Improving customer retention through loyalty programs.
- Developing new products and revenue streams.
- Entering new geographical markets.
Efficient Management of Overhead Expenses
To optimize overhead spending:
- Renegotiate office and equipment leases to reduce rent and lease payments.
- Adjust utility usage by installing energy-efficient systems.
- Cut back telecom and internet plans to match actual usage.
- Leverage automation and technology to reduce reliance on paper-based workflows.
Leveraging Technology for Cost Control
Emerging technologies like AI, process automation, and cloud computing can significantly lower operating expenses through:
- Reduced labor costs due to automation of repetitive tasks
- Increased operational efficiency and productivity
- Lower equipment costs by transitioning to cloud-based tools
Adopting new tech not only directly lowers overhead, but also enables businesses to scale without proportionally increasing operating expenses.
Conclusion: Mastering the Operating Expense Ratio for Financial Success
The operating expense ratio is a critical financial metric that provides insight into a company's operational efficiency. By tracking this ratio over time and comparing it to industry benchmarks, businesses can identify opportunities to streamline operations and boost profitability.
Here are the key takeaways for effectively utilizing operating expense ratio analysis:
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The operating expense ratio calculates operating expenses as a percentage of net sales, indicating the overhead costs required to run the business. Lower ratios signal greater efficiency.
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Core operating expenses include sales & marketing, R&D, G&A, plus other overhead costs like rent, utilities, etc. Non-operating expenses like interest and taxes are excluded.
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Compare your operating expense ratio to competitors and industry averages to gauge operational performance. Strive for ratios at or below the norm.
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Look for ways to cut controllable operating costs like office expenditures without negatively impacting operations. Reduce waste and streamline processes.
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Balance cost cutting with strategic investments in growth drivers like sales and marketing. An increase in operating expenses may ultimately boost revenue and profits.
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Monitor changes in operating expense ratio over reporting periods to track progress and catch emerging issues impacting efficiency.
With diligent monitoring, benchmark comparisons, and a focus on lean yet strategic operations, companies can leverage the operating expense ratio to maximize productivity and profitability. The key is striking the right balance between cost control and business expansion.
