Operating Ratio | Operating Formula
Description: The operating ratio is the ratio of production and administrative expenses to net sales. It excludes financing costs, non-operating expenses, and taxes. Essentially, it is the cost per sales dollar of operating a business. A lower operating ratio is a good indicator of operational efficiency.
The operating ratio is only useful for seeing if the core business is able to generate a profit. Since several potentially significant expenses are not included, it is not a good indicator of the overall performance of a business, and so can be misleading when used without any other performance metrics.
Formula: Add together all production costs (i.e., the cost of goods sold) and administrative expenses (which includes general, administrative, and selling expenses) and divide by net sales (which is gross sales, less sales discounts, returns, and allowances). The calculation is:
Production expenses + Administrative expenses
A variation on the formula is to exclude production expenses, so that only administrative expenses are matched against net sales. This version yields a much lower ratio, and is useful for determining the amount of fixed administrative costs that must be covered by sales. As such, it is a variation on the breakeven calculation. The calculation is:
Example: ABC Company has production expenses of $600,000, administrative expenses of $200,000, and net sales of $1,000,000. Its operating ratio is:
$600,000 production expenses + $200,000 Administrative expenses
$1,000,000 Net sales
= 80% Operating ratio
Thus, operating expenses are 80% of net sales.
Cautions: The operating ratio indicates little when taken as a single measure for one time period, since operating expenses can vary considerably between months. Instead, it is better to track the ratio on a trend line.