The operating ratio compares production and administrative expenses to net sales. The ratio reveals the cost per sales dollar of operating a business. A lower operating ratio is a good indicator of operational efficiency, especially when the ratio is low in comparison to the same ratio for competitors and benchmark firms.
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. For example, a company may be highly leveraged and must therefore make massive interest payments that are not considered part of the operating ratio.
To calculate the operating ratio, 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 measure excludes financing costs, non-operating expenses, and taxes. The calculation is:
(Production expenses + Administrative expenses) ÷ Net sales
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:
Administrative expense ÷ Net sales
For 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 Regarding Use
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. If sales are seasonal, it can make sense to compare a month's results to those of the same month in the preceding year.