Operating Ratio

Operating Ratio is a type of Profitability Ratio that determines the Cost of Operations relative to its Net Sales. It indicates the share of the Total cost of Operations in Net Sales.
Operating Ratio = (Operating Expenses + Cost of Goods Sold) / Net Sales
Where,
  • Operating Expenses are the various expenses incurred in the company by normal business operations (excluding the Cost of Goods Sold) e.g. Salary, Rent, Insurance, Electricity, Marketing, and Sales, etc.
  • Cost of Goods Sold is the direct expense incurred during production e.g. Material Cost, Labour Cost.
  • And Net Sales is the Total Revenue from Sales.

Significance and Interpretation

  • It is very important for a company to minimize its operating expenses in order to boost profit margin. Higher Operating Ratio indicates high costs involved in company and production which will ultimately affect the Net profit of the company.
  • An Operating Ratio of 0.9 indicates that 90% of Sales Revenue is attributed to various costs involved in the production and allied activities, hence profit margin is 10% only.
  • Few factors that affect Operating Ratio are as below:
    • Labour Cost
    • Material Cost
    • Administrative Expenses
    • Marketing and Sales Expenses
    • Transport Cost

Examples

Example 1: Given below are few details of M/S XYZ Ltd., use them an calculate the Operating Ratio for M/S XYZ Ltd.
Particulars Amount (in Rs.)
Revenue from Sales (Cash) 300000.00
Revenue from Sales (Credit) 50000.00
Cost of Labour 40000.00
Material Cost 45000.00
Salary Expense 100000.00
Rent of Premises 48000.00
Insurance Expenses 15000.00
  • Solution:
  • Cost of Goods Sold = Cost of Labour + Material Cost = Rs. 85000
  • Operating Expenses = Salary Expense + Rent of Premises + Insurance Expenses = Rs. 163000
  • Net Sales Revenue = Cash Revenue from Sales + Credit Revenue from Sales = Rs. 350000.00
  • Operating Ratio = (Cost of Goods Sold + Operating Expenses) / Net Sales
  • = (85000 + 163000) / 350000 = 248000 / 350000 = 124 / 175
  • Hence, Operating Ratio = 124/175 or 0.7085 or 70.85%
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