What Is the Operating Ratio?

The operating ratio measures how much of a company’s revenue is absorbed by its core operational costs. It combines both operating expenses (e.g., salaries, rent) and the cost of goods sold (COGS), such as raw materials or production labor. A lower ratio means the business retains more revenue after covering day-to-day costs, signaling better efficiency.

This metric is critical for industries like manufacturing or retail, where managing production and overhead costs directly impacts profitability. For example, a furniture maker’s operating ratio reveals whether material costs and factory expenses leave room for profit.

How to Calculate the Operating Ratio

The formula is:
Operating Ratio = [(Operating Expenses + Cost of Goods Sold) / Net Sales] * 100

First, add operating expenses (rent, marketing, administrative costs) to COGS (direct production or inventory costs). Divide this total by net sales (revenue minus returns or discounts). Multiply by 100 to express it as a percentage.

For example, a bakery has $200,000 in net sales. COGS (flour, baking labor) is $80,000. Operating expenses (rent, utilities, salaries) are $70,000.

Total costs = $80,000 + $70,000 = $150,000
Operating Ratio = ($150,000 / $200,000) * 100 = 75%
This means 75% of revenue goes toward core operations.

Why Use the Operating Ratio?

This ratio helps businesses and investors evaluate total operational efficiency, not just overhead or production costs alone. A company with an 80% ratio spends 80 cents of every dollar on running the business, leaving 20 cents for taxes, interest, or profit. Investors use it to compare companies in sectors like agriculture or retail, where both COGS and overhead matter.

Managers also track it to spot trends. If the ratio rises from 70% to 78% over a year, it could mean supply chain inflation or inefficient staffing. Addressing these issues early can protect profitability.

Interpreting the Operating Ratio

A lower percentage is better, but industry standards vary. A 65% ratio might be stellar for a grocery store (low-margin industry) but mediocre for a software company. Compare your ratio to competitors’ averages for meaningful insights.

For instance, a clothing brand with a 72% ratio might seem efficient, but if rivals average 68%, it’s lagging. Conversely, a ratio that drops yearly suggests improving cost control. Pair this metric with gross margin to see how pricing or COGS changes affect profits.

Practical Applications of the Operating Ratio

Businesses use this ratio to negotiate with suppliers or optimize production. A restaurant struggling with a high ratio might switch to cheaper ingredient vendors (lowering COGS) or reduce energy bills (cutting operating expenses).

Investors apply it to identify well-run companies. A logistics firm with a stable 70% ratio may be a safer investment than one swinging between 65% and 80%. Lenders also review it to assess repayment capacity—lower ratios mean more cash for loans.

Common Mistakes to Avoid

Mixing up COGS and operating expenses skews results. COGS should include only direct production costs, like factory wages or materials. Operating expenses cover indirect costs like office supplies or marketing. Mislabeling these inflates or understates the ratio.

For example, a manufacturer classifying factory maintenance as an operating expense instead of COGS might underestimate its true production costs. Consistency in categorizing expenses ensures accurate comparisons.

Real-World Example: Calculating the Operating Ratio

A toy company earns $1 million in net sales. COGS (plastic, assembly labor) totals $400,000. Operating expenses (warehouse rent, admin salaries, ads) add up to $350,000.

Total costs = $400,000 + $350,000 = $750,000

Operating Ratio = ($750,000 / $1,000,000) * 100 = 75%

This means 75% of revenue funds operations. If last year’s ratio was 80%, efficiency improved by 5%. The company could reinvest savings into new product lines or marketing.

Conclusion

The operating ratio is a vital tool for assessing how efficiently a business spends on production and operations. Using the formula Operating Ratio = [(Operating Expenses + COGS) / Net Sales] * 100, companies can pinpoint cost leaks, investors can spot strong performers, and managers can balance spending.

Regularly tracking this ratio helps businesses stay agile in competitive markets. Whether you’re refining a budget or analyzing stocks, understanding the operating ratio turns complex finances into clear action steps. Start calculating yours today—it might just unlock your next big efficiency win.