Operating expense ratio

Operating expense ratio (OER) - is a ratio between gross revenue and operating expenses including all costs related to the management and administration of certain unit. Operating expenses are costs that are indirectly connected to operational functions of company.

Formula for calculating OER

Formula to calculate Operating Expense Ratio uses three elements. To calculate the indicator Total Operating Expenses needs to be reduced by depreciation and divided by gross revenue.

$Operating\ Expense\ Ratio\ =\ {\frac {Total\ Operating\ Expenses\ -\ Depreciation}{Gross\ Revenue}}$

All needed elements of the equation can be found in profit and loss account also known as income statement of the company. Income statement consist of such elements as incomes, other incomes, stock variation, expenses, other expenses, financing costs, income tax expenses or profit before taxation. Cost can be defined as the amount of money paid to manufacture products, buy materials, or perform services. On an example of production company costs can be divided into three groups. Direct materials which include costs of materials used to manufacture product. The other group called Direct labor contains wages paid to actual people that were involved in process of manufacturing product. The third group called Manufacturing overhead are actually operating expenses which can be defined as the costs of the day-to-day activities of company. They consist of elements such as:

• materials and energy consumption,
• taxes, fines, insurances,
• salaries,
• depreciation,
• production costs,
• costs of buying materials and needed supplies,
• costs of making sales,
• general management costs,
• costs of social operations,
• other costs.

Revenue is simply the money received from certain operations. It can be created using company activities, mostly by producing and selling goods but also by increasing the value of assets or by decreasing the value of financial liabilities.

Business intepretation

Operating expense ratio data gathered trough many years can be helpful for investors to notice trends in operating expenses. If costs are getting higher trough the years result of calculating OER can indicate that in following years they might as well. The operating expense ratio can inform about management efficiency in cost controlling processes and in increasing company assets and revenues. It can be influenced by changes in depreciation policies or switches in ownerships of assets.

Examples of Operating expense ratio

• Operating expense ratio (OER) can be calculated by taking total operating expenses divided by total gross revenue. For example, if a company has total operating expenses of $10 million and total gross revenue of $50 million, then the OER would be 0.2 or 20%.
• Another example of operating expense ratio is the ratio of operating expenses to total assets. This ratio is calculated by taking total operating expenses and dividing them by total assets. For example, if a company has total operating expenses of $10 million and total assets of $50 million, then the OER would be 0.2 or 20%.
• A third example of operating expense ratio is the ratio of operating expenses to sales. This ratio is calculated by taking total operating expenses divided by total sales. For example, if a company has total operating expenses of $10 million and total sales of $50 million, then the OER would be 0.2 or 20%.
• A fourth example of operating expense ratio is the ratio of operating expenses to net income. This ratio is calculated by taking total operating expenses divided by total net income. For example, if a company has total operating expenses of $10 million and total net income of $50 million, then the OER would be 0.2 or 20%.

Advantages of Operating expense ratio

The Operating Expense Ratio (OER) is an important metric for assessing the overall performance of a company. The following are some of the advantages of using the OER:

• It helps to easily identify any excessive operating expenses that may be reducing the profitability of a company.
• It provides a more accurate way to compare the operating expenses of different companies in the same industry.
• It helps to identify areas where cost-cutting measures can be implemented in order to improve efficiency and reduce overhead.
• It gives an indication of how well the company is managing its operating expenses in relation to its revenue.
• It allows for better forecasting of the company's future cash flow and financial position.

Limitations of Operating expense ratio

Operating expense ratio (OER) can be a useful tool to measure a company's operational efficiency, but it has some important limitations. These include:

• OER does not take into account other expenses such as capital costs or taxes. It only looks at operating costs, which may not represent a complete picture of the company's overall financial health.
• OER can be distorted by one-time or extraordinary items included in operating expenses. These items can lead to an overstated or understated OER.
• OER does not reflect the quality of the company's operations or the effectiveness of its management team. It only measures the ratio of operating expenses to gross revenue.
• OER does not account for changes in the cost of goods sold, which can have an effect on the company's profitability.
• OER does not consider how much of the company's operating expenses are being used for growth or investment opportunities. It only looks at the current operational costs.

Other approaches related to Operating expense ratio

• Operating Expense to Sales Ratio (OESR): This ratio measures the percentage of gross sales that is attributed to operating expenses.
• Operating Expense to Gross Profit Ratio (OEGPR): This ratio measures the percentage of gross profits that is attributed to operating expenses.
• Operating Expense to Total Assets Ratio (OETAR): This ratio measures the percentage of total assets that is attributed to operating expenses.
• Operating Expense to Net Income Ratio (OENIR): This ratio measures the percentage of net income that is attributed to operating expenses.

In summary, the operating expense ratio is an important metric used to measure the efficiency of a company's operations. Other approaches related to the operating expense ratio include the operating expense to sales ratio, operating expense to gross profit ratio, operating expense to total assets ratio, and operating expense to net income ratio. These ratios are used to gauge how much of the company's resources are being allocated towards operating expenses.

Footnotes

Operating expense ratio — recommended articles

Combined Ratio — Book profit — Berry Ratio — Activity ratios — Segment margin — Gross margin in retail industry — Termination cash flow — LIFO Reserve — Du Pont analysis

References

• Barber, B. M., Odean, T., & Zheng, L. (2005). Out of sight, out of mind: The effects of expenses on mutual fund flows. "The Journal of Business", 78(6).
• Colin, P. (1992). Dictionary of accounting. A & C Black.
• Kovner, A., Vickery, J. I., & Zhou, L. (2014). 1-27. Do big banks have lower operating costs?. "Economic Policy Review", 20(2).
• Man, M., & Gadau, L. (2010). The profit and loss account in different approaches. Annales Universitatis Apulensis-Series Oeconomica, 12(1). ISO 690
• Morrell, P. S. (2018). Airline finance. Routledge. ISO 690.
• Rea, J. D., Reid, B. K., & Millar, K. (1999). Operating expense ratios, assets, and economies of scale in equity mutual funds. Perspective, 5(5).
• Walther, L. M., & Skousen, C. J. (2009). Managerial and cost accounting. Bookboon.

Author: Michał Bałos