Operating expense ratio

Operating expense ratio
See also
Costs and expenses Income from operations Absorbed costs Total income Profit Activity ratios Cost structure Net income margin Segment margin

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.

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