A company's financial reports are like a blood pressure reading for its owners, showing whether or not a company is in good financial health. While there is a massive amount of data put into these reports, one simple calculation provides a tremendous amount of insight. This is the expense-to-sales ratio, also called expense ratio or operating ratio.
Calculate the expense ratio by dividing your operating expense by your net sales and multiplying the result by 100. This creates the percentage of costs to sales.
Calculating the Expense Ratio
The expense ratio can calculate the overall ratio of expenses to sales or it can calculate individual product lines. The formula is the same for both scenarios; the later just uses specific product data.
Calculate the expense ratio by dividing your operating expense by your net sales and multiplying the result by 100. This creates the percentage of costs to sales:
Expense Ratio = (Operating Expense / Net Sales) x 100
Understanding the Terms
When collecting the data to determine the expense ratio, consider what exactly constitutes operating expenses and net sales. Operating expenses are derived from the income statement in the expenses column, and include everything it costs to produce and sell the goods, except taxes and interest. Remove these items from the operating expense number. For example, if the total expenses were $50,000 but taxes and interest totaled $5,000, the operating expense would be $45,000 ($50,000 - $5,000).
Net sales reduce the total revenue by the cost of returns, allowances and discounts. This number is also derived from the income statement. For example, if the gross sales revenue was $100,000 with $5,000 in returns, $1,000 in allowances and $4,000 in discounts, the net sales would be $90,000 ($100,000 - $5,000 - $1,000 - $4,000).
Using the expense ratio formula stated above, the expense ratio derived from the sample operating expanse and net sales numbers is 50 percent ($45,000 / $90,000 x 100).
Insights Derived From Expense Ratio
The expense ratio helps define the organization's financial health and its ability to scale operations up or down. The smaller the ratio, the better the chances are that the company has to generate profits, even if the revenues go down.
For example, compare two companies with the same net sales of $100,000. Company A has $60,000 in operating expenses, while Company B has $50,000. The expense ratio for Company A is 60 percent, whereas the expense ratio for Company B is 50 percent. Consider the actual numbers, if the revenue dropped for both by $10,000, and Company A's profit drops from $40,000 to $30,000, while Company B's goes from $50,000 to $40,000, keeping a stronger margin.
The business should use this ratio for individual products to determine the financial viability of any one product and how it fits into its overall sales strategy. For example, some companies have a "loss leader" product to get people in the door. This product has a very high expense ratio. The sales strategy here is to get consumers in the door, who then buy a much more expensive product with a low expense ratio – thus higher profits. It all integrates into how you choose to run your sales strategies. The combined expense ratio should demonstrate profitability.
With more than 15 years of small business ownership including owning a State Farm agency in Southern California, Kimberlee understands the needs of business owners first hand. When not writing, Kimberlee enjoys chasing waterfalls with her son in Hawaii.