Why Companies Calculate Their Expense

A sales and operations leader in Methuen, Massachusetts, Benjy Orbach worked as an operations manager for one of the largest import retailers in the country. Overseeing a territory that consisted of 10 stores and two customer service centers, Benjy Orbach had oversight over warehouse operations and budget preparations. He performed critical financial arithmetic such as calculating the business’ expense-to-sales ratio.

The expense-to-sales ratio, also called the operating ratio, is a calculation that reveals a company’s operational financial health. In simple terms, it is calculated by dividing a company’s expenses by sales and then multiplying the result by 100 to get a percentage. Therefore, if a company’s expenses in 2020 were $100,000 and its sales $200,000, it had an operating ratio of 50 percent.

In practice, however, deriving a company’s operating ratio is much more complicated. For example, only operating expenses are used in the calculation. These are the costs directly attributable to producing and selling a product or service. They include rent, utilities, office supplies, advertising, and salaries. Non-operating expenses like tax and interests on debts are not considered.

For sales, only net sales figures are included. This is the total revenue received in a year minus the cost of returns, discounts, and allowances. Both the net sales and operating expenses figures are derived from the company’s income statement.

Managers, executives, and investors use the operating ratio for comparative purposes. They can compare one year’s operating ratio to another year’s, one department’s or product’s ratio to another’s, or one company’s to another in a similar industry. Generally, a lower operating ratio is a good indicator that the company or department is efficient in how it spends cash to generate cash. A high operating ratio, on the other hand, shows that a company is inefficient in how it uses up cash to generate revenue.