Operating expense ratio is a financial tool business leaders use to evaluate the effectiveness in generating profit from operating expenses. A high OER is unfavorable to profitability. The formula for calculating OER is simply operating expenses for a given period divided by gross profit for the same period.
Operating Expense Ratio Example
To calculate a ratio for the most recent month or quarter, simply pull the variables from your income statement. If gross profit for the latest quarter was $100,000, and operating expenses were $40,000, you divide $40,000 by $100,000 to determine the ratio. In this case, you get 0.4, or 40 percent. Thus, your $40,000 in operating expenses contributed to the generation of $100,000 in gross profit.
Where Gross Profit Comes From
Gross profit, also called gross income, is computed without taking operating expenses into consideration. Simply subtract the direct costs of producing goods for the period from total revenue. Even though gross profit doesn't include operating expenses, you wouldn't normally have the capacity to generate gross profit without the requisite overhead. A manufacturer can't typically generate gross profit without a building, equipment and salaried workers, for instance. The key is how well you manage your costs to drive revenue-generating activities.
Typical Operating Expenses
While you calculate OER using the total operating expense number from your income statement, a manager needs to assess the itemized expenses as listed on the statement. Operating expenses, or fixed costs, include things you pay for to operate that stay constant regardless of production or sales. Building payments, salaries, insurance, monthly service fees, utilities, marketing and legal retainer fees are common examples of operating expenses.
OER Analysis and Interpretation
A typical OER varies by industry. Certain types of companies operate with relatively higher or lower OERs than companies in other sectors. What managers watch for is an increasing OER or a ratio higher than industry norms. In one of these scenarios, the manager must look for ways to reduce expenses or to better leverage fixed investments to generate revenue. You could negotiate for lower building rental fees, for instance, or produce more output by better utilizing the space that you have.