As a business owner you most likely have an instinctive feeling about how well your business is operating. However, you can get a more accurate assessment of what your business is doing by computing the operating ratio.
Operating ratio is computed by adding the cost of sales to the operating expenses then dividing the answer by your net sales. You will find these numbers on the Income Statement for your business.
What does this answer mean?
If the answer is greater than 1 (for instance, 1.1) the business is losing money because the cost of goods sold and operating expenses are greater than income from net sales.
If the answer is 1, your business is just breaking even.
If the answer is less than one, as it is in this example, the business is making a profit.
The goal is to have as low a number as possible when you compute the Operating Ratio.
Assume your business had net sales of $500,000
The cost of goods sold $300,000
Operating expenses were $100,000
Our formula would be:
Operating Ratio =
$300,000 + $100,000/$500,000 = $400,000/$500,000 = 4/5 = .8
The formula looks like this:
Operating Ratio =
Cost of Goods Sold + Operating Expenses/Net Sales
Let's look at an example using some numbers.
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