The smaller the ratio, the more efficient the company is at generating revenue vs. total expenses. Here, the cost of goods sold includes all the direct manufacturing costs, such as raw materials and labor wages. In contrast, operating expenses include all the indirect production costs, such as selling & distribution expenses, office & administration expenses, etc. The operating ratio is a measure of efficiency that is used by management to determine day-to-day operational performance.
- The operating ratio for Apple means that 78% of the company’s net sales are operating expenses.
- The ability to double-stack intermodal containers, first introduced in the U.S. in the early 1980s, paved the way for a 35% to 45% gain in productivity, according to Blaze.
- Maintaining a lower operating ratio is a good way to achieve operational efficiency.
- Companies can sometimes cut costs in the short term, thus inflating their earnings temporarily.
Meanwhile, there are other factors that might lead to a higher OR but that don’t necessarily mean a company is faring worse financially. A railroad might decide to be overstaffed or rent too much equipment in preparation of a volume surge. High fuel prices can also make the OR worse if the railroads capture the incremental fuel costs with higher fuel surcharges.
Operating Ratio vs. Operating Expense Ratio
It is useful to track the operating ratio over a period of time to identify trends in operational efficiency or inefficiency. In this day and age, investors looking at the Class I railroads generally view an OR in the mid-50s as being a financial target for railroads to hit, although OR can generally range from 55% to 65%. The rail industry’s operating ratios have come down steadily over the years and are currently the best they have ever been. If the ratio is increasing, the organization is not working as efficiently. In such a case, operating costs are going up relative to revenue or sales.
Companies must clearly state which expenses are operational and which are designated for other uses. “You can see whether one company has a cost structure that is highly elevated relative to another company that has a similar revenue mix,” Baudendistel said. “Transportation is historically a thin-margin business, and sometimes it has negative margins during cyclical downturns. So, it’s easier to think of it as 100% as margin breakeven,” said Mike Baudendistel, FreightWaves market expert for rail and intermodal. Therefore, the operating ratio of Walmart Inc. stood at 95.9% during the year 2018. Therefore, the operating ratio of Apple Inc. stood at 73.3% during the year 2018.
Using OR to assess transportation companies has pros and cons, say experts
If sales are seasonal, it can make sense to compare a month’s results to those of the same month in the preceding year. Sales represent the starting line item of the income statement (“top line”), whereas operating costs refer to the routine expenses incurred by a company as part of its normal course of operations. The operating expense ratio (OER) is used in the real estate industry and is a measurement of what it costs to operate a property compared to the income that the property generates. It is calculated by dividing a property’s operating expense (minus depreciation) by its gross operating income. Operating expenses are essentially all expenses except taxes and interest payments.
So, even though that business can benefit a company’s cash flow and return on invested capital, that business can make the OR worse, according to Baudendistel. The lowest-cost provider with the lowest amount of operating expense wins the game,” said railroad economist Jim Blaze. The operating ratio metric assesses how effective an organization or team is at maintaining a lower cost of operations while generating a certain level of sales and revenue. A smaller ratio indicates the organization is generating more revenue as compared to total expenditures.
A low ratio in comparison to that of competitors indicates that management is doing a good job of keeping costs in line. If we divide our company’s total costs by its net sales, the operating ratio comes out as 80% – which is the inverse of the 20% operating margin. If a company’s operating ratio is 0.60, or 60%, then this ratio means that $0.60 is spent on operating expenses for each dollar of sales generated. The operating ratio is only useful for seeing if the core business is able to generate a profit. Since several potentially significant expenses are not included, it is not a good indicator of the overall performance of a business, and so can be misleading when used without any other performance metrics.
On the other hand, if the ratio is decreasing, it implies the company is effectively cutting back on its expenses while creating more sales. As with any financial metric, the operating ratio should be monitored over multiple reporting periods to determine if a trend is present. Companies can sometimes cut costs in the short term, thus inflating their earnings temporarily. Investors must monitor costs to see if they’re increasing or decreasing over time while also comparing those results to the performance of revenue and profit. On the other hand, the operating ratio is the comparison of a company’s total expenses compared to the revenue or net sales generated.
Operating Ratio Calculation Example
Some companies take on a great deal of debt, meaning they are committed to paying large interest payments, which are not included in the operating expenses figure of the operating ratio. Two companies can have the same operating ratio with vastly different debt levels, so it is important to compare debt ratios before coming to any conclusions. Investors should monitor a company’s costs for changes while also reviewing these results against profit and revenue. In addition, an organization’s operating ratio should be compared with that of similar companies in the same industry to get a better sense of how positive or negative the ratio is. The operating ratio indicates little when taken as a single measure for one time period, since operating expenses can vary considerably between months.
This metric compares operating expenses, also known as OPEX, to net sales. On the other hand, a higher ratio results in a less favorable situation as it indicates lower profitability and so lower returns for the investors. Let us take the example of a company named ADG Ltd which is engaged in the business of manufacturing electronic parts for Tier I auto parts supplier. In the next step, we subtract SG&A – the only operating expense – from gross profit to calculate the company’s operating income (EBIT) of $20 million (and 20% operating margin). The operating ratio is calculated by dividing a company’s total operating costs by its net sales.