Operating Expense Ratio Formula

The Operating Expense Ratio is the ratio between the cost of operation to the net revenue. It is typically used in evaluating real estate properties, where a higher Operating Expense ratio means higher operating expense than its property income and serves as a deterrent. Therefore, a lower operating expense ratio implies lower operating costs and is preferable and investment-friendly.

Operating expenses are required for operating a business. When we compare the cost of operation with the revenue generated, we get the operating expense ratio (OER). OER is popular in the real estate industry, and it is a common ratio used while doing real estate analysis. In real estate analysis, the analysts judge the cost of operating a property with the income generated by the property.

This ratio is more useful in the real estate industry; let’s look at OER from that perspective.

In this ratio, there are two components.

• The first component to calculate operating expense ratio is the most important one. It is operating expenses. In the case of the real estate industry, operating expenses include utilities, property management fees, maintenance, property taxes, insurance, repairs, etc.
• The second component is the revenue. Revenues are the income generated from a specific property.

For example, a company has bought a property to rent out to other smaller companies. To find out how the property is doing, the company would look at OER.

• If the operating ratio is higher, the company would consider keeping the property.
• On the other hand, if the operating ratio is lower, the company would consider the property a great investment.

To calculate the operating expense ratio for financial analysis purposes, it is necessary to know the formula used for the calculation.

Here’s the formula for operating expense ratio –

Operating Expense Ratio = Operating Expenses / Revenues

In the above formula we notice that there are two different variables, the operating expense and the revenues. The operating expense refers to any expense made in the business related to its day-to-day operations or its core business activity. They may not be directly incurred in the manufacturing of its products and usually include salaries, wages, marketing and advertising expense, insurance, repair, maintenance, travel and entertainment, etc.  

The revenue is the amount earned from the sale of its goods and services in the market within a particular time period. It is the income earned from the primary business operation.

Here are a few steps to operating expense ratio calculation calculation properly:

Determine the operating expense – This is the most important step where the operating expenses should be correctly identified after gathering the value of each of them for a specific period. Then make a total of all such expenses for the numerator of the formula.

Net revenue calculation – Then comes the collection of data for the denominator. The net revenue is the total amount generated from sales after deduction of sales return, discount and any allowances. This data should be related to the same time period as the operating expense.

Plugging in the values – The next step is to put the values in their respective places, divide the operating expense by the revenue to get the ratio.  

Let’s take a simple example to illustrate the operating expense ratio formula.
Onus Inc. has been comparing its operating expenses for a property it bought and trying to find out the OER. Here’re the details –

• Operating expenses - $40,000
• Revenues - $400,000

Find out the OER of Onus Inc.

Using the operating expense ratio formula, we get –

• OER = Operating Expenses / Revenues
• Or, = $40,000 / $400,000 = 10%.

If we compare the ratio with the other companies in the same industry, we can interpret the OER correctly. Thus the above example not only shows in a very clear manner how to make the operating expense ratio calculation but also tells us that it can be used to make comparisons among companies.

The operating expense ratio formula is used heavily in the real estate industry. But that is not the only industry where it gets used. It is also used in the manufacturing industry and service industries.

• Using OER  is to see how much income a company has been generating concerning its incurring operating expense.
• Every company wants the OER to be lower. The lower the OER, the better the company is performing.
• If you are looking at a company as an investor, you need to see the OER of the company for a long period.
• If you look at the OER of a company for a long time, you will be able to discover a trend of how the ratio between operating expenses and revenues is getting shaped.
• Then you can take that trend and compare it with the OER of other similar companies under the same industry.
• If the OER of the target company is lower than other companies in the same industry, the target company can be the right company to invest in. However, it would be best if you also looked at other companies' financial ratios before you decide..
• OER measures the flexibility and competency of the managers of a company. Understanding this will help you a lot as an investor.

Let us now do the same example above in Excel.

This is very simple. You need to provide the two inputs of Operating Expenses and Revenues.

You can easily calculate the ratio in the template provided.