What it means
Operating expenses are the recurring costs of keeping the doors open: salaries, rent, utilities, marketing, insurance, repairs and administration. The ratio compares those costs with the income they support, which turns a long list of cost lines into a single number a manager can track.
It answers the blunt question of how expensive this business is to run relative to what it earns. The measure is popular because it is hard to argue with.
Revenue can be flattered by one-off deals and profit can be moved around by accounting choices, but the proportion of income consumed by running costs is a fairly honest signal of operating discipline. Investors use it to compare two businesses in the same sector without getting lost in the detail.
In property investment the ratio has a specific and slightly different meaning. There it compares operating expenses with gross operating income for a single building, excluding mortgage payments and capital improvements.
A commercial landlord will often say a ratio between 35% and 50% is normal, depending on whether the tenant or the owner pays for services. Interpretation depends entirely on the industry.
A supermarket runs on thin margins and a high cost base, while a licensing business may spend very little to service its income. Comparing a hotel group with a consultancy on this measure alone tells you almost nothing useful.
The most common trap is inconsistency about what counts as an operating expense. Depreciation, owner salaries and one-off legal costs are all treated differently by different analysts, so the ratio only works as a comparison when the definition is held steady.
Agreeing the definition once and sticking to it matters more than which definition you pick.
In practice
Real-world examples.
Example
A gym chain generates $1,200,000 of membership revenue and spends $780,000 on staff, rent and equipment maintenance, an operating expense ratio of 65%. Head office sets a target of 60% before it will approve a second site.
Example
A landlord reviewing a retail unit finds gross operating income of $600,000 against operating expenses of $270,000, a ratio of 45%. Moving the tenant to a lease where the tenant pays service charges is expected to drop it to 30%.
Example
A marketing agency reports revenue of $3,000,000 and operating expenses of $2,550,000, a ratio of 85%. Because people are the main cost, the founders realise the only way to improve it is to raise fees or increase utilisation, not to cut small overheads.
Think of it
“Operating expense ratio shows what percentage of revenue gets consumed by the cost of running the business.
Formula
Calculation
Operating Expense Ratio = Operating Expenses / Revenue x 100
For property, the version used is Operating Expenses / Gross Operating Income x 100.
Worked example. A regional courier company reports annual revenue of $4,000,000. Its operating expenses are wages of $900,000, vehicle running costs of $260,000, premises and utilities of $140,000, and administration and insurance of $100,000.
Total operating expenses = $900,000 + $260,000 + $140,000 + $100,000 = $1,400,000
Operating Expense Ratio = $1,400,000 / $4,000,000 x 100 = 35%
So 35 cents of every revenue dollar goes on running the operation, leaving 65 cents to cover the direct cost of deliveries, finance costs, tax and profit.
Property version. A small office block generates gross operating income of $850,000 and incurs operating expenses of $340,000, giving $340,000 / $850,000 = 40%.Case study
Seen in the real world.
The following is a fictional, illustrative case. Harbourline Coach Hire, an invented regional bus operator, had grown revenue to $2,000,000 but its operating expense ratio had drifted from 68% to 75% over three years. Nobody had noticed because revenue kept rising, so the raw cost figures always looked justified.
The board asked for a line-by-line review against revenue rather than against last year's costs. Two contracts had been renewed at fixed prices while driver wages and depot rent rose, and an unused second depot was still being paid for. Closing the depot and repricing one contract cut operating expenses to $1,360,000.
That brought the ratio to $1,360,000 / $2,000,000 = 68%, back to its earlier level, and added $140,000 to annual operating profit. The lesson Harbourline drew was that cost control means watching the ratio, not the absolute spend.
Watch out
Common mistakes.
- Including interest and loan repayments in operating expenses. Financing costs sit below the operating line and belong in a different ratio entirely.
- Comparing the ratio across industries as though the same target applies everywhere. A restaurant and a software firm have completely different natural cost structures.
- Chasing a lower ratio by cutting marketing or maintenance. The ratio improves for a year, then revenue or asset condition deteriorates and it gets worse.
Questions
People also ask.
Is a lower operating expense ratio always better?
Usually, but a ratio far below the sector norm can signal underinvestment in staff, systems or property upkeep.
Should depreciation be included?
Many analysts include it for a full picture and exclude it when comparing cash costs, so state clearly which version you are using.
How does it differ from the operating margin?
The operating margin measures the profit left after all operating costs, while this ratio measures only the share consumed by overheads.
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