Operating expense ratio (OER): Definition, formula, and example

Overview and definition

What is the operating expense ratio (OER)?

The operating expense ratio (OER) is a financial metric that measures how well a business manages its operating expenses relative to its revenue. It is commonly used to assess operational efficiency and applicable to businesses of any type, including online enterprises.

Categorising overhead expenses

A big part of accurately calculating the OER is understanding and correctly categorising overhead expenses. These costs keep the business running but are not involved in directly making the products or delivering services.  

Overheads tend to recur regardless of how much the company produces and generally fall into three groups:  

1. Fixed overheads: Costs that stay the same no matter how much the business operates, like rent or staff wages.
    
2. Variable overheads: Costs that fluctuate with business activity or the volume of products sold, like freight costs, temporary labour, or commissions.
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3. Semi-variable overheads: Costs that are fixed up to a certain point but increase once a threshold is reached, like maintenance or warehouse costs.

Properly categorising overhead expenses allows your expense to revenue ratio calculation to accurately reflect operational performance.

Operating vs. non-operating expenses

Understanding the distinction between operating and non-operating expenses is also essential for calculating the OER accurately.  

• Operating expenses include the costs incurred through core business functions in regular operations, such as payroll, rent, and utilities.
• Non-operating expenses include costs like interest payments or one-time legal fees, which shouldn't be mixed into the OER calculations as they don't reflect ongoing operational efficiency.

Since the OER aims to show how well the business manages ongoing costs, only operating expenses should be included in the calculation. Including non-operating costs would give an inaccurate picture of day-to-day efficiency.

Research and development expenses

Research and development (R&D) costs can sometimes be included in operating expenses if they support continuous business innovation. However, whether R&D should be included depends on the industry.  

For example, most businesses and commercial property investors tend to exclude R&D, but it is often viewed as a core operating expense in sectors like tech and pharmaceuticals.

Therefore, accountants must consider industry-specific standards when classifying these expenditures.

Why is the operating expense ratio important for commercial property investors?

The OER is important to commercial property investors because it provides a snapshot of a rental property's profitability. It helps property investors see how much they spend to keep the property running compared to what they earn.  

If the OER percentage is low, it usually indicates better cost control and a higher net operating income (NOI), which makes the property a more attractive investment.

Formula and calculations

How to calculate operating expense ratio (OER)

The standard formula for calculating OER is:

OER = (Total operating expenses / Total revenue) x 100

• Total operating expenses: All recurring expenses necessary to maintain business operations.
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• Total revenue: Total revenue generated before any deductions.

Walkthrough of formula calculation

1. Identify operating expenses, which are the sum of all business operations costs.
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2. Determine the total revenue.
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3. Divide operating expenses by total revenue, then multiply by 100 for a percentage.

Let's say a company has the following figures:

• Operating expenses: $300,000
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• Total revenue: $1,000,000
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  OER = ($300,000 / $1,000,000) x 100 = 30%

In this example, the business spends 30% of its total revenue on operating expenses.  

Examples and interpretations

Operating expense ratio calculation example (OER)

Consider a real estate investment property with the following annual figures:

• Property management fees: $40,000
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• Insurance: $10,000
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• Repairs and maintenance: $20,000
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• Property taxes: $30,000
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• Total operating expenses: $100,000
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• Total rent income: $250,000

Input the values into the operating expense ratio formula:

OER = ($100,000 / $250,000) x 100 = 40%

This means 40% of the total rent income is used to cover the operating costs.

Operating expense ratio analysis and interpretation

The ratio of operating expenses may suggest how well a business manages its costs compared to its income, but it is still crucial to interpret the OER carefully.  

This means looking at how the OER changes over time, comparing it to industry standards, and understanding what different OER levels say about a company's cost control and profitability.

Indications of a low/high operating expense ratio

Low operating expense ratio

A low OER shows that only a small part of the business's revenue is eaten up by operating expenses, which is generally a good sign of solid cost management.  

Here's what a low OER percentage can tell us:

• Strong operational efficiency: The company controls its regular costs effectively, suggesting good internal management.
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• Better profitability: Less money spent on expenses typically means more income is retained as profit.
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• Good overhead control: Regular reviews will likely keep fixed and variable overheads in check.
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• Competitive advantage: Efficient cost management allows more aggressive pricing or reinvestment in growth areas.

However, while a low OER is considered positive, it's important to ensure that essential areas like maintenance, staffing, or compliance aren't being underfunded to reduce costs. Cutting things too lean can cause quality problems or create long-term risks.

High operating expense ratio

A high OER means a larger chunk of revenue goes towards operating costs. While this doesn't automatically mean the business is in trouble, it can raise concerns about how efficiently costs are being managed and future profitability.  

Here's what a high OER might suggest:

• Poor cost control: Too much overhead spending, underused resources, or misallocated costs.
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• Lower profitability: Higher expenses leave less money for profits or reinvestment, making the business more vulnerable to setbacks.
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• Operational inefficiencies: Excessive spending on administrative tasks, outdated processes, or redundant systems.
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• Misclassification of expenses: Sometimes, non-operating or one-time costs get mixed into operating expenses, making the ratio look worse than it is.

Before drawing conclusions, it's a good idea for accountants to investigate and pay closer attention to any big jumps in the OER over time.  

Comparisons & benchmark

The OER is most useful when viewed in context, not in isolation. Comparing your OER to industry standards or related metrics can tell you whether you're on track or where you need to improve.  

This makes it easier for businesses to make smarter, data-backed decisions.

Operating expense ratio vs. capitalisation rate

While both the operating expense ratio (OER) and the capitalisation rate (Cap Rate) are used in property and investment analysis, they provide different insights.

OER focuses on operational efficiency, whilst cap rate measures the return on investment from a property. The cap rate is calculated as:

Cap rate = (Net operating income / Current market value) x 100

• The OER shows how much of your revenue goes toward daily operating costs and how cost-efficient you are.
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• The cap rate gives you an idea of how much return you're making on a property relative to its value.

While OER helps you spot issues with controlling costs internally, the cap rate is more about the external valuation and return expectations. Many experts use both in tandem, especially in property management and real estate contexts.  

Industry benchmark comparisons

Checking your OER against industry averages is a great way to see how your business performs and evaluate whether you are spending more than your peers.  

For instance, if your OER is at 30% but the industry average is 25%, you might be overspending on certain expenses.  

Some benefits of benchmarking include:  

• Identifying operational areas where you can improve or cut costs
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• Building a case for investing in new tech or automation
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• Setting more realistic performance goals  

Industry standards can vary depending on the company size and growth stage, so consider those factors when comparing your OER to your peers for more meaningful analysis.

Impact on return on assets and equity

OER directly influences profitability metrics like return on assets (ROA) and return on equity (ROE). Lower operating expenses result in higher net income, which boosts both ROA and ROE.  

Monitoring OER alongside these metrics provides a more holistic view of a company's financial health.

Limitations and best practices

While the OER is a valuable financial metric, it has limitations. Knowing where it falls short and how to fill in those gaps helps you get a more accurate picture of what the numbers really mean.

Limitations of using the OER

• Excludes capital expenditures: OER does not account for long-term investments that might improve operational efficiency.
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• Overlooks revenue quality: The ratio doesn't reveal how sustainable or profitable that revenue is.
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• Varies significantly by industry: Difficult to draw one-size-fits-all conclusions, as comparisons should always be industry-specific.

For these reasons, the OER should be analysed in tandem with other performance indicators to build a well-rounded picture of operational health.

Factors that impact the operating expense ratio

Several variables can influence a business's OER. These can include:

• Location-based costs (rent, utilities)
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• Staff wages and benefits
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• Economic and regulatory changes
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• Efficiency of internal processes

Best practices for managing operating expenses

Here are a few best practices that can help manage your OER effectively:

• Budget regularly: Frequent budgeting and forecasting help catch any overruns early before they snowball.
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• Get expenses right: Make sure you're categorising costs correctly, as misclassifying costs can skew OER data.
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• Benchmark against peers: Compare your expenses to industry peers to determine whether you're staying competitive.
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• Audit vendors and contracts: Periodically revisiting your service agreements can help you find opportunities to negotiate better deals and save more.

Optimisation and strategy

These are the four ways to improve your OER:  

1. Identifying areas for reduction
   Conduct an audit to identify recurring expenses that add little value. Examples include under-utilised software or subscriptions, which can be reduced to improve operational efficiency.
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2. Increasing sales revenue
   Expanding into new markets or revising your pricing might help boost your OER and generate more revenue without dipping into costs.  
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3. Efficient management of overhead expenses
   Consider reducing overhead expenses by outsourcing non-core functions, renegotiating vendor contracts, or simplifying administrative processes to save more money.
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4. Leveraging technology for cost control
   Adopting accounting software, cloud-based systems, and automation tools can save time and labour, reducing operating expenses.

Role of property management solutions in improving OER

For commercial property owners, technology-driven property management solutions can make a difference.  

Features like automated maintenance scheduling, digital lease management, and real-time financial tracking can all simplify operations and slash operational costs, which can significantly boost your OER.

Final thoughts

OER is a key metric for accountants and business owners who want to better manage their cost control and boost profits. When used thoughtfully and compared against the right benchmarks, the OER helps guide smarter decisions and supports long-term financial planning that's grounded in real operational insight.

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