What is Overhead Ratio?
Overhead ratio is the ratio of operating expenses to the operating income; giving details about the percentage of fixed costs involved in generating a specific operating income for a company; a lower overhead ratio means that the higher proportion of expenses are related to direct product costs, implying that the company has minimized expenses that are not directly related to production.
Overhead Ratio Formula
The overhead formula is specifically useful for banks. Here we take the operating expenses into account and compare the expenses with the total income that can’t be attributed directly to the production of goods and services.
Here’s the overhead ratio formula –
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For eg:
Source: Overhead Ratio (wallstreetmojo.com)
Alternatively, many argue that overhead can be expressed as the proportion between operating expenses and the revenue; however, this proportion is called the operating expense ratioOperating Expense RatioOperating Expense Ratio is the ratio between the cost of operation to the net revenue and is commonly used to evaluate real estate properties. A higher Operating Expense ratio indicates that the company's operating expenses are higher than its property income, which acts as a deterrent. A lower operating expense ratio implies lower operating costs, which is preferred and investment-friendly.read more, not an overhead ratio.
Explanation
In this ratio, we have to consider two components.
The first component is the operating expenses. Operating expensesOperating ExpensesOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit.read more are the day to day expenses that the company needs to run the business. For example, utilities, machinery maintenance, office rent, professional fees, insurance, etc. are operating expenses.
The second component of overhead Ratio is a tricky one.
- We will take the operating income and also the taxable net interest income.
- When we deduct the operating expenses from gross profitGross ProfitGross Profit shows the earnings of the business entity from its core business activity i.e. the profit of the company that is arrived after deducting all the direct expenses like raw material cost, labor cost, etc. from the direct income generated from the sale of its goods and services.read more, we get the operating income.
- To get the net interest income, we need to look at the difference between how much a company receives interest and how much it pays off.
- Net interest income is a common measure for banks. But we can calculate the same for companies also.
- We will add the operating income and the taxable net interest incomeNet Interest IncomeNet Interest Margin is a popular profitability ratio used by banks which helps them determine the success of firms in investing in comparison to the expenses on the same investments. It is calculated as Investment income minus interest expenses (this step is referred to as netting) divided by the average earning assets.read more to get the denominator.
Examples
Let’s take a simple example to calculate overheads.
HoHey Restaurant has the following information –
- Operating Expenses – $23,000
- Operating Income – $115,000
- Taxable Net Interest Income – $46,000
Find out this ratio of HoHey Restaurant.
We know both the numerator and the denominator of this ratio.
- Operating expenses are $23,000.
The denominator would be the sum of operating income and taxable net interest income.
Using the overhead formula, we get –
- Overhead Formula = Operating Expenses / (Operating Income + Taxable Net Interest Income)
- = $23,000 / ($115,000 + $46,000)
- = $23,000 / $161,000 = 14.29%.
To interpret this ratio of HoHey Restaurant, we need to look at the ratios of other restaurants serving similar food and providing similar services.
Use of Overhead Formula
Overhead Formula is a significant measure for any company; because if it is lower, better would be the performance of the company. On the other hand, if it is higher, the company isn’t utilizing its resource prudently.
Every company should try to lower the ratio as much as it can.
There are two portions of the operating expenses that a company can look at.
- The first component of the operating expenses is expenses that can’t be curbed at all. In this case, the company should try to reduce this component as much as it can.
- The second component of the operating expenses can be removed completely. The company should take steps to pare down this second component to reduce this ratio.
However, reducing the ratio shouldn’t affect the company’s performance. Too much reduction in operating expenses may affect the company negatively. The company should try to maintain a balance and reduce only that much, which doesn’t reduce the efficiency of the company.
Overhead Ratio Calculator
You can use the following Overhead Ratio Calculator
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Overhead Ratio Formula in Excel (with excel template)
Let us now do the same example above in Excel. This is very simple. You need to provide the three inputs of Operating Expenses, Operating Income, and Taxable Net Interest Income.
You can easily calculate the ratio in the template provided.
Overhead Ratio Formula Video
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