Overhead Ratio

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 –

Overhead Ratio = Operating Expenses / (Operating Income + Taxable Net Interest Income)
Overhead-Ratio-Formula

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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 ratio, not an overhead ratio.

Explanation

In this ratio, we have to consider two components.

The first component is the operating expenses. Operating expenses 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.

Examples

Let’s take a simple example to calculate overheads.

You can download this Overhead Ratio Excel Template here – Overhead Ratio Excel Template

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

Operating Expenses
Operating Income
Taxable Net Interest Income
Overhead Ratio Formula =
 

Overhead Ratio Formula =
Operating Expenses
=
(Operating Income + Taxable Net Interest Income)
0
= 0
(0+0)

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 in excel

Overhead Ratio Formula Video

Recommended Articles

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