Operating ratios may be even more useful than financial ratios because of the timely nature of their calculation and the decision specific nature of their use. While these ratios are in keeping with the thinking of most engineers and managers of sales, service and manufacturing can also use the principles of operating ratios effectively. But what is operating ratio? Let’s talk about the ratio.
Comparison of Financial and Operating Ratios Similarities
(1). Both financial and operating ratios are most useful when the information generated by the ratio is timely. Ratios are like other tools; they are beneficial only if you have them when you need them.
(2). As with financial ratios, operating ratios can be generated for any two numbers, for example: the number of salespeople and the dollars of sales per month. These two numbers will generate an average sales per salesperson, against which there may be a relative performance index. Also like financial ratios, unless there is a relationship, the resulting ratio is meaningless.
(3). Like financial ratios, operating ratios should not be accepted at face value. For the sales per person ratio, assume we find the average to be 17 sales per salesperson per day in an automobile dealership. Two of the salespeople make 43 and 53 sales per day, respectively, and the remaining five salespeople make 3 sales, 6 sales, 5 sales, 5 sales, and 4 sales, respectively. It would appear that you could replace the five salespersons with one aggressive person and be better off. However, additional information may reveal that the low-volume employees are automobile showroom salespeople and the other two are in the parts department. The parts room accounts for only 17 percent of the revenues but has 28.6 percent of the sales force. Several more ratios can be generated that would help in determining whether the sales force is well managed, efficient, and economical. Standing alone, no one ratio is as useful as a series of related ratios.
(4). Ratios for operations, like financial ratios, can be more effective if they are “trended“. Taking the salesroom salespeople’s past 12 months average ratio of sales per day, we observe these data:
Jan. 3.6 | July 4.9
Feb. 4.2 | Aug. 2.1
Mar. 5.4 | Sept. 4.7
Apr. 6.1 | Oct. 7.0
May 7.7 | Nov. 6.3
June 6.3 | Dec. 4.1
From this we see a two-peak cycle of automobile sales. The dealership can plan when it should order more cars to increase the inventory in anticipation of seasonal sales. It also may help plan for sales incentives, promotional advertising, vacation schedules, and other operational elements.
(5). The cost of generating the data necessary for any ratio should not exceed the benefit derived from the information produced from the data. As with any tool, a ratio should itself have a favorable cost-benefit relationship. In other words, the benefits should outweigh the costs.
(6). Ratios are useless if they do not meet a need. Looking back, the ratio of average sales per salesperson per period was designed to measure the relative performance of sales personnel. It did not do that adequately. It failed to inform management what the meaningful performance was for automobiles versus parts sales personnel.
(7). Properly structured, an operating ratio or series of ratios can be used for planning and control. As an example, some of the financial ratios mentioned can be used to evaluate credit policy. The same is true for operating ratios. If we monitor how well auto sales personnel are doing individually, compared to the monthly historical figures, we have a quantitative measure of individual performance. If we look at the aggregate sales figures of average sales per person per day against the historical average, we have a measure of how well the business is doing compared with past performance.
Dissimilarities of Financial and Operating Ratios
(1). Financial ratios relate to numbers from the balance sheet and income statement, whereas operational ratios are oriented more toward production, service, and sales—figures that may not be accumulated in the accounting system. Because of this, standard financial ratios are more likely to be routinely prepared, whereas operating ratios are more often tailored to meet particular needs. There is a greater tendency to compare financial ratios among businesses almost indiscriminately—resulting in bad comparisons among dissimilar businesses. Because operating ratios may be tailored, there is less of a tendency for misapplication and greater reliance on historical trends.
(2). Operating ratios often can be calculated very quickly from obvious data. For the example: of average sales per salesperson, management can have an accurate number for the previous day’s sales for each member of the sales force at the start of each workday. It is often more difficult to compile and verify the financial data.
The Use of Operating Ratios
Operating ratios can be used to evaluate any function. There may be a very large number of data-gathering efforts necessary to compile the needed input for ratio generation. Data gathering is costly and time consuming. It represents an investment that should have an expectation of a return to justify the expenditure. Therefore, you should first implement the use of ratios that have the greatest return or control. The ability to improve control through ratio generation and evaluation should be directed at critical steps in the process.
Breakdowns at critical steps may halt all production. For example: in a law firm specializing in appeals, time constraints are externally generated by rules of court with limited opportunities for extensions of time or deviations. Operationally, research is accomplished using sophisticated terminals connected to national data banks. Writing and editing is done on word processing software. All work flows through personnel highly skilled in the use of word processors. A breakdown in the word processing function could be very serious for the meeting of critical deadlines. Often the speed of input into the word processor is slower than dictation. Therefore, the ratio of skilled typists to writers may be critical. Ratio analysis can play a key role in determining a proper relationship.
There is a general five-step process for designing and implementing a control system based on ratio analysis. The number of steps may vary based on system complexity. The five steps are:
- Analyze the process or system: Write a step-by-step description of the process.
- Look for and identify critical steps: Is there any one step through which most or all work flows?
- Analyze the critical step: Is it a potential bottleneck or constriction? Why is it a bottleneck?
- Set a target performance ratio: Determine from past historical data how well you have done and ask, “How much better can we do?”
- Evaluate performance and feedback: How well are you now doing? How do you improve the system? What is the justification?
Applications Of Operating Ratio [A Case Example]
Operating ratios can be applied to any business. The next case study applies a ratio analysis to a service company (an accounting firm). Other suggestions will be given for a retail store and a manufacturing enterprise.
The firm of Lie Dharma Putra and Associate is a South-Pacific accounting firm composed of 6 partners and 11 associate accountant and tax accountant. They represent three large automobile insurance companies and tens of retail stores and manufacturing enterprises in various tax litigations.
The firm’s business is basically steady, with two small seasonal variations. The firm has a sophisticated word processing system with satellite terminals; one draft, high-speed printer; one letter-quality printer; and a laser printer.
The firm has two senior secretaries, two junior secretaries, and one clerk-typist/receptionist. As the caseload has grown, one senior secretary spends almost all her time setting up new case files. The firm noticed that the secretaries were putting in more overtime, and the senior partner was concerned that things were getting done only just in time. Ratio analysis was undertaken by an associate who had an undergraduate degree in business.
She analyzed the flow of paper from the receipt of a complaint through the final order of the trial court.
She prepared a flowchart of what work was done, when, and by whom. She discovered two critical steps:
- All work products passed through the two junior secretaries and one senior secretary as they input, edited, and printed out lawyers’ work products.
- The reproduction and mailing of letters, pleadings, and briefs.
The technical word processing function was on the verge of becoming a bottleneck. The work just seemed to take too long to process.
The reproduction facility was a disaster. The equipment was always breaking down; when it worked, people were constantly walking back to work without copies because “the line was too long” or “a long critical job was on the machine.”
After studying the number of words processed by each of the three secretaries, she found an average of 52 words per minute. Not to be fooled by averages, she looked at the distribution. The two junior secretaries typed at 38 and 42 words per minute each and the senior secretary typed at 75. The other senior secretary, who only set up files, could type at 81 words per minute. The associate, told that this secretary had been hired because of her typing speed, calculated that if the senior secretary switched roles with the junior secretary, the firm could target word input at 67 words per minute, average, without changing personnel (a 29 percent increase). The junior secretary and the receptionist would be able to prepare all the files as they came in. The associate found that the senior secretary had started or updated 61 files per day. She set a target of 45 files for the junior secretary and 20 for the receptionist (because of her other duties).
She ran a study of the copier by asking each user to log in the number of copies made of each original and the number of originals. From this, she learned several things. There were only two basic types of copying requirements: (1) long runs (many copies of large jobs with many originals) and (2) short runs (few originals, few copies). The long runs, on average, consumed 6 hours a day total time and the short runs 1.5 hours. The average short run took less than 30 seconds, but the average long run took 17 minutes. Twenty-one long runs and about 200 short runs were run each day. With the machine breakdowns considered, the copier (owned by the firm) worked properly on average 8.2 hours each 9-hour day. Often copies were run through lunch hour on a staggered secretarial shift.
From these ratios, the associate made these recommendations: Buy a highly reliable small copier and dedicate it to short runs. Hire a clerk to do the copying. As justification, she made these findings based on ratio analysis:
- On average, each secretary saved up five small runs or one long run before going to the machine.
- On average, the machine was tied up doing long runs or broken down 6.8 hours out of every 9 hours, roughly 75 percent of the time. On three out of every four trips to the machine, a secretary found it occupied by a long run. Because the secretaries made 40 successful trips to the copier per day (200 short runs/5 runs per trip), they were making approximately 120 unsuccessful trips to the machine. If they waited for a long run to finish rather than returning to their desk, they waited 81?2 minutes (17/2).
- By assigning a clerk to copying, all unsuccessful trips were eliminated. Even though an unsuccessful trip to the copier took only 45 seconds, 1.5 hours of secretarial time was saved (120 trips × 45 seconds).
- By reducing the demand on the copier, the breakdown rate was expected to improve.
- The biggest bonus to the firm was the actual freeing up of 7.5 hours of secretarial time. Simply to do the copying, a secretary stood at the machine for 6 hours a day for long runs and 1.5 hours per day for short runs. This, coupled with the 1.5 hours of time saved on unsuccessful trips, amounted to enough savings in dollars of overtime to pay for the small-run copier in nine months and still pay the salary and benefits of the clerk.
Ratio analysis improved the operation of the firm, gave it quantifiable measures of performance, and got some control over the operation.