How to Calculate the Cost to Income Ratio

The cost to income ratio is an important financial metric that measures a company’s operational efficiency. It compares operating costs to operating income to show the percentage of revenue used to cover expenses. The lower the ratio the more efficient the company is at generating profit from revenue.

Calculating the cost to income ratio is straightforward once you understand the components. Here is a step-by-step guide to calculating this ratio for your business.

What is the Cost to Income Ratio?

Also called the operating cost ratio or operating expense ratio, the cost to income ratio evaluates the costs of running your business relative to the income earned

It is calculated by dividing total operating expenses by total operating revenue. The result is expressed as a percentage.

Cost to Income Ratio = Total Operating Expenses / Total Operating Revenue x 100

This ratio shows what percentage of revenue is consumed by operating costs. For example, a ratio of 60% means operating costs are 60 cents for every dollar of operating revenue.

The lower the ratio, the more efficiently the business is run. Higher ratios mean more revenue is being spent on expenses rather than profit.

Why Calculate Cost to Income Ratio?

Tracking cost to income ratio over time is useful for:

• Measuring efficiency – The ratio monitors if costs are growing faster than revenue. This helps identify problems with spending or pricing.

• Benchmarking – Comparing your ratio to competitors and industry averages helps assess operational efficiency.

• Setting targets – Establishing a target ratio provides a goal for optimizing operations and reducing costs.

• Forecasting – Projecting future ratio levels helps with budgeting, planning, and managing growth.

For most businesses, keeping the cost to income ratio below 50% is a best practice. However, ideal levels vary by industry. Assessing your ratio versus benchmarks is important.

How to Calculate Cost to Income Ratio

Follow these steps to accurately calculate your company’s cost to income ratio:

1. Determine the Reporting Period

Decide which time period you want to measure. Many businesses calculate this annually using full-year financials. However, quarterly or monthly ratios can also be useful.

2. Identify Total Operating Expenses

Add up all operating expenses for the chosen reporting period. This includes:

• Cost of goods sold
• Selling, general and administrative expenses
• Depreciation and amortization
• Research and development
• Advertising
• Rent
• Utilities

Operating expenses exclude capital expenditures, taxes, interest, and other non-operating costs.

3. Identify Total Operating Revenue

Calculate total revenue earned from normal business operations during the period. This includes:

• Sales revenue
• Service revenue
• Membership/subscription revenue
• Licensing revenue

Do not include non-operating income like dividends, rent, or interest.

4. Divide Expenses by Revenue

Divide total operating expenses by total operating revenue.

Be sure to use the expenses and revenue figures from the same reporting period. This gives you the cost to income ratio.

5. Convert to a Percentage

Multiply the ratio by 100 to express it as a percentage. This helps when comparing over time or to industry benchmarks.

Cost to Income Ratio Example

Let’s look at an example to see how to calculate cost to income ratio in practice.

Jumping Fish Inc. is a small retail company. Here are their financials for 2019:

• Total sales revenue: $800,000
• Cost of goods sold: $320,000
• Selling expenses: $110,000
• General and administrative expenses: $150,000
• Depreciation expense: $20,000

Total operating expenses = $320,000 + $110,000 + $150,000 + $20,000 = $600,000

Total operating revenue = $800,000

Cost to Income Ratio = Total Operating Expenses / Total Operating Revenue

= $600,000 / $800,000

= 0.75

To convert to a percentage, multiply by 100:

0.75 x 100 = 75%

Therefore, Jumping Fish Inc.’s cost to income ratio is 75%. This means operating costs consume 75% of total revenue.

While not terrible, it’s a bit high, so they should look for ways to reduce expenses or increase revenue.

Tips for Improving Cost to Income Ratio

If your company’s cost to income ratio seems too high, here are some tips to improve it:

• Increase sales – Focus on boosting revenue through volume discounts, upselling, new products, etc. More total revenue improves ratio.

• Raise prices – Increase margins on existing products to grow revenue faster than costs.

• Reduce labor costs – Assess staffing needs, overtime, and compensation to optimize human resource expenses.

• Lower materials costs – Negotiate better deals from suppliers or change materials to cut these variable costs.

• Cut overhead – Look for savings on fixed costs like rent, utilities, insurance, subscriptions, etc.

• Improve productivity – Get more output from existing resources through process improvements. This increases income without raising costs.

Regularly monitoring your cost to income ratio and taking steps to lower it promotes greater profitability over time.

Limitations of Cost to Income Ratio

While useful, the cost to income ratio does have some limitations to be aware of:

• No indicator of profit – The ratio only looks at revenue and expenses. Your net profitability still depends on variables like taxes and interest.

• No cash flow measure – The ratio uses accrual accounting. It does not consider the timing of actual cash inflows and outflows.

• No balance sheet data – The ratio excludes capital structure metrics like assets, liabilities, and equity.

• No benchmark standards – There are no universal standards for “good” cost to income ratios. Comparisons within industries are needed.

• Susceptible to manipulation – Companies can artificially alter revenue and expenses to influence the ratio.

Use cost to income ratio as one key metric among many to assess performance. Combine it with other financial ratios and management tools to obtain a complete picture.

The cost to income ratio is easy to calculate but provides powerful insights into a company’s operational efficiency. As a key profitability metric, monitoring it regularly helps identify issues with expenses or revenue.

Use the steps outlined here to accurately calculate your business’s cost to income ratio. Look for ways to lower the ratio through cost-cutting or revenue-boosting strategies. Over time, improving your cost to income ratio leads to higher profit margins and better bottom line results.