The operating expense ratio measures
how much of a farmer’s revenue is used to cover operating expenses.
The operating expense ratio is one of the key financial efficiency ratios used in farm financial analysis.
Operating Expense Ratio Formula
Operating Expense Ratio = Total Operating Expenses ÷ Total Revenue
This article is a part of our series on Farm Financial Performance Ratios.
Description
The operating expense ratio in farm financials is a key financial metric that measures the proportion of a farm’s revenue that is consumed by operating expenses. It provides insight into the efficiency of a farm’s operations by comparing operating expenses to total revenue generated.
These operating expenses include all expenses directly related to the day-to-day operations of the farm, such as labor, fuel, maintenance, utilities, supplies, and other operating costs.
A lower operating expense ratio indicates that a smaller proportion of revenue is being consumed by operating expenses, which is generally favorable as it suggests higher efficiency and profitability.
Conversely, a higher operating expense ratio suggests that a larger proportion of revenue is being used to cover operating expenses, which may indicate lower efficiency and profitability.
Ideally, a farmer should strive to keep the proportion of operating expenses low enough to cover non-operating costs and take home an income. Operating costs should not be so low that corners are cut or the farm produces a low quality product – this most always backfires!
Calculating the Operating Expense Ratio
The operating expense ratio is calculating by dividing the total farm net income by the depreciation and capital costs associated with assets.
Operating Expense Ratio = Total Operating Expenses ÷ Total Revenue
Total Operating Expenses includes all expenses directly related to the day-to-day operations of the farm, such as labor, fuel, maintenance, utilities, supplies, and other operating costs.
Total Revenue represents the total income generated by the farm from sales of agricultural products, including crops, livestock, and any other sources of revenue. Total revenue is also known as gross revenue or gross income. These terms are interchangeable. Remember that this is the amount of money that a farm generates before accounting for expenses and cost of goods sold.
For a full breakdown of Operating Expenses and Total Revenue, take a look at our section outlining farm income statement.
Guided Example
To understand a working example of the operating expense ratio, consider the following example. In a given year, a farmer generates total income of $500,000 from the sale of crops and livestock. To produce these products for sale, the farmer incurred operating expenses of $300,000, including fuel, seed, feed, chemicals, labor, etc.
With these numbers, we can find the Operating Expense Ratio. Start by taking our formula:
Operating Expense Ratio = Total Operating Expenses ÷ Total Revenue
Next, plug the variables into the equation.
Operating Expense Ratio = $300,000 ÷ $500,000
Operating Expense Ratio = 60%
What this tells us is that 60% of all revenue is consumed by covering total operating expenses on the farm. This is a fairly healthy operating expense margin.
Ideal Rate of Return on Farm Assets
The ideal operating expense ratio for a farm can vary depending on factors such as industry, size, location and other factors. Each type of operation may be different and have different costs structures associated with the types of products they produce.
Based upon benchmarks within the agriculture industry, a good operating expense ratio should be 80% or lower. Efficient farm operations can attain an operating expense ratio below 60%.
How to Improve Your Operating Expense Ratio
The most practical approach to improving the operating expense ratio involves strategies to make the operating more efficient and reduce overall costs for each unit of output.
Here are some examples where this can be accomplished:
Efficiency Improvements
The most practical approach to improving the operating expense ratio involves strategies to make the operating more efficient and reduce overall costs for each unit of output.
- Technology Adoption. Invest in modern farming equipment, machinery, and technology to streamline operations, increase productivity, and reduce labor costs.
- Process Optimization. Analyze farm workflows and processes to identify inefficiencies and implement improvements that minimize waste, reduce downtime, and enhance overall efficiency.
- Resource Management. Optimize the use of inputs such as water, fertilizers, and pesticides to minimize waste and reduce input costs while maintaining productivity.
Cost Reductions
- Negotiate Supplier Contracts. Negotiate with suppliers for better pricing, discounts, or bulk purchase arrangements to lower input costs for seeds, fertilizers, chemicals, and other supplies.
- Energy Efficiency. Implement energy-saving practices and technologies, such as energy-efficient equipment and renewable energy sources, to reduce utility expenses related to electricity, fuel, and water.
- Labor Management. Evaluate labor requirements and staffing levels to ensure optimal utilization of labor resources while minimizing labor costs. Consider alternative labor arrangements such as part-time or seasonal workers when feasible.
Diversify Income Sources
- Value-Added Products. Explore opportunities to diversify farm revenue streams by offering value-added products or services. This can increase overall income and provide additional funds for asset replacement.
- Alternative Revenue Streams. Identify alternative income sources such as agritourism, farm events, or rental agreements for unused land or facilities. Supplementing traditional farming income can improve financial resilience and enhance the RCR.
By implementing these strategies, farmers can gradually improve their ratio, enhancing their financial resilience and ensuring they are running the most efficient operation possible.
How the Operating Expense Ratio is Used
The operating expense ratio is one of the most important metrics used to gauge farm performance and its uses are many.
First and foremost, the operating expense ratio is a performance measurement indicator. It helps farmers assess the efficiency of their operations by comparing expenses to revenue. It allows them to identify areas where operating costs may be excessive or inefficient.
Monitoring the operating expense ratio also enables farmers to track trends in operating costs over time and implement strategies to control expenses, improve efficiency, and maximize profitability.
This ratio is often used heavily by investors and lenders as a benchmarking tool as well. These individuals may use this performance indicator to understand how the farm or ranch is performance compared to peers in the industry. Comparing the operating expense ratio to industry benchmarks or historical performance allows farmers to assess their competitiveness and identify opportunities for improvement.
Further Reading
Farm Financial Standards Council – https://ffsc.org/
Basics of a Farm Balance Sheet, Ohio State University – https://ohioline.osu.edu/factsheet/anr-64
Farm Financial Analysis Series: Balance Sheet, Mississippi State University Extension – https://farms.extension.wisc.edu/articles/preparing-a-balance-sheet/