Financial managers perform various calculations and activities to analyze a company’s yearly and quarterly performance.
The cost-to-income ratio is one of the efficiency ratios used in financial management through the relationship between the cost and income of an entity. It is used to evaluate a company’s performance and the fundamental role is to validate the profitability of the company.
Financial managers use this efficiency formula to compare operating expenses or costs with the income generated.
The cost-income ratio portrays the effectiveness at which the company is being run. There is a roundabout connection between the expense ratio and the organization’s benefit.
It is considered that the lower the cost-to-income ratio, the better the company’s performance.
In this article, we’ve highlighted everything about the cost-income ratio to help you understand this financial management ratio quickly and easily.
How is a cost-to-income ratio defined?
The cost-income ratio is a ratio of efficiency that examines an organization’s costs in contrast to its profit. The two major things compared here are the expense of income and the complete income.
The expense of income includes assembling, showcasing, and transportation costs. The overall revenue or complete income calculates the total earnings obtained from sales during a specific financial period of the company.
The cost-income ratio analyzes these two figures to help managers evaluate the organization’s proficiency.
How is a cost-to-income ratio calculated?
A simple formula calculates the cost-income ratio, also known as the cost-revenue ratio.
Cost Income Ratio = Operating cost/operating income
The cost-to-income ratio is calculated by dividing the operating costs by operating income.
There are four major steps that financial managers take to perform calculations of the cost-to-income ratio.
1. Determine the Operating cost of Income:
Consider the manufacturing and assembling costs to discover your operating cost of income. You can utilize a fiscal report like a Statement of Financial Position (SOFP) to discover an organization’s operating costs.
Think about the immediate cost of work, materials, advertising, and dissemination. Likewise, incorporate any overhead expenses as recorded previously.
Add these expenses together to get the operating cost of income.
2. Identify the total operating income
You can track down the complete operating income on an organization’s financial record (Statement of Financial Position) at the end of the specific financial period of an organization.
An organization may list a few sorts of income but it is necessary to understand which figures you should include in calculating the total operating income.
For this estimation, utilize the aggregate or gross income, which displays the total income generated by the sales.
3. Calculate the Cost to Income ratio:
Once you’ve calculated both the operating costs of income and total operating income, it’s time to calculate the cost-income ratio.
Divide the operating costs by operating income to get the final cost-income ratio. This ratio will display the performance of an organization.
4. Find out the Ratio in Percentage:
In professional organizations, financial managers or clerks use the cost-income ratio in percentage.
So, once you’ve calculated the cost-income ratio by dividing the values, multiply the obtained ratio by 100.
After multiplying the ratio by 100, you will get a specific percentage. This percentage helps to identify whether the cost-to-income ratio is maximized or minimized.
Thus, the percentage makes it easier to evaluate the existing performance.
Example#1:
Mr. John needs to find his cost-income ratio to calculate his organization’s efficiency.
He uses different financial statements to find his direct material and labor costs. It makes up a total of $25,000. This further includes the laborers’ salaries and operating materials costs.
His marketing and advertising costs are $30,000. He spends $10,000 a year on overhead expenses, which include rent and light expenses.
He adds these expenses to determine his total operating cost of income:
$25,000 + $30,000 + $10,000 = $65,000
He uses his financial statements to identify the total operating income, which is $350,000.
He calculates the cost-to-income ratio by taking the operating cost of income and dividing it by the total income:
$65,000 / $350,000 = 0.185
He multiplies this number by 100 to find the ratio in a percentage form.
0.185 x 100 = 18.5%
Mr. John’s cost-to-income ratio is 18.5%. It shows that for every $18 he spends on manufacturing expenses, he acquired $100 in sales.
He can use this number to track the efficiency next quarter. By increasing the revenue and reducing the costs, he can generate a smaller ratio in the future. This will benefit the organization.
Example#2:
Let’s take another example to calculate the cost-to-income ratio of XYZ Inc., a small agency.
XYZ Inc
Statement of Comprehensive Income
| Particulars | 2021 (USD) |
| Income from financing | 85,000 |
| Income from Portfolio | 550,000 |
| Income from investment | 250,000 |
| Other income | 160,000 |
| Total income | 1,045,000 |
| Expense from financing | 123,000 |
| The expense of the client’s deposit | 129,000 |
| The expense of the borrowed loan | 235,500 |
| Other expenses | 123,660 |
| Total expense | 611,160 |
| Financial margin | 433,840 |
| Loan/loss provision | 125,440 |
| Foreign exchange gain/loss | 56,900 |
| Operating income after LLP and forex adjustment | 251,500 |
| Administration expenses | 60,000 |
| Employee expenses | 90,000 |
| Operating expenses | 150,000 |
| Income before tax | 101,500 |
| Taxes paid | 5,000 |
| Income after tax | 96,500 |
This is how the cost-to-income ratio for XYZ Inc. is calculated:
Total income = 1,045,000
Financial expense = 611,160
Operating income = 1,045,000- 611,160 = 433,840
Cost to income ratio = operating cost/ Operating income
= 150,000/433,840*100
= 34.57%
This ratio of 34.57% implies that XYZ Inc. made an expenditure of 34.57% to generate operating income.
However, we need to compare with the agency’s past figures or its peers for actual comparison. Here, the costs are lower, so the agency is performing efficiently.
Conclusion:
An organization’s financial managers calculate its company’s cost-income ratio to analyze its performance.
The cost-income ratio is calculated yearly to understand whether the company is performing well or requires further improvement.
The cost-income ratio is calculated by its specific ratio and all the entries are made appropriately in the journal entries.
We’ve also shown how financial managers can calculate the cost-of-income ratio for their company.
