What Is a Cost Ratio?

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An investor uses cost ratios to determine his potential return on investment.
An investor uses cost ratios to determine his potential return on investment. (Image: Brand X Pictures/Brand X Pictures/Getty Images)

Investors and companies commonly use cost ratios to assess risk and measure efficiency, productivity and value. Using their internal data, companies can measure the effectiveness of their operational activities as well as monitor trends and potential internal or external problems. An investor uses ratios involving cost and yield to calculate the return on investment of a potential investment opportunity.

Measurement of Efficiency

Cost ratios measure a business's efficiency. Managers divide the business's operating costs by its operating income to calculate operating cost ratios. The lower the cost-to-income ratio, the more efficient the business. For example, for a bank to assess a rise in costs at a rate higher than the income it earns from interest, it would calculate the cost-to-income ratio. The bank can identify any changes in costs compared with income to measure its operational efficiency.

Measurement of Staffing Productivity

A real estate firm might gauge its productivity based on the value of real estate it sold. Similarly a company could gauge its staffing productivity based on the starting salary of new recruits. A company calculates the costs incurred to foster the recruitment and divides the costs by the total amount of starting salaries of new recruits. Recruiting costs might include overhead, advertising, recruiting fees, Internet advertisements, bonuses, travel and relocation costs including visas.

Internal Operations Indicator

Production managers use cost ratios to monitor trends and identify problems using data from their companies' operations statements. They can calculate the ratio of labor costs to sales, direct materials to sales, factory overhead to sales, computer expenses to sales, travel expenses to sales or any other expense to sales. A significant change in cost ratios involving operations could identify one of two things: either an internal operational problem or an external problem involving economic conditions.

Return on Investment Gauge

Investors use cost and yield ratios to gauge the potential return on investment before making investment decisions. The investor weighs the benefits of the potential investment project compared with its costs. In simple terms, a project that costs $10 and yields $100 would arrive at a net benefit of $90, which means the project yields $90 after costs. The return on investment as a percentage is the net benefits divided by the costs and multiplied by 100, which in this case calculates as ($90/10) x 100 = 900. The investor of $10 receives a return on investment of 900 percent.

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