What were the main topics of conversation at your last board meeting?
If you’re lucky, you’d probably hope for some of these items
Everyone in the room sees a strong growth level and is in high spirits.
Until… the PE firm, the strategic buyer, or that naggy new board member starts pulling on this one thread.
Expenses as a percentage of revenue, overhead creep, cand ost structure versus peers. Suddenly, the story gets complicated.
What was supposed to be a breezy board meeting turns into a tense environment.
That's basically what the expense ratio conversation is all about. It's got a way of bringing to light things that organizations didn't even know they had to talk about in the first place.
The problem is that "expense ratio" means one thing to investors, another to CFOs, and yet another to everyone else. Investors want to know how much it costs to own an ETF, while CFOs want to know how efficiently their organization is turning their revenues into profits without turning them into unnecessary expenses in the process.
These are completely different math problems, and mixing them up is what leads to all the unnecessary confusion.
We'll look at both, but then we'll delve into what really matters to running a business: the operating expense ratio. We'll get into how to calculate it, what it should look like in comparison to industry averages, how it relates to EBITDA, and what it means to have an expense ratio that's a problem versus one that's a choice.
The term shows up in two very different financial contexts, and the definition changes depending on which world you're operating in.
An expense ratio represents the annual cost of running a mutual fund or ETF, expressed as a percentage of assets under management.
A fund holding $500 million in assets with $3.75 million in annual operating costs carries a 0.75% expense ratio. Investors pay this indirectly.
To answer the question directly: a 0.03% expense ratio is excellent for a fund, among the lowest you'll find anywhere.
A 0.75% or 0.9% expense ratio is reasonable for an actively managed fund, though it creates a meaningful performance hurdle that the manager needs to clear before you're actually ahead of a low-cost index alternative.
The expense ratio takes on a different meaning entirely. It measures operational efficiency — what percentage of total revenue gets consumed by operating expenses. This is the version CFOs, boards, and investors scrutinize when evaluating a business.
Operating Expense Ratio Formula:
Expense Ratio = Operating Expenses ÷ Total Revenue
A company with $10 million in revenue and $7.2 million in operating expenses has a 72% expense ratio. This leaves a 28% remainder to cover all of the EBITDA adjustments, taxes, debt service, etc.
The rest of this guide deals with the corporate finance definition.
The formula is simple. The application of the formula, however, needs a bit more attention.
Operating Expense Ratio = Total Operating Expenses ÷ Total Revenue * 100
To illustrate this, let's assume a regional professional services firm has a revenue of $18 million. Its operating expenses, which include salaries, rent, technology, marketing, and G&A, amount to $13.5 million.
$13.5M ÷ $18M = 0.75, or 75% Operating Expense Ratio
One number, by itself, does not tell you if the company is successful or struggling.
Is 75% good, bad, or ugly?
That depends on the industry, the growth stage, and what’s causing the cost structure to grow. A SaaS company with a growing sales organization may have an 85% expense ratio, which they might think is perfectly reasonable. A mature services company with a 75% expense ratio may have a serious problem.
Context is key here.
One important definitional note: Operating expenses may include COGS, SG&A, R&D, depreciation, etc., depending on the business model. Before comparing expense ratios between companies, make sure you understand exactly what each calculation includes. Inconsistent definitions can create more distortion than most people realize.
The term "expense ratio" appears across several financial contexts. Each version measures something distinct, and knowing which one you're discussing matters.
The Operating Expense Ratio (OER) is the most important ratio from a strategic point of view in corporate finance. Boards use the ratio to determine if the business is gaining operating leverage—i.e., if the revenue growth is outpacing expenses or if the two are rising at the same rate.
SG&A expenses are also important for growth-stage companies. When growth is rapid, sales, general, and administrative expenses tend to increase quietly. If the business grows revenue two times over but grows its SG&A three times over, it has not gained operating leverage; it has merely grown at the same rate.
The overhead ratio seems to be used most visibly in manufacturing, real estate, or other capital-intensive industries where indirect expense management is critical to maintaining margins as volume increases.
Expense ratio is one of those metrics that doesn't generate much conversation until it becomes a problem — at which point the explanation better be ready.
When expenses rise faster than revenues, profitability declines gradually but imperceptibly. A business with a consistent 78% expense ratio, while competitors operate at a 63% rate, is either investing for future growth, which is defensible if intentional and temporary, or has structural expenses that will ultimately hurt the business, which is not defensible.
Each percentage-point reduction in the expense ratio adds directly to EBITDA. A $25 million revenue business that reduces the expense ratio from 74% to 70% adds $1 million to EBITDA. At a 7x EBITDA valuation, that's a $7 million enterprise value benefit, with no need for revenue growth.
Private equity firms analyze expense ratios carefully during due diligence. They look for areas of operational inefficiency that they believe can be corrected post-deal, analyze cost synergies in platform roll-ups, and gauge management's comprehension of their cost structure. A high expense ratio is not necessarily a deal-killer, but a management team that cannot explain it clearly is.
Expense ratio benchmarks belong in board packages. Not as a standalone metric, but trending over time, indexed against industry peers, and connected to capital allocation decisions. Boards tracking only top-line growth without monitoring expense efficiency are making decisions with half the information they need.
Understanding cost structure before analyzing expense ratios is foundational to any investment decision. High expense ratios that are driven by planned R&D expenditures is vastly different from administrative bloat.
Sometimes, Margin and Expense Ratio as terms get mixed up or conflated. While they are related, they’re not measuring the same exact thing.
Represents the difference between revenues and direct production costs. It does not take into account SG&A expenses, R&D expenses, and other production overheads. Hence, it’s quite possible for a company to have high gross margins and still have an unimpressive expense ratio.
As mentioned above, it’s essentially the inverse of the expense ratio. If the OER is 68%, then the Operating Margin will be around 32%. They are essentially two sides of the same coin.
As discussed above, EBITDA Margin essentially adds back Depreciation and Amortization. It’s particularly useful when comparing different companies with different capital structures and different depreciation policies.
As the name suggests, it focuses on expenses. It represents the percentage of revenues spent on expenses. It’s not essentially a profitability metric but rather a management metric.
The practical implication is clear: a rising expense ratio requires a different diagnostic than a declining gross margin. The former signals problems with efficiency, the latter with pricing, product mix, or supply chain effects. Treating them as equivalent risks obscuring the real issue and creating an inappropriate solution.
In considering the role of operational efficiency in supporting sustainable market share growth, the conversation inevitably turns to expense discipline, as it becomes clear that a company which is unable to manage its expense structure will ultimately struggle to maintain price competitiveness, investment capacity, or preferential customer relationships as well.
There is no one-size-fits-all answer, and anyone stating such an answer without context is an oversimplification of the situation.
That said, there are some broad metrics that can be used as guidelines:
SaaS/Technology: Early-stage SaaS businesses tend to have expense ratios of 85-95%+ while heavily investing in product development and sales force build-out. Totally appropriate, as this business model is predicated on future operating leverage, or the expectation of revenue growth far outpacing the growth of expenses over time. Mature SaaS businesses tend to fall within the 60-72% range. Leaders of categories tend to be closer to 55-65%.
Professional Services: Consulting, legal, accounting, and staffing businesses tend to fall within the 70-85% range. Labor costs are the primary expense driver for these businesses, and while these costs can be reduced somewhat through efficiency measures, there is limited opportunity for operating leverage.
PE-Backed Businesses: Private equity firms tend to establish EBITDA margin targets that imply a certain expense ratio tolerance level. For example, if a firm is setting an EBITDA margin target of 25%, it is effectively setting an expense ratio target of 75%. This is typically a four- to five-year journey to achieve such a goal. The journey is just as important as the goal itself – a firm moving from 82% expense ratio to 74% expense ratio over three years is a very different story from a firm moving from 69% expense ratio to 77% expense ratio over the same time frame.
For early-stage financial performance metrics, expense ratio benchmarks behave differently than those for established businesses — the growth investment logic changes the acceptable range significantly.
The key to improving expense ratio is not just to reduce expenses. Equating expense ratio with expense reduction is how companies end up reducing their muscles instead of fat.
The idea is to improve your expense ratio, not eliminate every cost. There is of course, two common sense ways to move the expense ratio needle
The answer for your specific business depends entirely on where the inefficiency is located.
Let’s look at a simple step by step roadmap most companies use to get started :
Conduct a Cost structure analysis
Before making any decisions, it is important to understand all the major expense categories as a percentage of revenue, identifying which expenses are fixed, which are variable, and which are semi-variable.
Some companies realize they are spending 25% of their expenses on activities that generate less than 8% of their revenue. This is the beginning of the conversation. Knowing your costs.
Understand which costs are growth investments and which are true expense bloat
Growth expenses
Possible Bloat
Now, you not only understand your overall cost structure, but you also understand what costs drive what, and what drags you down.
The last step is to create operating leverage.
Real operating leverage means revenue grows faster than expenses. In a services business, it means standardizing the delivery model, increasing utilization, or investing in technology to reduce the amount of human effort required per engagement. In a product business, it means that as revenue grows, the cost structure improves proportionally.
Here are some targeted examples :
Renegotiate vendor contracts systematically.
Growing companies often have vendor contracts that made sense at $6M revenue but have not been renegotiated at $30M revenue. That's money on the table that should be going towards growth, not being spent on unnecessary fees. Again, this is related to weighted average cost of capital because every dollar saved on operational costs doesn’t require additional capital, which means that cost reduction ROI is highly relevant.
Review shared service opportunities.
Finance, HR, IT, and legal functions often make sense for shared service models, especially for companies that have duplicated costs for the same function twice, which many midsize companies do.
This is exactly where a seasoned Fractional CFO adds tremendous value because they’ve navigated this process before, structurally changing cost models at many different companies, across many different industries, and we know what cuts will really make a difference and what cuts will cause talent or capability issues that will cost twice as much to fix eighteen months down the road.
Let’s get practical about what it really takes to dial in your expense ratio.
Expense ratios aren’t difficult to understand.
The math isn’t hard.
The benchmarks exist.
And the concept of reducing the amount of revenue spent on expenses?
Easy to understand.
The hard part is executing it well in the real world, in the midst of hyper-growth, with a team to manage, with a board to manage, with all the other pressures.
The companies we work with struggle with three key challenges.
The first one is visibility. Getting expense ratios by expense type, by business unit, by product line, requires financial systems and reporting sophistication that many mid-market companies just haven’t developed yet. You can’t manage what you can’t measure.
The second one is trade-off analysis. We can save $180,000 by renegotiating a contract with one of our vendors. But if that vendor supports one of our top three customer relationships, then we may just have created a $1.8 million problem by saving $180,000.
The third one is execution accountability. We can create all sorts of great plans, great slides, great reports, great meetings, great presentations, etc. But the gap between plan and outcome is often about execution, about ensuring that there’s enough focus at the right level of the organization to make it happen.
Whether that looks like an Interim CFO navigating a specific transition, a Fractional CFO providing ongoing strategic support, or finance team development that builds internal capability — the goal is the same: connecting expense ratio management to the business outcomes that actually matter.
Companies that get this right don't just have better margins. They make better investment decisions, tell more credible stories to investors, and build more durable enterprise value.
Ready to turn expense ratio analysis into a strategic advantage?
Let's talk about what that looks like for your business. Reach out to us at McCracken Alliance today for a complimentary Expense consultation call!
In corporate finance, the expense ratio is a measure of the percentage of the total revenue that is absorbed by the operating expenses. This ratio is computed as the Operating Expenses divided by the Revenue, multiplied by 100. This ratio can be used to measure the efficiency of the operation of the business or the discipline of the costs over time, as well as the comparison of the business performance to its peers. This is different from the investment fund expense ratio that measures the fund management costs as a percentage of the assets managed.
The answer depends on the industry and the company’s position in its growth curve. SaaS companies that are growing rapidly may operate with 80-90% or better, as the business model assumes that future operating leverage will help improve the number over time. Professional services companies that are mature may target 70-82%. Manufacturing companies depend on capital intensity. Worrying about the trending direction is most important.
Directly and proportionally. Every point of improvement in the operating expense ratio translates to a higher EBITDA margin, assuming revenue holds steady. For investors and acquirers using EBITDA multiples to set enterprise value, this relationship is significant — a two-to-three point improvement in expense ratio, sustained over multiple periods, can generate millions in enterprise value at common transaction multiples.
Related but not exactly the same. The operating margin represents a profit expressed as a percentage of revenues, while the expense ratio represents costs expressed as a percentage of revenues. Essentially, these two metrics are inverses of one another, with an expense ratio of 68% implying an operating margin roughly around 32%. The difference between these two metrics is how you apply them: the expense ratio is a metric for management, while the operating margin is a profitability metric. EBITDA margin takes this a step further by including depreciation and amortization, making it easier to compare different companies that have different capital structures.
.svg)
.svg){kind=icon}