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An operating expense ratio (OER) is a financial calculation that expresses the total cost of managing an investment as a percentage of its income or net worth. The relative cost of overhead is an important quality indicator for investors, because operating expenses ultimately cut into overall profitability. OER is used to evaluate management efficiency in keeping expenses low while maximizing profitability.
Investments are very much like businesses. Like a business, an investment vehicle has to spend money to make money. Costs to manage a complex investment and to keep it viable from day to day are considered operating expenses in the same vein as the expenses that a business incurs to keep its doors open. An investment is subject to the sort of business analysis that seeks to determine whether managers are keeping expenses under control while still maximizing profits. Calculation of an investment's operating expense ratio is the way that investors determine whether potential profits will ultimately be wasted through inefficient management.
An operating expense ratio is the total amount spent during a fiscal year in operating expenses divided by a measure of the investment's value. The calculation differs, depending upon the type of investment under evaluation. Some types of investments divide operating expenses by yearly gross income to determine OER. Others divide expenses by the average net dollar value of the investment's assets over the year.
For example, one of the most common uses of the operating expense ratio is to evaluate real estate investment property. The calculation takes all operating expenses for the year, including management fees, property taxes, maintenance, insurance and utilities, and it divides the total by the property's gross income or total amount of rent collected. OER is used to determine whether the property managers are doing a good job keeping costs under control and whether the price of rent needs to be raised to reach a targeted level of profitability.
Another common use of the operating expense ratio is in evaluating mutual funds. With this type of investment, operating expenses are divided by the average value of the assets under management to determine the OER. It might seem strange that the calculation uses the value of assets rather than the income the assets generate, in the same way as a real estate investment. In the financial industry, however, many of the operating expenses for mutual funds are set as a percentage of the fund's value. So as the fund grows, the costs for certain services increase proportionally, making it more relevant to calculate OER as a percentage of fund assets used for management expenses.
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