What is Return on Investment?

Defining ROI in the Business Landscape

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The formula for ROI is straightforward: ROI equals net profit divided by total investment cost, expressed as a percentage. The net profit is the difference between the revenue generated by an investment and the associated expenses.

The total investment cost includes all the expenses related to the investment, such as the purchase price, maintenance costs, and any other expenses incurred in the process.

Return on Investment, otherwise known as ROI, is an important concept in the business world. In any industry, you need to ensure the money you spend is generating financial value in return. The concept of “ROI” is demonstrated by a mathematical formula investor can use to judge how well a particular purchase performs in comparison to others.

ROI calculations can be ideal at generating business cases for specific proposals. For instance, you may use a demonstration of potential ROI for an email marketing campaign to convince business leaders an investment in email is necessary.

Let’s take a closer look at return on investment, and what it means to you.

What is Return on Investment?

In simple terms, a Return on Investment is defined as the ratio of net profit obtainable from an item, over the total cost of an investment.

The return is simply the profit made as a result of your investments. ROI is most useful to your business goals when it refers to something measurable and concrete. Companies use ROI to identify the gains and financial returns of everything they spend money on. While most companies analyse their investment with monetary figures, it’s also possible to look at ROI in a situation where “time” or “effort” is the investment.

When companies calculate ROI, they present the concept as a ratio, such as $4 for every $1 spent. The ROI metric or figure can be used over a range of investments and industries, and influences concepts like return on equity, return on ad spend, social return on investment, and return on assets.

What is an Investment?

To properly understand and calculate ROI, you first need an idea of what an “investment” is. The term is usually leveraged to refer to purchasing stock in a company or financing a business venture for another person. Investments made into your own business are a little different, but they have a similar purpose of increasing your profit.

Depending on your industry, the types of investments you make can look extremely different. They don’t always have to be a tangible concept, like an initial investment in new equipment or high-quality materials. Online store owners or app developers can make investments in things like cloud storage or a new server, for which they’d want to define ROI.

Companies selling in brick-and-mortar locations need to calculate ROI too. For instance, a retail business might want to determine how much money they can make on a product.

How Do You Calculate ROI?

Calculating ROI is a lot simpler than you might think.

While there are few different methodologies available, the most common option is to use the net income divided by the total cost of the investment. In other words, the ROI equation would be:

ROI = Net Profit / Investment x 1000

Let’s look at an example to see ROI in practice.

Imagine you spend a total of $1,000 to promote your hat business across social media. After your campaigns had ended, you would look at your net profit (how much your store made after things like taxes are removed). The total cost of your sales may equate to $5000 more than it did during the same period without the social media marketing.

The benchmark is important if you’re trying to calculate an increase in ROI. In this case, comparing the earnings to the investment would give a ROI of 500%.

Another example might be an investor placing $10,000 into a venture with no additional fees or costs. The profits of the company may have been $15,000 in total for the year, which would mean the investor made around $5000. This would lead to an ROI of around 150%.

There are other ways to calculate ROI, such as by looking at investment gain divided by investment base. In this case, the ROI = the investment gain / investment base.

Examples of ROI Calculations

For a business owner, calculating ROI can be an important part of ensuring your invested capital leads to better opportunities over time. However, it’s crucial to note that understanding the results of your investment opportunities may require a consideration of more than just ROI.

For instance, if you’re spending on long-term investments, like the cost of deploying new computers, you need to consider a variety of inputs, such as the cost of the actual computers, shipping and task costs, maintenance costs, installation and so on. All of these elements would need to be implemented into the ROI formula to deliver accurate profitability ratios.

You’d also need to think about your ROI percentage over a set period of time. The profits you gain from a new investment (like computers) could include hard dollar amounts coming from increases in productivity, as well as a reduction in maintenance costs coming from the savings account compared to the previous devices.

The company would then be able to calculate the ROI when evaluating different kinds of computers, using anticipated gains and costs to determine the higher ROI. The company could also calculate the ROI at the end of a specific period using actual figures for the total cost and net income of the investments. Actual ROI can then be compared to projected ROI to evaluate whether the investment opportunities are worth it.

How to Interpret your ROI Calculations

In most cases, ROI is used to gauge and understand different metrics, all of which help to define how profitable a business or venture is. To calculate your ROI with the utmost accuracy, you’ll need to ensure you’re fully considering all of the total costs and returns.

When ROI calculations have a positive return percentage, this means the business or whatever venture being measured is profitable. However, it is possible to see a negative ROI too, which means that you’re spending more money, or owe more than you are earning.

If your ROI is negative, you’ll know the investment you’re making is not useful for your business. For instance, a negative ROI obtained from a new product in a retail or ecommerce store would indicate you should stop buying and selling that product.

Alternatively, a positive ROI indicates you’re making the right decision with a venture, which may prompt you to spend more money on that particular strategy. If a certain kind of investment yields a high return on investment, you may also choose to spend more of your time on similar investments in the future.

The Pros and Cons of Using ROI as a Metric

Notably, ROI is just one form of metric available to use for your business. Calculating ROI isn’t always easy. Some investments will overlap, making it harder to determine which generated the highest amount of profit.

In the example above referencing social media spending, you can only estimate the ROI of social media for your business as a whole using this method. It wouldn’t be possible to understand which channel or strategy generated the most ROI without further investigation.

Additionally, it’s difficult to know when a complete estimation of ROI should be attributed to one idea. For instance, with social media ROI, you may have other ongoing investments to think for growth, such as a word-of-mouth marketing, offline advertising, or email campaigns.

Despite these challenges, ROI is still a very useful metric when ensuring you’re earning more for your business than you spend.

The benefits of ROI include:

  • Simplicity: For the most part, ROI is relatively easy to calculate. You don’t need many figures to complete your calculation, and most of them will be available in balance sheets and financial statements.
  • Flexibility: Because ROI is such a widespread metric, and a common calculation among all industries and environments, it’s easier to make investment return comparisons between organizations and different ideas.
  • Profitability: ROI can give you an excellent insight into the profitability of your business by team or company.

Of course, there are limitations to using ROI too, hence the creation of various other calculations for rate of return and cash flow over the years. ROI doesn’t allow you to consider “time” in your equation. While a higher ROI might indicate a good investment at first, it’s no good if you don’t see the return for a number of years. This is why many people look at “Annualized ROI” or annual return to get a more specific, time-based financial rate.

ROI calculations can also differ between businesses. Some companies use different various of ROI for different investments, so it can be difficult to find a consistent number to represent value. Despite this inconsistency, managers may still only select investment opportunities with larger ROI, which may harm the company’s profitability.

Notably, a higher Roi might mean a better gross profit for companies in the short-term, but this calculation also doesn’t give any insights into non-financial benefits. For instance, an increase in worker morale might inadvertently lead to a higher internal rate of return, but it wouldn’t be possible to calculate this by looking at an amount of money gained over time.

What are Some Alternatives to ROI?

Understanding the current value and ongoing value of your investments can be an important part of running a successful business. However, the limitations of ROI could mean that companies choose to examine different financial ratio calculations instead. For instance, common alternatives include:

  • ROE and ROA: Return on equity and return on assets look at specific investment cost returns. For instance, with return on equity, you look at the current value and ongoing value of real estate used by your company. For Return on assets, you’d examine the potential profitability of an investment such as a stock investment.
  • Annualized ROI: This is a form of ROI which considers the length of time a stakeholder is going to be holding a particular investment. This can provide a more accurate look at the investment cost and potential outcomes over time, as it considers how time influences the outcomes of an investment with things like taxes and capital gains.
  • Social ROI: This is a form of outcome-based investment calculation which considers the broader impact of environmental, economic, and social value on a purchase. This calculation translates all of those more intangible concepts into a net present value of benefits, and the net present value of an investment.
  • Marketing statistics ROI: This is a kind of financial ratio calculation which helps to determine the effectiveness and outcomes of marketing programs and campaign strategies. The basic calculation is usually Sales growth – marketing cost / marketing cost.
  • Social media statistics ROI: Again, this is a kind of investment calculation which looks at a specific concept – the effectiveness of a social media campaign. It can look at things like time taken to generate results, views generated, and resource use.

Financial analysts and experts can often work with companies to help them determine the best possible alternative to ROI for their calculations.

Can You Improve ROI?

It’s definitely possible to improve your ROI. Often, the best thing you can do is evaluate your situation and options as carefully as possible. Examining things like interest rates on your investments and how the value of a purchase may change over time will give you more information to make the right decisions with. For various kinds of ROI calculation, there are numerous analytics tools out there to help you experiment with your options.

It’s important to be willing to explore different routes and engage in various calculations too. The more you explore your options and examine different kinds of investment, the easier it is to make decisions according to facts, statistics, and data.

Collecting information on everything from your target market to your industry should make a difference to what you can expect to accomplish with “return on investment”.

Rebekah Carter

Rebekah Carter is an experienced content creator, news reporter, and blogger specializing in marketing, business development, and technology. Her expertise covers everything from artificial intelligence to email marketing software and extended reality devices. When she’s not writing, Rebekah spends most of her time reading, exploring the great outdoors, and gaming.

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