- Return on investment (ROI) refers to the amount of money you make that can be directly tied to an expense or series of expenses.
- For every investment, you should determine a target ROI and track performance against it.
- There are multiple ways to measure ROI, depending on the type of analysis your company chooses.
- This article is for managers or business owners who are interested in understanding what ROI is and how to calculate it.
In business, few concepts are as important as return on investment (ROI). The adage that “you have to spend money to make money” is often true, but only if you’ve anticipated the ROI potential of your investments. Whether you’re implementing new business software or aggressively investing in a marketing campaign, the ultimate goal is to make more money. Understanding how to calculate ROI can help you understand which investments are paying off and which costs should simply be cut.
What is ROI?
Return on investment refers to the amount of profit directly related to an expense or group of expenses. Companies generally use ROI to measure the success of a specific project or purchase. If a business owner were to invest money in an advertising campaign, they’d analyze the sales generated by the ad and use that information to determine the ROI. If the money generated exceeded the amount spent, the profit would be referred to as the ROI of the ad campaign.
Investors also want to know the potential ROI of an investment before committing any funds to a company. Forecasting a company’s potential ROI is a key factor for investors who, after all, ultimately want to profit from their investment.
What is annualized ROI?
Annualized ROI describes the average yearly return on an investment over a period of years. This shows how profitable the venture is overall. Annualized ROI can help you analyze and compare the performance of your investment during specific time periods.
Why is ROI important in business?
Only smart businesses that spend wisely and monitor ROI closely survive in the long run. Some reasons why ROI is so important include:
- Budgeting insight: Calculating ROI can give you a clearer insight into what parts of your business aren’t performing well. This way, you can make more informed decisions on where you should focus your budget.
- Better hiring decisions: Tracking the ROI on your labor spending can help narrow your criteria when hiring new employees. With insight into your team members, you’ll be able to find the ones that work best for your business.
- Long-term business planning: ROI can help you understand where your business shines and where you can improve it. With detailed analytics, you can plan for business growth more effectively and have more confidence in your decision.
- Meeting customer expectations: Keeping track of ROI can also help you meet your customers’ needs. When those needs start to shift, your ROI might decrease. Tracking it means you’ll have enough time to pivot your business strategy.
If you don’t see an optimal ROI on a certain endeavor, stop throwing money at it — you’re better off scrapping it. Continuing to spend on lost causes is a surefire way to run out of money and run your business into the ground.
What is considered a ‘good’ ROI?
What’s considered a good ROI depends on the investment. When a company is spending money on a piece of equipment, for example, the ROI is in productivity. Meanwhile, marketing spending requires an ROI in sales. The ROI you expect from your search engine optimization efforts will be different from the ROI you look for from an investment in a new factory.
A healthy double-digit ROI is great for starters, and if you identify high-percentage ROIs, you should aim to figure out how to amplify and extend those effects. Consider carefully whether you get an ROI at all and be realistic before signing contracts and spending money. Don’t make any big purchases right away — someone promising the moon is likely not going to deliver good returns.
Make sure that you properly research any potential investment before you purchase it. Any investment will have its pros and cons, and it’s up to you to measure them.
Limitations of ROI
You can gain a lot of financial foresight by calculating your ROI but measuring your business’s success based on an ROI has its limitations.
Here are three limitations to consider.
- Your company’s cash flow is not directly reflected in your ROI, so your business’s financial health may not always be measured accurately using ROI alone: “For example, the ROI may be 5%, but it may be losing cash flow and be a very costly investment,” said Robert Gauvreau, certified public accountant and chief executive officer (CEO) of accounting firm Gauvreau. “Whereas another investment that is generating 4% ROI may be generating a positive cash return to the investors.” Depending solely on ROI to evaluate the financial health of a project only gives you a partial understanding of what’s affecting your finances.
- To calculate an accurate ROI, you need a firm grasp of your future business expenses: If you don’t yet have accurate numbers for future expenses, or if the numbers comprising your calculation are variable, such as interest rates that may change, the ROI may be inaccurate.
- ROI only measures the financial success of a project: For example, investing in new computers and tech for your employees may have a negative ROI, but it may make your employees happier and increase retention. The ROI of a project or venture doesn’t account for the nonfinancial benefits of an investment.
An ROI supplies specific information, which means that it doesn’t always speak to the entire company. It’s a helpful calculation, but it can’t speak to qualitative, nonfinancial benefits.
Benefits of calculating ROI
Understanding your profits and the impact of an investment on your business is important and extremely helpful when making decisions for your company.
Here are two more benefits that calculating your return on investment provides:
- Calculating ROI allows business owners to track and analyze short- and long-term projects: “You can set simple targets for both short-term and long-term goals, and ROI can measure if you are achieving those benchmarks quickly and easily,” Gauvreau said.
- Determining ROI helps you evaluate your business’s financial performance: Knowing your ROI keeps your company on track by demonstrating whether your business is profiting above or below its average, said Leonard Ang, real estate agent and CEO of iProperty Management. It’s a good reminder for companies to maintain a standard for their finances.
- ROI is one of the simplest performance metrics to calculate: All ROI does is measure the cost of an investment vs. the revenue that investment yields. It’s a universally accepted financial metric because it’s easy for anyone to understand and translates directly to how much money you’ve made from a given expense.
- Knowing ROI can help you better understand the impact each department is having on your profits: Since ROI is so simple to calculate, it’s one of the easiest ways to compare the performance of departments within your company. Comparing a department’s ROI this year to its past ROI can help you understand how efficiently it’s performing.
Remember, not every department should necessarily be delivering an ROI. While your sales team should ideally be generating a large ROI, your human resources department likely will not even though it serves a critical function. Consider the context when using ROI to determine the performance of departments.
ROI formula
To calculate ROI is to take the gains of an investment, subtract the cost of the investment and divide the result by the cost of the investment:
ROI = (gains – costs) / costs
For example, let’s say you make a major purchase, like buying a home.
“You purchase your home for $1 million,” Gauvreau said. “After living in your home for three years, you sell it for $1,120,000. The result, after three years, your home increased in value by $120,000.”
If we follow the ROI = (gains – costs) / costs formula, we find that the return on investment is 12%.
($1,120,000 – $1,000,000) / $1,000,000 = 0.12
Another example of ROI would be investing in the stock market, Gauvreau said. If you invest $100,000 in shares of a company, and 12 months later it grows to $160,000, your ROI would be 60% because:
($160,000 – $100,000) / $100,000) = 0.6
To determine ROI, use the simple formula ROI = (gains – costs) / costs.
Use return on investment for more effective growth
Understanding the ROI of any project or marketing campaign helps in identifying successful business practices. Many companies use ROI to identify methods of marketing and advertising that yield the highest return based on previous successes. This way, ROI becomes not only a measure of past success but also an estimate for the coming months.
ROI can be applied to most areas of your business and works as a simple but effective method to measure your performance. Using it in combination with non-numerical data, such as employee happiness, can give you some ideas about how to grow your business. With proper ROI use, you can make the most of your resources for long-term success.