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.
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.
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.
Only smart businesses that spend wisely and monitor ROI closely survive in the long run. Some reasons why ROI is so important include:
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’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.
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.
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.
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:
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.
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.
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.