Return on investment, or ROI as it’s often referred to for short, is a way of measuring how much money you will get back in comparison to the initial investment made or several investments made over time.
The term is most commonly used as a key performance indicator by business owners as a way of deciding if their decision to invest money into new products, services, people or software is good or bad based on how much money they will lose, generate or save for the business. ROI is shown as a ratio and the higher the ratio, the greater the benefit earned.
ROI can also be used in day-to-life for all of us, for investors looking to grow their portfolios, or in marketing as a way of determining if the time, effort and energy put into something is worth it based on the output given. The simplest way to measure ROI is to divide the net income generated by the total cost of the initial investment, multiplied by 100. [ Net income / cost of investment ] x 100
ROI in Business
Acronyms are commonplace in business settings but some are more important than others. ROI, or ‘return on investment’ is one such abbreviation that it pays to understand and know how to factor into all of your business decisions that incur an initial outlay of time and money.
It’s also a useful term that can have an impact on decisions you make in your personal life too. Whether at home or work, taking a logical approach to assessing upfront costs and outlay of outlay in comparison to the return that you’re getting back, can make making decisions much easier when the ROI is clear to see.
Read on to understand more about ROI, and how it can be used, calculated and used to simplify decision making.
What Is ROI?
ROI stands for return on investment and it’s a measurement that shows how much you are getting back for every pound that you put in. It’s a useful tool that can be used to review and analyse past, present or future investment opportunities. When it comes to knowing if the return on investment is good or bad if you’re making more money back than you put in originally, then it’s a good return on investment. If however, you’re making less money than you originally put in, then you are losing money and it’s a less beneficial investment.
How Do You Measure ROI?
ROI is referred to as a ratio or a percentage. For example, The investment generated a 46% return on investment. To get to your ROI percentage or decimal, you need to be able to work out what your net return is.
To work out the net return, take away the amount of money that you originally put in from the amount that you got back. This figure is your net return. To see this as a percentage, multiply it by 100.
Benefits Of Measuring ROI
ROI is a simple calculation tool that can be used to create fair comparisons between investments made to determine if they are good or bad. As a ‘return’ will mean something different to each person using it, ROI calculations can be used regardless of what it means to you.
As well as being easy to use, ROI is universally understood by most people. This means that if you are explaining the pros and cons of an investment in terms of ROI, it’s likely that whoever you are talking to will understand the metric and how it can influence a decision.
Difficulties In Measuring ROI
When measuring ROI, you should be aware that some difficulties can exist. For example;
- When measuring ROI for time spent, rather than money, it can be hard to quantify just how much time is being spent on something. This is especially true when more than one person is involved and a variety of different tasks are being measured.
- When measuring ROI for marketing campaign success, it can be hard to factor in everything involved, particularly if marketing is taking place across a variety of channels with different performance metrics and varying amounts of time invested in setting them up. Blogs, social media, and advertisements are all very different.
- ROI doesn’t take into account how long something takes to generate results. When using ROI for business planning, if you had a 90% ROI, but it took ten years to deliver, you may think something that generates less ROI over a shorter time frame is more beneficial.
Why Does ROI Matter In Business?
Business owners need to keep their business profitable for them to survive. This means their bottom line needs to be positive which is achieved when they make more money than they spend. Whilst their business strategy will shape the types of investments made to achieve a profitable business, it’s the business owner that has to take a calculated risk that their investments into staff, tech, financial markets and more, are going to pay off. If their investments don’t pay off, then the poor ROI may cause the business to run into cash flow difficulties and eventually cease trading.
ROI As Time Or Money
So far, we’ve discussed ROI in terms of monetary input and output but you can also use ROI as a metric to see the success of marketing campaigns, purchasing tools, services, staff or product lines for your business too. When using ROI to see if business decisions have gone well either now or in the future, then you can either look at time or money as the output.
In the example below we’ll consider a recent purchase such as CRM software for your business that was purchased to try and save the time spent doing manual jobs that could be automated.
- For example; if your sales team of 5 people currently spends 50 hours a week manually inputting and updating sales leads for £20 an hour in wages, this is costing you £5000 a week.
- To try and reduce this cost, you may want to look into purchasing software that can either manage this process automatically or speed the process up to save the cost of the manpower that you’re spending on these easily automated tasks.
- To calculate the ROI of the new software, you would need to calculate how much time was saved each week as a result of purchasing the software and attribute a cost to this from the hourly salary paid. In the example above, if the software saved a significant number of hours that covered the £5000 a week cost you already have, then it would be a good investment.
Although the software costs money to bring in, in this example, it will be saving you money in the long run by reducing the amount of time it takes your sales team to process their leads. This in turn means they can get more done in the same amount of time, thus creating the potential to generate more revenue for the business. The return on investment, in this case, may take place over several months or years depending on the cost of the software purchased and how long it took to recoup in man-hours saved.
What Is A Good Return On Investment?
The definition of what is a good return on investment will depend entirely on the business or individual involved and the sums of money or time that are being outlaid, and how long it takes to make a return. What may be deemed a good ROI for some people, will not be seen as good enough for others depending on the total value, type of return and how long it takes to be delivered.
Whatever your situation though, if your ROI calculations result in a positive figure (above zero), then it means that the net returns have exceeded the total cost and are therefore a good return on investment.
You must remember though, that ROI isn’t a static figure and it changes over time as the variables involved adjust. ROI should therefore be a business metric that is regularly reviewed across important business areas to ensure that you’re still making financially sound decisions that aren’t losing money, long after the initial successful investment was made.
What Is A Bad Return On Investment?
As with a good return on investment, every business or individual will have a different tolerance level when it comes to ROI, but if the ROI calculations result in a negative figure, then it means that the net returns are less than the initial outlay and would generally be seen as a bad return because a loss has been made.
Remember though, that because ROI isn’t a static figure and can change over time, something that may initially present as a poor ROI, may improve in time. This means you will need to use ROI as a tool in your decision-making processes but it shouldn’t be the sole determining factor on whether to proceed or not.
Different Types Of ROI
Knowing the return on investment can help you make decisions across your business including;
- Equipment/tool purchases
- Hiring new staff
- Expanding or starting new departments
- Sales & Marketing strategies
Buying equipment and tools for your business can be expensive. By using an ROI calculation to see how valuable your purchases are will give you an excellent steer on future equipment investments to make too.
If you can see that a new employee or department is boosting or decreasing business profitability by using ROI calculations, it will help you to streamline your recruitment process and ensure you only invest money where it needs to go.
If you track your sales and marketing activity, you can use ROI to trace which strategies led to profitable sales and then replicate this again. Having this valuable ROI information helps you to cut dead wood from your business plans and focus on projects that will benefit your bottom line.
One of the biggest uses of ROI is in terms of stock or property investment. Whether investors decide to reinvest, stay put or cut their losses and move on to another trade is often a direct result of ROI.
We hope this article has given you a simple overview of what does ROI mean and how do you measure it. To recap,
- ROI is a standard, universal measure of profitability and is used to aid business decision-making by measuring how much money you will get back as a result of an investment or several investments over time.
- ROI is to divide the net income generated by the total cost of the initial investment, multiplied by 100. [ Net income / cost of investment ] x 100. This calculation provides a net return on investment.
- When calculating ROI, it’s important to ensure you’re comparing like-for-like and over the same period. Consider annualising your costs for true ROI comparisons.
- Calculating ROI allows you to separate low-performing investments from high-performing ones to make your time and money work harder as well as they can.
- Use ROI as a key business tool to analyse the worth of expenses that you have. If you can invest money into people, tech or software that could reduce your expenses, then it puts your bottom line in a better position.
- ROI is a useful tool for anyone looking to gauge if their investment of time, money or effort is worth it based on the output given. As ROI can change over time, it shouldn’t be the only factor considered when making business decisions but instead should serve as a useful tool along with sound judgement and review of all factors involved.