Simply stated, ROI measures the amount of return on an investment, relative to the cost of the investment. ROI is a key performance indicator (KPI) that's used by businesses to determine how profitable a purchase (or expenditure) is. Measuring your ROI is useful for determining your success over time and by simply taking the guesswork out of future business decisions.
How to Measure Your Return on Investments (ROI)
What is ROI (Return on Investments)
ROI is the most common ratio of all to gauge overall profitability, but the formula can also be used in several other key ways: to determine the effectiveness of your marketing, the suitability of your pricing, the profitability of inventory, and the viability of equipment purchases.
When calculating ROI, you take the benefit (or return) of an investment and divide it by the cost of the investment. The result is expressed as a percentage or a ratio. The formula is simple: ROI = (Earnings - Cost) / Cost
If you are projecting the profitability of a business over the course of years, rather than just a one-time investment, the calculation may be a bit more complicated.
Let's say you are in startup mode and looking to launch a new restaurant. You've lined up investors willing to pitch in a total of $400,000. You consider all of your expenses and projected income and estimate a $100,000 per year profit. That's an ROI of 25 percent.
However, extend your projections over a longer period of time and toss in a worst-case scenario. Perhaps your restaurant jumps out of the gate and averages a $100,000 profit for each of its first four years. But then your meal-time mojo starts to fade and your profit is $75,000 in year five, $50,000 in year six, and zero in year seven. Your charming café is out of business. And in this case, your real world rate of return is 14%. This is more believable and not a bad return for your investors, either.
Return on Intangibles
Determining your profitability on tangible costs is one thing, but applying the same methodology when it comes to intangible expenses, like advertising and marketing, can be quite another.
In the past, when small businesses used newspaper, radio, and television advertising as their primary marketing tools, it could be a challenge to determine effectiveness. Unless you were using a coupon or some other direct manner to track response, you had to estimate only the broad impact on sales.
These days, Internet advertising and social media can be held to granular accountability. Using Google Analytics and other web traffic measurement programs can tell you the exact source of your website's inbound traffic and will detail "conversion" statistics when purchases are made. Plugging in the ROI formula can give you a perfect snapshot of your marketing results.
Considering More Than Money
Calculating bottom-line return is just one consideration in making a business investment. Tim Berry is a developer of business plan software and says that sometimes it pays to forget the formal financial definition.
Berry says that every business expense, including time, resources, and money, is an investment. While you may not always get a positive value return, what you gain can be more than just cash.
The process of developing a ROI analysis puts the business strategy under a microscope and helps prioritize what is unique and most important. Sometimes strategic flaws and threats to a business plan are revealed, which can be a valuable insight.
So there may not be a perfect answer to the question "Is this investment worth it?" but the ROI formula can give you a quick analysis of possible profitability. Often your accounting software can help calculate the numbers for you. The percentage your ROI calculation comes back with can keep you away from the rocks when charting a new course for your business.