What is ROI? (Definition & How to Calculate It)
- Emjae Williams
As an entrepreneur or new business owner, you know that a lot goes into getting your business up and running and maintaining day-to-day operations. You’re paying close attention to how much you’re spending, and what areas you might need to tighten on or allot more money to. That’s only part of it though.
To run a successful business, you need to keep close tabs on the results that each financial input is yielding. In business terms, you need to pay attention to your return on investments or ROI. What is ROI and why does it matter? Your ROI plays a major role in so many of your financial decisions – getting loans, hiring a team, working with partners, or offering new products and services.
Let’s take a closer look at what exactly ROI means and how you can ensure you’re staying on top of it!
What is ROI?
ROI stands for Return on Investment and speaks to the value you receive from your input. All businesses require investments – time, energy, money, and the results need to match the effort. For instance, if you’ve invested $200 into a course, you expect to use the knowledge to make a profit. Similarly, if you’ve invested 3 hours into creating content advertising your services you expect to gain clients or sales.
The idea is that whatever your input, the outcome should exceed that. If not, you’ll be operating at a loss. Your ROI will be a major determinant for how company funds are allocated as it gives you a clear picture of which areas or strategies have proven to be most effective.
Why is ROI Important?
Being able to analyze the effectiveness of your efforts is one crucial reason to focus on ROI. It allows you to gauge whether or not your strategy is working, what areas might need adjustment, or if you need to increase your efforts.
This insight will also guide future efforts. If you previously spent $200 on a Google ad with the expectation of making 10 new sales but only received 8 you know you’ll need to go back to the drawing board for your next ad. On the other hand, if you had a goal of 10 and got 15, not only did it pay off but you surpassed your goal. We would consider that a great return on your initial investment and it would be best to replicate that strategy in the future.
Additionally, it comes in handy when making financial decisions or seeking partnerships, loans, or expanding your business. If you plan to upgrade a particular software you need to measure the benefits of this new software, and how it can improve your functions and yield better returns than the software you’re currently using.
If you’re borrowing money to improve your business you want to be sure that you can turn a profit or you’ll find yourself in debt. In fact, your previous ROI and financial performance will be key factors that investors or partners consider when deciding to invest in you.
Similarly, if you intend to expand your team you’ll want to know that the return (additional income or business) will be worth the investment (salaries, training, time).
How Do You Calculate ROI?
At its most basic, ROI measures the profitability or success of your investment. A simple ROI formula to use when measuring this is to divide the net profit (value of investment – the cost of investment) by the cost of investment and then multiply by 100 to find the percentage.
Let’s look at a few scenarios to make things a bit easier.
You spent $500 on an ad and received $800 in sales so your ROI would be calculated like this:
800 (value of investment) – 500 (cost of investment) = 300 (net profit)
300 (net profit)/500 (cost of investment) x100 = 60%
You hired 2 new team members and that expense comes up to a total of $1300 monthly but with them on the team, you’re able to take on 3 new clients who bring in $4,000 monthly:
4000 – 1300 = 2700
2700/1300 x 100 = 207%
But there are instances when you’ll operate at a loss which is why it is so important to pay close attention to your ROI.
You spend $600 printing hard copies of a book and only secure 6 sales which earn you $200:
400 – 600 = -200
-200/600 x 100= -33%
In all three scenarios, you’ll be able to see what has been working and make decisions on what changes need to be made. Paying close attention to your ROI can prevent you from repeating mistakes and allows you to capitalize on your success.
What is a Good ROI?
You’re probably thinking, Any positive return is a good return and you aren’t wrong. After all, the goal is to see a profit from your investment. In general, an ROI of 7% or more is considered to be good, but it differs for all businesses based on a few factors.
In order to set realistic expectations for your ROI, here are a few things you should consider:
- Previous performance: You want to ensure that your ROI matches up to your previous performance. While an ROI of 10% might be great, seeing that after consistently having an ROI of 15 – 20% might mean your strategy is no longer effective.
- Your risk tolerance: In some cases, you need to invest a lot to see great returns. Not all businesses can afford to or want to do that. You have to accept that there is a chance that things won’t work out as planned and ensure that you have a plan B in the event they don’t.
- The amount of time: You can get good results overnight but great results tend to take time. If your aim is to see marginal increases then it’s ok to start with a short-term plan but for larger goals, you need to give your strategy time to work.
What are the Benefits of ROI?
There are many reasons to focus on your ROI as a business owner and we’ll look at a few of those benefits below.
Clear Indicator of Growth
Due to its formulaic nature, your ROI is a straightforward, unquestionable indicator of how your business/strategy is performing. Positive numbers mean good results, and negative numbers mean bad results. It makes it easier to make the necessary decisions on your way forward.
Allows for Cohesive Goal Setting
You might be implementing different strategies for different aspects of your business, but by keeping your general ROI in mind you’re better able to assess the performance of each strategy. If the goal for the year is to double your income you’ll plan all your activities with that in mind and judge them accordingly.
Helps to Properly Allocate Resources
Without solid numbers, it can be challenging to decide which areas require the largest investment. Your ROI gives an indication of what efforts have been most successful so where there are limited resources you can allocate them accordingly.
What are the Limitations of ROI?
Difficulty in Determining Standard ROI
While you can use other companies within your industry as a benchmark, it can be challenging to find a standard ROI. There are many variables at play – how long the company has been in operation, the amount spent, previous investments, and market size.
Does Not Factor in Time
The ROI formula is fairly standard but it only looks at the numbers – not the time. In many cases, your ROI will be significantly lower as a start-up or when you first implement a new strategy. Over time you might find that the same approach yields overwhelming positive results.
Can Result in Premature Decisions
While we can agree that your ROI is a great tool in deciding your company’s strategy, it can push you to make decisions too soon that negatively impact your overall performance. If a marketing campaign does not yield the expected results after a week you might be tempted to reduce the spending when in fact, it simply needed more time.
Using Your ROI to Improve Your Business
If you haven’t been paying attention to your own ROI or you just weren’t sure how to, this article should help to simplify it. The aim of analyzing your ROI is to ensure that all your business decisions are made with your success in mind. It gives you hard numbers to make these decisions easier.
There is no guessing needed and you can improve your strategy from an informed position. It also reduces a lot of the stress associated with finances because you’re better able to allocate resources since you can anticipate the outcome.
So what are you waiting for? Go ahead and calculate the ROI for your business today!