When operating any type of business, you need to understand what Return on Investment (ROI) is, how to calculate it, and how to use it effectively in your business planning. However, this is perhaps even more important for small businesses, because money is often a lot tighter and you need to make every dollar count.
ROI is a great way of working out whether products are worth the cost, and which investments generate the best return. Without understanding ROI, you could be wasting money or missing out on more lucrative investments.
So, in this article, we’ll be taking a deeper dive into ROI, how to calculate it, and how you can use it in your business.
What is ROI?
ROI is a great measure for discovering which investments into your business are generating the most income. It can be used to measure the return on certain products, services, processes, materials and even your own time.
You may have a lot of different motivations for being in business, but making money is always one of them, otherwise, the venture becomes unviable. So, when you invest money or time into your business, you need to know that it’s actually generating income for you. This applies to starting a new business activity, buying equipment, hiring staff, changing business processes and practically everything you do in the pursuit of business income.
ROI is most commonly calculated as a percentage, so even an investment that has a low total profit can actually have a high ROI. That’s because it’s relative to the amount invested.
Importance of ROI
Ok, we’ll go into the actual ROI formula shortly, and show you how to use it in business applications. But first, let’s look at why ROI is so important.
ROI is important when assessing the viability of a product, service or entire business. When performing your financial analysis, you attempt to forecast your return on investment. This is all part of helping you make important financial decisions. For example, if you want to develop and introduce a new product into the market, you need to be sure that your financial investment will deliver a favourable return.
Examining your ROI regularly also keeps you agile. Successful businesses can adapt, pivot and change their course when required. But this is difficult if you’re not aware you need to change. Knowing your ROI is a great driver for necessary change.
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The formula for calculating ROI is actually quite simple. It’s your Profit divided by the Cost of Investment. Let’s look at a very basic ROI calculation in a business setting.
You decide to employ a new salesperson. Their annual cost is $100,000 per year (salary, wages, associated employee costs). This is your Cost of Investment. To work out the Profit, you need to look at the total value they have generated in sales. Let’s say this $200,000.
But remember, Profit is determined by subtracting expenses from income. So, in this case:
$200,000 (the salesperson’s total sales) - $100,000 (salesperson’s costs) = $100,000 (Profit)
To determine the ROI, we simply divide the Profit by the Cost of Investment:
ROI: $100,000 / $100,000 = 1
So, the total ROI for hiring your new salesperson is 1, and we multiply this by 100 to get the percentage of 100%.
What if the salesperson only generated $130,000 in sales? Well, the calculation looks like this:
Profit: $130,000 - $100,000 = $30,000
ROI: $30,000 / $100,000 = 0.3 (30%)
If they generate fewer sales than their cost, you’d be looking at a negative ROI, which is never ideal!
How to Use ROI
You can use ROI in all sorts of situations. The example above is quite a simple one, however, ROI can be used for anything in business, including:
- New product lines
- Marketing expenditure
- Equipment purchases
- Hiring staff
- Opening new locations
- Hiring consultants
- Outsourcing work
- Training expenditure
- Software upgrades
This list isn’t exhaustive by any means, but it gives you an idea of the common things you can use ROI for in business. Now, the only difficulty arises when the numbers aren’t as clear-cut as the basic example we used before. Many business investments have intangible benefits, meaning they’re hard to put a dollar value to. Marketing costs, for example, may not have an immediate impact but could build brand recognition that results in more future sales.
The biggest advantage of ROI is that it’s usually a very simple calculation. We’ll touch on the limitations soon, but when income and expenses are clearly defined, ROI is a terrific way to see if something is working or not. If you can clearly ascertain the financial benefit (the Profit) and the expenses (Cost of Investment), you’ve got a powerful key performance indicator.
This is great for businesses with a diverse portfolio of products or services, because they can look at the ROI for each one and compare them all. If you’ve got 5 services that deliver a 60% annual ROI and 2 that only deliver 10%, is it worth persisting with the latter two? You could put the resources (Cost of Investment) for the underperforming services into the better-performing ones and see considerable gains.
The Disadvantages of ROI
When there is a clear Cost of Investment and Profit, ROI is a simple equation. But what if profits aren’t always so clear? Sometimes, the financial benefit of something is extremely difficult to work out. For example, when you purchase equipment that makes a job easier. It could be a software program that automates tedious tasks. This makes life easier for staff, but what do they do with the time saved? This is where you would need to apply a certain set of rules and stick to it. Such as, the new software saves 10 hours per week for one staff member. They earn $35 an hour, so the saving is $350 per week. Now, if the staff member doesn’t perform any other valuable work with those saved hours, you’re not really saving anything, but the cold, hard numbers of ROI would say differently.
The other limitation is that ROI doesn’t really take into account the time of investment. Sometimes, the ROI of a certain investment may not be known for several years. For example, you might open a store in a new location. It takes time to build a presence, and when you take into account the setup costs, you may not make any money in the first year. This reflects poorly as an ROI, however in years to come, that location could become very lucrative.
What is a good return on investment?
Finally, let’s take a look at what is a good ROI. Well, there’s really not a simple answer. Naturally, higher is better. If you had to choose between investments that earn 200% ROI and others that earn 5%, the decision is pretty simple.
However, when calculating returns on investment, you need to go back to your goals. Not every single investment in your business is designed to make money. Some investments are there to support other business functions. Staff training, for example. You may not see a high ROI on the training costs, but you end up with more skilled staff, and this improves multiple facets of your business.
So, in summary, always consider your goals when calculating ROI, and use it to change your business for the better.