This article is for educational purposes and does not constitute legal, financial, or tax advice. For specific advice applicable to your business, please contact a professional.
In business, measuring your return on investment on anything from new products to offer to equipment to purchase can be a powerful tool. Calculating ROI of potential investments for your small business can help you better predict the areas of your business to invest in as well as the ones where there is potential to cut back.
What is ROI?
ROI stands for Return on Investment. This is a measure of profitability used to determine if an investment in your business is efficient. It takes into account the initial profits or losses of an investment in regards to its initial cost. Considering the ROI will help you determine how much benefit or profit you may get in exchange for an investment of your time, money, or resources.
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How do you calculate ROI?
Net Gain or Loss / Cost of Investment = ROI
In the formula above, the net gain or loss is calculated by subtracting how much money was spent on the investment from the expense. In other words, this variable is how many profits were made or lost in your investment.
Example of an ROI calculation
Let’s take a look at a sample calculation for a new marketing campaign. Suppose your business is thinking about marketing a new candle for Valentine’s Day. For this example, you track the sales of this new candle through a promo code used in the campaign. The campaign costs $600 to run and your business sees $2,000 in profit from the candle.
Your net gain or loss is calculated by taking the growth in revenue, $2,000, and subtracting the marketing costs from it. In this case your net gain is $1,400. Now, let’s apply this to the ROI formula:
($2,000 - $600)/$600 = 2.3
In this case your ROI is 233.3%. Though this measurement doesn’t take into account risk or time for this marketing campaign, it can give you an idea of what future campaigns may look like and how much you stand to gain or lose, and the size of possible return. A good return on investment can be relative — perhaps you see that 233% and think it isn’t worth investing in the marketing campaign or you feel that it is a good number and you will invest in future, similar marketing campaigns.
What is a good ROI?
A positive ROI means that you are receiving a good return on your investment. On the other hand, a negative ROI means the cost outweighs the revenue. A “good return” on your investment is relative. ROI is best used in this case to help you better forecast your future business decisions so it may be that a 10%, 30%, or 50% return on your investment is what you’d like to see as a return on your investment in order to move forward.
What can ROI be used for?
There are several ways you can use an ROI calculation to look for opportunities to invest in your business. Here are a few examples:
A marketing campaign: Calculate if you are getting a return on sales of a product or services you marketed to see if the cost outweighed the revenue.
Introducing a new product: Evaluate if the costs to launch a new product would yield a return on that investment.
Hiring staff: Consider the potential of added profit for each new hire and how much it would cost to compensate them. This could help you determine how much staff, or even what type of staff (i.e., full-time staff, part-time staff, contractor, or freelancer), you need for your business.
Purchasing new equipment: If you are investing in capital equipment, much like inventory, calculate how much you expect to get in return once you incorporate that equipment into your business.
Leasing a new space: Work out if an additional location or expanded footprint for your business is the right next step for your business.
Your business will have basic needs such as rent, power, or a computer if you run an online business. These expenses shouldn’t be considered as ROI projects. There are instances, however, where you may want to calculate the ROI of lower rent, switching service providers, or using an alternative power source (such as solar, for example) to see how that may impact your business.
You can use ROI calculations as a financial barometer of sorts. This will give you a simple view of whether or not to explore an investment related to your business. This calculation will not include risk, returns over a period of time, or annualized returns on an investment, so consider using financial tools or seeking the advice of a professional to get a more complete picture of your financial health to better manage your cash flow.