There are many different metrics businesses use to evaluate profitability and general financial health. One of the most popular, and most effective, is return on investment (ROI).
In this article, we’ll cover all the basics you need to know about ROI, along with some tactics you can use to increase your ROI.
What is ROI?
In business, your investments are the resources you put into improving your company, like time and money. The return is the profit you make as a result of your investments.
ROI is generally defined as the ratio of net profit over the total cost of the investment.
ROI is most useful to your business goals when it refers to something concrete and measurable. Analyzing investments in terms of monetary cost is the most popular method because it’s the easiest to quantify, although it’s also possible to calculate ROI using time as an investment.
Examples of investments
The term “investments” is often used to refer to buying stock in a company or financing another person’s business venture. Investments you make in your own business are distinct from these, but have a similar purpose: to increase your profit.
Depending on your industry, the types of investments you make can look very different. They don’t always have to be tangible, like an investment in new equipment or higher quality materials. An e-commerce store owner or app developer, for example, might make investments in more digital goods like cloud-based storage services or a subscription to a new content management software.
Other examples of common business investments include ad campaigns and leases for brick-and-mortar retail locations.
How to calculate ROI
ROI is calculated as the net profit during a certain time divided by the cost of investment, which is then multiplied by 100 to express the ratio as a percentage. The equation looks like this:
ROI = (Net Profit / Investment) x 100
The value of net profit should be taken from your company’s profit and loss (P&L) statement.
Calculating ROI in practice
Here are some examples of what calculating an ROI might look like for a business.
Scenario 1: Samantha’s e-commerce business
Samantha owns an e-commerce site that sells cat-themed merchandise. It’s right around the holiday season and she wants to increase awareness and sales, so she decides to invest in some social media ads. She spends a total of $1,000 for ads across social media channels to attract holiday shoppers to her site.
Once the holiday season comes to an end, Samantha calculates her net profit and learns her e-commerce store has earned $5,000 more than it did during the same period last year. She can then calculate the ROI of the ads as:
ROI = ($5,000 / $1,000) x 100 = 500%
This means that for every dollar Samantha spent on the ads, she got back $5 in net profit. Encouraged by this strong ROI, she can begin to budget for an increased spend for the next holiday season.
Scenario 2: Mario’s Pizzeria
Mario owns a pizzeria on a side street in New York City. He notices business is slow and starts to brainstorm ways he can improve his business. Guessing that the quality of his pizza may not be meeting customer expectations, Mario decides to swap out his outdated pizza oven for a cutting-edge replacement.
The new pizza oven costs $500. By the end of the year, his pizzeria ends up earning $2,000 more than it had the year before.
Given that the new pizza oven was the only atypical investment made by Mario during the year, the return on investment for that year can be calculated as:
ROI = ($2,000 / $500) x 100 = 400%
This means that each dollar Mario spent on the new pizza oven generated $4 in net profit. Because Mario’s new oven will continue to generate increased sales over time, his ROI will grow as time passes.
Scenario 3: Mike’s freelance video editing work
ROI is usually calculated in terms of cost of investment, but you can also use it to determine whether the time you spend on a project is worth the monetary return.
Mike is a graduate student who decides to supplement his monthly stipend with freelance video editing work. He quickly finds a client and earns $200 in the first month.
While this $200 is nice extra pocket money, Mike notices himself falling behind in his classes. He decides to calculate his personal ROI from the editing work to determine how much time he should split between classes and freelancing.
It took Mike 20 hours to complete his freelance work, so he can calculate his ROI as:
ROI = ($200 / 20 hours) = $10 per hour
Mike can now consider whether each hour spent studying for class is worth more than $10, then adjust the time he allocates to his freelance work.
Why is ROI important?
Calculating an ROI can help you understand how an investment directly contributes to your business. This is a useful tool for evaluating your past business decisions and informing future ones. You can also use information from ROI calculations to compare new business opportunities and decide which to pursue.
If a certain kind of investment returns a high net profit, you can focus more time and energy on similar investments. Investments that don’t generate enough profit to cover their costs can indicate that you should try a new strategy or invest in a different area of your business.
Challenges to determining ROI
Calculating ROI is not always clear-cut. Some investments will overlap, making it difficult to determine which investment generated the most profit.
In the case of Samantha’s social media ad spending, she may not be able to determine if any single social media platform contributed largely to her returns. She may also have other ongoing investments to thank for her increase in sales, like a monthly email newsletter campaign or word-of-mouth marketing.
Despite the potential difficulty of determining the ROI of a specific investment, the metric is still very useful when trying to ensure you earn more than you spend. Don’t worry about complete accuracy when calculating ROI, instead consider how you’ll be able to measure results each time you make a new investment.
How to increase your ROI
Depending on the kinds of investments you want to make, the best way to increase returns will change. However, there are a few universal strategies you can try out before making investments to better your chances of getting a high ROI.
Make analytics your friend
Samantha’s social media spend is a good example of the importance of using tools with advanced analytics capabilities. When considering an investment trequiring the use of a platform or external software, pay attention to the reporting features different providers offer. Statistics like website traffic and customer engagement are particularly useful when measuring the success of an investment.
Know your market
Effectively connecting with your target audience is one of the best ways to boost your ROI. Investments that will deepen your knowledge of your target market or increase their engagement with your brand will likely have high returns because these are the people who are most likely to buy from you.
Examples of investments you can make to connect with your target market include conducting marketing research and creating targeted ad campaigns with your audience in mind.
Be willing to experiment
The real test of any idea’s value will come in the market, so don’t be afraid to try something that doesn’t come with a tried-and-true track record. Start small with more experimental tactics—you can measure ROI over a shorter period of time to test whether an investment is worth expanding.
The more practice you have with thinking about your ROI, the more refined your decision making will become. ROI is only a single performance metric, but it’s one of the most essential tools for business owners looking to get the most out of their investments.