The concept of Return on Investment (ROI) is a critical metric in finance and business. It measures the profitability or efficiency of an investment by estimating the profit or loss. This metric helps assess a business plan, a marketing campaign, or any other type of investment.
Whether you're a seasoned investor or a business owner looking to gauge the financial impact of your decisions, understanding how to calculate and interpret ROI is paramount to making informed choices that drive success. Read along to learn ROI basics, such as definitions, calculation formulas, benefits, limitations, and alternatives.
This is the most basic definition of Return on Investment: ROI is the ratio between the net profit and the investment cost. In other words, ROI shows in percentages how much you gain or lose because of an investment.
The definition applies regardless of the object of investment. For instance,
So, remember the basic definition and use it whenever you need to assess how much money you get back from an investment.
ROI definition mentions the net profit and cost of investment. The net profit is calculated by deducting the cost from the total income. So,
Net Profit=Total Income-Cost
The formula for ROI is,
ROI (%)=100* (Net Profit)/Cost=100* (Total Income-Cost)/Cost.
As ROI doesn’t consider the time between investing and getting the income, more complicated formulas were developed for scenarios where time is essential. One example is the annualized return on investment. It is outside the purpose of this article, but we provide it here. Nevertheless, we want to inform you that more complicated financial tools are available.
The annualized ROI calculates the rate of return on investment over a specific length of time in a year-long time frame. It’s useful for comparing investment performance, for instance, in stocks and real estate. The formula for annualized ROI is,
where,
• Return Value of Investment is the current value of your investment,
• Initial Value of Investment is how much money you initially put in, and
• Number of Years is the length of time for which you calculate the profitability of your investment.
| Investment Gain | $9000.00 |
| ROI | 900.00% |
| Annualized ROI | 64.38% |
| Investment Length | 4.5 years |
Here is how calculating ROI may look in different practical scenarios:
Example 1: Social Media Campaign
Consider a company that allocates $10,000 to a social media marketing campaign. The company can determine the revenue generated from this investment by tracking metrics such as click-through rates, engagement rates, and conversions. If the campaign results in $15,000 in sales, the ROI is calculated as follows:
ROI (%)=100* ($15,000 - $10,000)/$10,000=50%
Example 2: Technology Update
Consider a company that allocates $100,000 to update the production line. The cost includes buying and installing new technology.
By tracking metrics such as increased productivity, higher customer satisfaction, reduced operational expenses, and targeting new markets, the company can determine that the revenue generated from this investment will be $250,000 in the following six months.
However, buying and installing new machines isn’t the only cost generator. The company also needs to train the staff in using the machines, which costs $200/hour and takes 40 hours. Another $8,000 is added to the total cost. In addition, the company hires a health and safety consultant to create the protocols for safely using the technology, adding a $20,000 fee to the bill, and hires two team members, adding an estimated cost of $4,000 per person per month.
The total cost after 6 months becomes:
Cost=$100,000+$8,000+$20,000+$48,000=$176,000
The ROI is calculated as follows:
ROI (%)=100* ($250,000 - $176,000)/$176,000=42%
Example 3: Digital Transformation
Consider a company that allocates $2,000 to buy dedicated HR software. By tracking metrics such as the value of time saved on repetitive HR tasks, employee engagement rates, and productivity increases, the company can determine the revenue generated from this investment to be $5,000.
However, implementing the new HR software costs the company $1,500 in employee training and hiring a consultant to explain the benefits of this change to each team. At this point, the total cost reaches $2,000 + $1,500 = $3,500.
The ROI is calculated as follows:
ROI (%)=100* ($5,000 - $3,500)/$3,500=42,85%
The basic ROI formula doesn’t consider risks. However, most businesses must account for potential uncertainties that might affect the expected returns on an investment, especially in the long term. The basic approach to include risk in ROI calculations means:
Instead of the basic formula, you can use the one for risk-adjusted return on investment (RAROC), which provides a more conservative estimate of ROI and includes the impact of potential risks:
Risk Adjusted ROI (%)=100* (Risk Adjusted Returns-Cost)/Cost
ROI offers several significant advantages for businesses and investors alike, such as:
While ROI is a powerful and widely used metric, it does come with certain limitations that businesses and investors should be aware of. The most important ones are:
ROI (%)=100*(Net Profit)/Cost=100*(Total Income-Cost)/Cost.
Businesses often use a few more detailed approaches to the basic ROI. The most popular is the annualized ROI, which calculates the annual performance rate. Annualized ROI addresses the lack of time accountability in the base formula.
Other ROI alternatives are:
Conclusion
ROI offers a convenient snapshot of investment performance, is user-friendly for businesses and individuals, and provides a clear comparison between various investment opportunities. Once you grasp the benefits and limitations of ROI, you will be equipped to make informed decisions among multiple alternatives and navigate the complexities of financial decision-making with greater ease.