All business owners know that sometimes, you have to invest money to make money.
You might invest in talent, equipment, technology, or general improvements to your people, property, and processes to increase profits. But you need to know your net return to assess the value of each investment and make smarter decisions in the future.
The return on investment (ROI) formula lets you do this. It’s a simple calculation, so it’s not a perfect tool for gauging success — but when you know how to use it, you can use it to invest intelligently.
What is ROI?
ROI stands for return on investment. ROI is a financial metric that is typically expressed as a percentage and measures the efficiency or profitability of an investment relative to the total amount invested in a particular investment.
A positive ROI suggests that the investment is expected to generate more profit than its cost where a negative ROI means the business will lose money from the investment. Calculating the ROI of a decision helps both business owners and investors to make informed decisions when deciding where to spend their money.
How to calculate ROI
You can use the ROI formula for any business investment.
There are a few components involved in the ROI formula. Those include net profit and investment cost.
- Net profit: The total return from the investment minus the initial investment cost. This represents the gain or loss from the investment.
- Investment cost: The amount the company invested.
Basic ROI formula
The basic ROI formula is best for simple investments, small-scale project, or basic financial reporting. The basic ROI formula is also great because it’s simple and can be calculated quickly.
ROI = [Net Profit / Cost of Investment] X 100
The math would look like this:
[($200,000 - $50,000) / $50,000] X 100% = 300%
Expanded ROI formula
The expanded ROI formula involves a few other components including total revenue, total costs and total investments. This helps to provide a more detailed and comprehensive view of an investment’s performance.
Here’s how to find each of the components of the expanded ROI formula:
- Total revenue: The total income generated from the investment
- Total costs: All costs associated with the investment, including initial and ongoing costs.
- Total investment: The total amount that was invested.
And in order to calculate the final total, the math would look like this:
ROI = Final investment value - initial cost of investment x 100 / Cost of investment
Basic ROI formula vs expanded ROI formula
The key differences between the basic ROI formula and the expanded ROI formula are scope, complexity and accuracy. The basic ROI formula is helpful when focusing on a single investment and the profit that comes from that. Whereas the expanded roi formula includes all costs and revenues to give business owners and investors a bigger picture of the investments performance.
ROI example
Let’s say you own a cafe but notice that customers don’t linger in your establishment. That means they aren’t staying to snack on your delicious baked goods or buy coffee refills. You’re also not getting a lot of foot traffic, but you notice people are frequenting the swanky cafe up the street.
You conduct some market research and find out that target customers believe your coffee and baked goods are just as tasty as your competitor’s products. But your interior design could use some work.
So, you decide to purchase new furniture for the cafe, including tables, chairs, and decor, at a cost of $20,000, with the intent of encouraging people to spend more money and attracting new customers.
You expect the new furniture to increase revenue by $3,000 per month, resulting in a projected annual revenue increase of $36,000.
To calculate the ROI, we divide the net investment ($36,000 - $20,000) by the cost of the investment ($20,000) and express it as a percentage.
Here’s the math: ($16,000/$20,000) x 100 = 80%
This scenario suggests that your decision to purchase expensive furniture does yield a good return on investment over time. But you won’t see that projected return for about several months.
Benefits of using the ROI formula
The ROI formula calculation is critical for evaluating business success because it allows you to determine whether your investments generate a positive return. It also reveals which investments create the most impact for your business, helping you decide what to spend money on in the future to try and drive growth.
Here are some examples of how the ROI metric and formula can help you evaluate your company’s performance.
Benefit #1: Evaluating the profitability of investments
You can determine whether or not an investment is producing a positive return by calculating its ROI. A high ROI figure indicates that the investment is profitable, whereas a low ROI figure may indicate that the investment is not worthwhile.
Benefit #2: Comparing different initiatives
You can compare the profitability of each business initiative and determine which ones generate the highest return on investment by calculating the ROI. This can assist you in making informed decisions about how to allocate your resources to maximize profits.
Benefit #3: Identifying areas for improvement
If your ROI is low, it may indicate that there are areas of your business that need to be improved. For example, if your marketing ROI is negative, you know you need to investigate why and make changes to your strategy.
Benefit #4: Tracking performance over time
By tracking ROI over time, you can monitor your company’s performance and determine whether it’s improving or declining. This can assist you in identifying trends and fine-tuning your business strategy to ensure long-term success.
Limitations of using the ROI formula
While helpful, you shouldn’t use ROI alone to make decisions. It does have limitations you need to know about.
Let’s look at the inherent challenges so you know how to address them and make the ROI formula work for your business.
Challenge #1: The ROI formula doesn’t account for time
The ROI formula alone doesn’t account for time, so you could compare apples to oranges if you look at your returns for investments you purchased in different years.
Solution: You can use the annualized ROI formula to add time into the equation, where n is the number of years.
Annualized ROI = { [ (Net Investment / Cost of investment ) ^ (1/n) ] - 1} x 100%
Here’s an example:
Let's say a business invested $50,000 in new equipment on January 1, 2021, and the investment yielded a total gain of $70,000 by December 31, 2023. To calculate the annualized ROI, the business would use this formula:
Annualized ROI = { [ (70,000 - 50,000) / 50,000 ) ] ^ (1/3) ] - 1} x 100% = 11.87%
Here, "n" is the number of years, which is three since the investment was held for three full calendar years, from 2021 to 2023.
So the annualized ROI for this investment, taking into account the three-year time period, is 11.87%. This indicates that the investment was profitable and provided a return on investment for the business over the three-year period.
If you only looked at the ROI, you’d get a different picture. The return on investment is 40%. But by calculating the annualized ROI, you understand what your business gained annually (11.87%).
Challenge #2: You can’t always tie net profits to an investment
Not all investments have an explicit return, as other factors impact the ROI in one way or another. For example, our cafe might have seen a massive boost from the furniture investment — or it could be because a competitor down the street closed its doors.
Solution: Use ROI to gauge your return on investment, but consider other elements. There could be other factors inflating or deflating your ROI.
Challenge #3: Most business investments come with multiple costs
To get an accurate ROI, you need to look at all costs involved in an investment. For example, suppose you’re looking at the ROI of a marketing campaign. In that case, you must include the money you pay the marketing agency and the hours your employees spend managing the relationship in your investment cost.
Solution: You need an accurate and robust expense tracking system to track data for your ROI calculations easily.
What do business owners use the ROI formula for?
There are several things a business might spend money on to try and generate a positive return on investment. Here are some examples:
- Marketing and advertising: A new marketing program or ad campaign can boost brand awareness, sales, and customer acquisition through digital advertising, content marketing, social media marketing, and search engine optimization.
- Technology and automation: Technology and automation can streamline business processes, improve efficiency, and lower costs over time, such as new CRM, inventory, or billing and payment systems.
- Employee training and development: Improving employee skills and productivity increases sales, customer service, and innovation. Your business could invest in training, mentoring, and leadership development to generate a positive return.
- Product development and innovation: Businesses can stay competitive and meet customer needs by investing in product development and innovation. Research and development, product redesigns, and product launches are great examples.
- Infrastructure and equipment: Investing in infrastructure and equipment can improve business efficiency. You can invest in upgrades for technology, facilities, and tools.
Ultimately, the key to creating a good ROI for your business is to carefully evaluate potential investments and choose the most likely to generate significant returns.
It’s also important to regularly monitor and analyze your ROI to ensure that your investments meet your expectations and contribute to your business’s long-term success.
Fortunately, you have the handy formula and know how to calculate ROI for anything your business invests in to try and increase profits. As long as you track your expenses and income, you can always calculate ROI and gauge the monetary value of your choices.
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Part of planning for any future investment is knowing what your books look like. Managing your business expenses is important to know how much money is available for new investments.
With BILL, you can control spending with spend and expense management tools to help you know where your company can comfortably afford to spend. Not only will this give you insight into the bigger financial picture, but it will provide you with the numbers you need to perform accurate roi calculations. Get expense management software from BILL.
