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.
In this article, you’ll learn:
- The definition of ROI
- Why you should track return on investment
- How to calculate ROI
- Three shortcomings with the ROI formula and how to overcome them
What is ROI?
ROI stands for return on investment. It’s typically expressed as a percentage and measures the efficiency or profitability of an investment relative to the total amount invested in a particular investment.
You can use the same ROI formula for any business investment, including the business itself.
Say you spend $50,000 to start your company. Then the company brings in $200,000 in profit, making your net return $150,000.
To find the ROI, start with the profit ($200,000) minus the cost of the investment ($50,000) to find the net investment ($150,000). Then, divide the net investment by the cost of the investment ($50,000).
You then find the ROI percentage by multiplying that value by 100, making your ROI 300%.
Here’s the formula:
ROI = [Net Investment/Cost of Investment] X 100%
So the math would look like this:
[($200,000 - $50,000) / $50,000] X 100% = 300%
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.
Why ROI calculation is important for making business decisions
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.
A real-life example of using and calculating ROI
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.
How to calculate ROI
The ROI formula looks at two variables: net profit (the gain from the investment) and the initial cost of the investment.
With these two figures, you can measure your business’s return on investment for just about anything. Here’s another example to illustrate how the ROI formula can help business owners make smarter decisions:
Let's say your business has invested $40,000 in a new delivery truck, and you're wondering whether the money spent was worthwhile or not.
You want to know the return on the investment because you're considering scaling up your business. You might buy a second delivery truck, but only if the first truck generated an ROI of 50% or higher.
After one year, you determine that the new delivery truck has generated a $6,000 increase in profits. That’s your gain from the investment. To calculate the ROI percentage, you’ll find the net investment (gain from investment - cost of the investment), and then divide it by the cost of the investment.
ROI = [(Gain from Investment - Cost of Investment) / Cost of Investment] X 100%
Plugging in the numbers, you get: ROI = [($6,000 - $40,000) / $40,000] X 100% = -85%
So the ROI for the delivery truck investment is -85%. A negative ROI means that the investment has resulted in a loss. It’s definitely not enough to meet your desired target of a 50% return on investment after one year.
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.
Three challenges business owners face when using the ROI formula for making decisions
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 take it with a grain of salt. 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.
Take charge of your expenses with BILL
Part of planning for any future investment is knowing where your expenses and accounts payable are at right now. With BILL's automated AP platform, you can have the answers you need at your fingertips, and plan your investments with confidence. Learn more here.
