ROI

ROI

At first glance I suspect that most of you know what the acronym ROI is. For those of you who do not, it is Return on Investment. The most common understanding of ROI for most comes in the world of investments, specifically the stock market or in real estate. Today I would like to address ROI as a financial metric that assesses the profitability of an investment relative to its cost, in the context of business purchases. Every company at one point and time or other purchases items that will facilitate the process, product, manufacturing, or delivery of that company’s product and/or service. In these cases, ROI is commonly used to evaluate performance and value generated by investments such as:

• Equipment, usually obtains a positive result by increasing productivity or reducing labor.
• Technology, usually obtains a positive result by opening new markets.
• Marketing campaigns, usually obtains a positive result by increasing sales.
• Or any other significant expenditure that positively effects your company’s bottom line.

As a side note, it is safe to say that anything that effects your bottom line negatively or even neutrally usually turns out to be a luxury and a “want” to have rather than a “need” to have, to wit you find that you have purchased at your own peril. More profit is our main driver for major purchases.  Safety and Government regulations can also be drivers, however ROI can still be calculated on “What if”, like “what if we had an accident”, or, “what would the fines be if caught in violation of a regulation?”. What we want to know is what additional revenue or cost savings will this new purchase produce and how long before those savings add up to the original cost of the investment. Keep in mind that we always have profit as an end goal.

Let’s look at ROI over the life of the purchase and construct the simple calculations needed to do so. We simply take the Net Gain from the Investment (Gain – Cost) and divide that by the original Cost, then multiply times 100 to give us our answer as a percent. Shown here:

ROI = (Net Gain from Investment ​/ Cost of Investment) × 100

For example, suppose a business invests $10,000 in a new marketing campaign, leading to an additional $30,000 in revenue. The ROI would be calculated as follows:

ROI = (30,000-10,000 ​/ 10,000) × 100 = 200%

A 200% gain, seems pretty good, until you ask “over what period of time”, is this a 3-month investment or a 10-year investment?

So how do we simplify this math into a usable number and make it Biz Easy…

Rather than go through all the above, I like to understand my monthly gain and then divide that into the investment. So, in this example let’s say we bought a new piece of equipment for $10,000, and we save $1,000 a month on labor costs each month.  If we divide $10,000 by $1,000, we now know that it will take us 10 months to have saved enough to pay for the equipment or breakeven.  If we assume the equipment has a 5-year lifespan our total ROI would be 600% over 5 years.  Conversely, if we only saved $100 per month it would take 100 months or over 8 years to breakeven, which is beyond the expected life of the equipment, making it a bad investment. Identifying the ROI calculated with a specific timeline helps determine the voracity of the investment. Simple enough? You can also complicate it a little by reducing the Original Cost by the Residual Value, perhaps only scrap value, at the end of its useful life cycle. While these examples are simple and a bit extreme, you get the point that this calculation can tell you whether it is worth investing or to keep doing what you are doing presently.

A word of caution; it is very easy to lie to ourselves when determining the “divisor”, the “denominator”, or the “Gain” part of the equation.  Will your savings, or additional revenue really be that large?  This is where your due diligence is critical.  Have your considered everything or have you just taken the salesperson’s word for it?  Your mileage will vary so I recommend caution when endeavoring down this path.

A good example of that is when doing ROI on Marketing, which is VERY important to do though few take the time to do it. It can get a little tricky to make assumptions about how much new business it will bring in and asking the question, “does that marketing offer include a discounted price or additional cost?” When it comes to a major marketing investment, always test with small amounts of money to get fairly accurate data as to what the larger campaign will do, and then perform your ROI analysis to gain a better understanding what your expected return should be.

In the stock market, analysis is what separates the amateur from the professional.  The professional can significantly reduce their risk by applying analytical tools.  Inside your business, you can eliminate almost all risk with a simple Return on Investment analysis. After all, isn’t that the fundamental objective of running your own business… limiting risk and maximizing return.

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