Business owners often focus on revenue to measure their company's health. Of course, revenue is important, but return on investment (ROI) can sometimes give you more color on the profitability or health of the business. You see this ring true in fast-growing enterprises. Why? Because ROI reflects the additional value generated from the investment.
Let's explore ROI, how it's calculated, and why it's an important metric to measure your business success.
The return on investment, or ROI, formula is used to calculate the gain or loss on an investment. It is a simple process to determine a mathematical result for any investment. The results are expressed as a percentage of the original investment. Fortunately for us, the simple formula can be stated as follows:
ROI = (Gain from Investment - Cost of Investment) / Cost of Investment
Here is an example of the ROI formula in action:
Suppose you invested $250 in LinkedIn ads last month and landed $1000 of new business generated from the ads.
ROI = (1,000 - 250) / 250 x 100 = 300%
Using the formula above, your investment has returned a gain of 300% over the last month. In simpler terms, every $1 you spend on Facebook ads earns you $3. That's a good ROI. It is also a fantastic metric, especially when your head of marketing wants to increase the ad spend budget. It's an easy decision.
Reasons to Track ROI
If the above example did not convince you, here are a couple more reasons. As stated in the example above, ROI helps you make better decisions. You can see clearly how your choices are driving your bottom line. It connects the cost of the decision with the financial outcome. Also, it is easy to compare like with like. For example, we ran a similar ad campaign on Facebook. Our ROI was negative on that platform, a -20%. We only showed $200 of revenue generated from the $250 invested. The decision was easy. Pause Facebook ads until we optimize our marketing to reach that audience. The simplicity of calculating ROI makes it very easy to use, understand and take action on. We have focused on marketing in our examples, but ROI is useful in many different areas of your business.
How Does This Help You?
There are many ways to use this in your business. Here are a couple of examples:
Equipment or asset acquisition: some of our clients work in manufacturing or construction equipment rentals. ROI is key in choosing how to allocate funds and if they should invest in leasing or purchasing equipment.
Marketing: (as we mentioned in our examples above)
Employee Performance: one of our clients measures ROI on her team of six. She is primarily contract-based and uses hours billed and budgeted to measure her employee's productivity ROI. It took her some time to get the metric in place, but it helps her quickly make decisions on who gets more projects and also helps her hold her team accountable. They have also seen a bounce in efficiencies on some of their processes because of this metric.
Soft skills: Everything cannot be measured quantitatively. One of our clients measures ROI on his networking. He depends heavily on his networking skills to generate revenue. He has set up an ROI on the different organizations and networking events he attends to know if it is a good fit for his business.
Limitations of ROI
ROI isn't perfect for all situations. It does have some limitations. Here are some pitfalls to avoid when using ROI as a metric.
Focus on the long-term impact.
Sometimes ROI can lead to decisions focused on short-term results, sacrificing the long-term projects that might initially measure a negative ROI but can yield long-term sustainable growth. Abdulaziz Alhamdan with Story Bonding gives us some clear insight. "For small business owners who desire long-term success, ROI will drive them to make the wrong decisions," he says. Alhamdan cites an example of two companies: one startup that discounts its price on a first sale to establish a client relationship that results in future sales, versus a second that is unwilling to lose money—meaning, generate a negative ROI—and maintains a higher price that new customers are unwilling to pay. In the long run, the first company has the opportunity to build a steadily increasing revenue flow. In contrast, the second has created a barrier that may be more difficult to overcome long term.
ROI fails to account for time.
There is a time value of money. A $1000 today is worth much more than $1000 tomorrow. For example, "should I hire the new employee or pay off existing debt?" ROI cannot help you there. An Internal Rate of Return formula would be a more accurate way to measure that impact.
Despite those shortcomings, ROI is still a quick and easy way to navigate business decisions and profitability. ROI helps business owners maximize business value and ultimately prepare their businesses for a dream exit. For more on ROI, check out our eBook.