Definition of Return on Investment (ROI):
Do you want to understand where to deploy your business resources to give the best return? Do you want to be able to evidence and track your investment decisions? If you’re answering yes to these questions, understanding return on investment (ROI) will be important for you. Let’s explore further.
Overview: What is return on investment (ROI)?
In its simplest form, return on investment (ROI) is a commonly used business metric to help us understand the financial return we can expect based upon our investment. It is sometimes referred to as profit ratio and is typically quoted as a percentage. Mathematically, it is expressed as:
((financial gain or loss – total cost) / total cost)) x 100
A positive ROI indicates a financial gain, a negative ROI a financial loss. The level of ROI is highly dependent upon a number of factors, including industry sector, maturity of product or service, and appetite for risk.
Crucially, ROI is independent of time period, so care needs to be taken when reviewing and comparing ROI data and the underpinning assumptions. Two projects both with 30% ROI are potentially very different investment decisions when considering a 2 or 5 year calculation period. When generating an ROI calculation, a business needs a clear and thorough understanding of all associated costs and projected financial gain (or loss). To help with this task, it’s useful to understand and explore the meaning of tangible benefits and intangible benefits.
2 benefits and 1 drawback of ROI
Often, there are numerous reasons we might consider investing resources, and using ROI can be helpful to justify and evidence investment decisions. Let’s explore some benefits and drawbacks of ROI.
1. It’s a well-known and well-used business metric
Whether you’re in charge of a multimillion-dollar capital investment project or a new start-up marketing campaign, the ROI metric is equally applicable to help stakeholders make their investment decision.
2. It’s relatively easy to calculate
Doing the math is relatively easy, but confidence in the projected ROI typically requires a verified cost model and a thorough understanding of the expected financial gain (or loss).
3. It only tells you about financial health
It can be tempting to only consider high-ROI projects, products, or services but remember this does not necessarily account for all of a project’s impacts. This is especially true for socio-environmental improvements, those intangible benefits that may not have a direct financial gain.
Why is ROI important to understand?
By using ROI, we have an accepted metric that helps a business grow with robust financial decisions that underpin growth.
It provides investor confidence
A carefully researched and calculated ROI forecast that is plausible and deliverable inspires investor confidence.
It provides feedback on financial health
Managing the expectations of stakeholders and investors is important. ROI calculations and forecasts are useful tools for evidencing business financial health.
It provides support for future business investment
If we have realistic ROI forecasts that actually deliver, we are far more likely to gain the trust and confidence of key stakeholders for future business investment.
An industry example of ROI
A global automaker wanted to develop a new research and development centre to take advantage of local expertise supporting the European market. A cross-functional team investigated the potential for investment in a bespoke technical centre. Due to the complexity and capital investment required, a formal ROI was requested.
The team analysed all associated costs and options from complete new build to repurpose of existing infrastructure, including legal and conveyancing costs, utilities, insurance, personnel, and fit out. Business gains were assessed with inclusion of costs saved from reduction of outsourced work and agency staff.
The ROI period was set at 20 years and included offsets for asset depreciation. The project was forecast at a positive ROI at 7 years and 5% at 20 years, highlighting the challenge of such high-capital investment projects.
The investment was secured, and the technical centre opened in 2018.
3 best practices when thinking about ROI
We should be diligent and transparent when calculating and presenting ROI values. Let’s explore three best practices to consider.
1. Choose your timeline carefully
When we calculate and quote an ROI, this can be for the lifetime of the asset, the duration of the investment, or some other defined time period. These can vary hugely and must be clearly defined.
2. Capture all of your costs
Accurate ROI calculation needs all of your costs to be included — both direct and indirect. Often, things like staff hiring and staff training for example are missed out.
3. Consider the non-financial returns
Your investment may yield improved customer satisfaction or maybe improved employee retention, which could have no dollar value assigned but is complementary to your financial ROI.
Frequently Asked Questions (FAQ) about ROI
1. What is a bad ROI?
Usually an ROI that is zero or negative will be determined as a bad ROI, but there may be exceptions depending upon your industry sector, maturity of product or service, and appetite for risk.
2. How do you calculate ROI?
The formula for ROI expressed as % = ((financial gain or loss – total cost) / total cost)) x 100
3. Why is my ROI so low?
There could be many reasons why an ROI is low, the two most common being poor cost control and immaturity in forecasting financial gain.
A final thought on ROI
Generating ROI calculations and forecasts can initially be a daunting prospect. However, a methodical approach to cost and financial gain calculations coupled with good financial discipline can help win investment utilising realistic and carefully considered ROI numbers.
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