What Is Return on Investment (ROI)
Return on investment (ROI) is a common financial metric used to evaluate the incremental revenue generated from an investment. The investment amount, however, may not include other costs associated with generating that revenue. The materials, personnel and other costs required to operate the equipment would have to be subtracted. These costs are often left out when calculating ROI.
For instance, a $100K piece of manufacturing equipment might generate $500K in revenue, but the additional $400K wouldn't all be profit. The materials, personnel and other costs required to operate the equipment would have to be subtracted.
- Return on investment (ROI) helps you evaluate and compare various business investments.
- ROI estimates are used to decide if an investment will generate positive returns over a specific period and to compare multiple investments.
- ROI is best used in combination with other metrics to fully inform major financial decisions.
Return on Investment (ROI) Explained
Return on investment is a simple formula, but the value it provides is immense. Businesses can compare ROI from previous investments and ROI estimates to decide if an investment meets your expectations for value. This financial metric can also be a powerful tool in earning the support of key leaders and stakeholders for a specific investment.
When you use ROI to compare past investments and ROI estimates to consider potential ones, there’s less guesswork about which one will help the business excel quickly — using estimates about returns, you can better identify the proper choice. This can help you prioritize different growth initiatives, juggle requests from various teams or discover that a certain investment wouldn’t meet your payback requirements at all.
Why Is ROI Important? And How Is ROI Used?
ROI is used to decide if an investment will generate positive returns over a specific period and to compare multiple investments. This measure helps shed light on the viability of different investments and can be crucial to the lasting success of a company. Business executives appreciate its ease of use and applicability across many different scenarios.
A large business can use ROI to help decide which organizations out of a larger pool of candidates make the most sense to acquire or expand. It could just as easily help a small business make decisions around expansion or upgrades. A growing mid sized company may use ROI to decide between adding a new enterprise resource planning (ERP) system or hiring additional staff. There are endless combinations and possibilities where ROI can help.
Large companies employ financial and data analysts who can work together to create complex ROI models. Most small businesses don’t have large financial planning and analysis (FP&A) teams, but that doesn’t mean they can’t calculate ROI and use it to evaluate key business decisions.
In most cases, ROI shouldn’t be the sole metric used to evaluate an investment, particularly when making large and complex decisions. While you can use ROI to assess past projects with measured accuracy, forward-looking projects rely on assumptions, so they may not be perfect.
In the next section, we will look at some pros and cons of using ROI to make business decisions.
Advantages and Disadvantages of Using ROI
While ROI is widely used, it does have some limitations. Return on investment is a valuable and simple financial indicator, but it shouldn’t necessarily be used in a vacuum without considering other metrics. Here are the top advantages and disadvantages of ROI.
- Easy to Calculate: The ROI formula is simple and requires just a few basic inputs. That makes it quick and easy to calculate.
- Many Use Cases: You can use ROI for a wide range of products and services. Whether you run a tiny business or a sprawling enterprise, ROI is almost certainly a useful measure for at least some situations.
- Simple to Understand: You don’t need an MBA or extensive financial background to use ROI. Any member of your board or leadership team may be able to tap into the power of ROI, even if they don’t have financial expertise.
- Relies on Assumptions: Forward-looking ROI decisions are only as accurate as your assumptions. If you are too aggressive on revenue assumptions or too conservative on costs, you could wind up making a poor decision.
- Doesn’t Always Factor in Time: Two similar investments may both have an ROI of 30%, but one may have achieved it in two years while the other reached it in four. That can make the number misleading if the time frames aren’t clear. A simple way to account for this is to divide the total ROI by the number of years, though there are nuances to this (see the next point). But when comparing potential investments, ROI estimates should always be time-based.
- Doesn’t Consider Net Present Value: Return on investment generally considers all dollars as equal. However, in financial terms, a dollar today is probably worth more than a dollar tomorrow due to inflation and risk factors. Some more robust calculations rely on the net present value (NPV) of future dollars. For example, a discounted cash flow (DCF) model may be more precise than ROI.
- Only Looks at Dollars and Cents: ROI is a strong measure of profitability, but it doesn't consider other factors like the effects of decisions on your staff, customers, community or the environment. It’s a somewhat limited look at the financial impact of a certain project or decision.
What Is a Good ROI?
There is no specific number that demonstrates a good ROI or bad ROI. Each business and industry has its own typical ROI benchmark to consider. In general, it’s important to have both a positive ROI and an ROI higher than 1.0, or 100%.
Can ROI be Negative?
An investment can lose money, so ROI can be negative. If your projected net income from an investment is less than zero, it would be a losing investment and yield a negative ROI.
If you’re ever working through a business scenario and come across such an ROI, it may not be an error. It could just be a bad investment (up to that point, at least).
How to Calculate ROI
Now that you have a solid grasp on what return on investment means and how businesses and investors use it, let’s look at how to calculate it.
The ROI Formula
The simple ROI formula is typically used when purchasing a piece of equipment, launching a new product or other typical business investments. It’s expressed in terms of revenue generated (or money saved).
ROI = Net Return on Investment / # Cost of Investment x 100
One limitation that we have not spent much time on is clear when looking at this version of the formula: It only looks at the returns for a specific period. What about comparing long-term investments that may take five, 10 or more years to pay for themselves? For those cases, it's best to look at formulas that can give an annualized return on investment.
Alternative Ways to Calculate ROI
You could even use it outside of work when buying investment properties, purchasing stocks or other assets that fluctuate in value. Here is the formula to calculate ROI:
ROI = (Current Value of Investment – Cost of Investment) / Cost of Investment x 100
Here’s a basic example of calculating ROI. Let’s assume the current value of a particular investment is $110,000 and the starting value was $100,000:
Return on Investment = (Current Value of Investment – Cost of Investment) / Cost of Investment x 100
ROI = ($110,000 - $100,000) / $100,000 x 100
= $10,000 / $100,000 x 100
= .10 x 100
Annualized Return on Investment (ROI) Formula
The simple ROI tells you how much you’ve earned since your initial investment. To compare investments that don’t offer easy apples-to-apples comparison opportunities, it may be best to use an annualized return on investment formula.
Annualized ROI averages your return over the investment length, giving you an average return rate per year. Annualized ROI also includes interest and other gains realized over time. This is the annualized ROI formula:
Annualized ROI = [(Current value / Cost of Investment) ^ (1 / Number of years) – 1] x 100
For shorter-term investments, you can substitute 1 for the number of days and divide by 365.
We have walked through a few examples to understand ROI better, but most real-life business scenarios won't give you such clean and simple numbers. Here are two additional ROI examples to provide you with a better idea of what to expect:
A manufacturer of industrial fasteners has outgrown its legacy system for managing customer records and support cases and is considering replacing it with a new customer relationship management (CRM) system. The business estimates that its CRM license would cost $25,000 per year after a $100,000 expense for the initial implementation and configuration. However, the CRM would also save the company an average of $40,000 per year in staffing costs. The IT manager wants to know if the business would recover the cost of the CRM in the first year.
ROI = [(Current Value of Investment – Cost of Investment) / Cost of Investment] x 100
= [($40,000 - $125,000) / $125,000] x 100
= -.68 x 100
= -68% ROI
In this example, the new CRM would return -68% of the original investment, so it would lose money in the first year. However, if you were to extend the math out over several years, you can calculate the project’s break-even point, another useful metric when making investment decisions. In this example, the project would break even during the sixth year. From year seven onward, it’s a profitable project.
A restaurant chain is deciding whether to offer franchise locations in a new city. Based on the owner’s experience, each new location would cost about $650,000 to open and expects each location to net an average of $725,000 in annual operating profit. The owner wants to estimate the ROI to make the business case for these restaurants to potential new owners.
ROI = Net Return on Investment / Cost of Investment x 100
= $725,000 / $650,000 x 100
= 1.115 x 100
Common ROI Mistakes
While ROI is an insightful metric, there are a few common mistakes business leaders make or things they overlook when using it. Here are some common ROI pitfalls to avoid:
- Comparing Different Types of Investments: Comparing two types of investments is fine, but they may not have the same expected return periods or cash flows. It's essential to take those differences into account.
- Forgetting Additional Costs: Don’t forget about added costs that go beyond the initial price of something, like installation, labor, utilities, taxes, interest, insurance and other expenses that could come with an investment.
- Choosing the Wrong Period for Measurement: If you look at the ROI after one year and see a poor result, you may skip what could be a great long-term investment. Consider multiple return periods to get the best estimate of your potential profits and understand those time frames before making the investment.
3 Simple Ways to Improve ROI
If you’re looking to improve how you measure ROI, here are three simple tips to follow:
- Add in Other Metrics: In addition to ROI, consider other models that can give you different vantage points on an investment, such as:
- Return on assets (ROA): ROA is an indicator of how well a company uses its assets to turn a profit.
- Return on equity (ROE): ROE is a measure of a company’s net income over its shareholders’ equity.
- Discounted cash flow (DCF): DCF calculates the value of a company’s investment adjusted to the net present value of money.
- Make Detailed Estimates: Don't just guess what an investment will earn. Dig into the details of an investment, like savings in payroll, time, equipment, efficiency and more, to create a more robust — and accurate — estimate. The more on-target your estimates, the clearer and more realistic your expectations, setting you up to make the right choices.
- Check Your Math: Manual methods like spreadsheets or handheld calculators are ripe for typos. Check your math twice and consider sharing it with a colleague to ensure you’re making important decisions based on accurate calculations.
Free ROI Calculator Template
Tracking and Measuring ROI With Accounting Software
While knowing what ROI means and how to calculate it is useful for most business owners and leaders, you don’t have to make all these calculations by hand, especially more complicated ones like annualized ROI. Leading accounting software can handle the underlying numbers for you, saving you time and money as employees can focus on other tasks. An accounting system can also provide more accurate, detailed and complex ROI calculations to encourage data-driven decision-making.
How do you calculate return on investment?
Return on investment is calculated by dividing the net return on an investment by the investment cost. The two ROI formulas are:
ROI = (Income from Investment / Cost of Investment) x 100
ROI = [Current Value of Investment – Cost of Investment) / Cost of Investment] x 100
What is a good ROI?
A good ROI depends on the specific investment, industry and expectations. Some companies may operate on slim margins and be happy with an ROI of 5%. Other businesses may have higher requirements and seek an ROI of 200%, 300% or more for a major investment.
What does an ROI of 1 mean?
An ROI of 1 means the investment’s return is equal to the cost of the investment. You can consider an ROI of 1 the same as a 100% return. If you spend $1,000 on an investment that yields a $1,000 profit, you would have an ROI of 1.