What is ROI? The definitive guide to understanding how it works
Updated: Apr 6
Return on Investment, or ROI, is the measurement of the return on investment. If you have never heard of this term before, don’t worry, we will break it down for you.
It is an important metric for evaluating the efficiency of any given business or investment. By measuring ROI, you can determine how much value you are getting from your money. It’s also a more tangible measure than the abstract concepts of “profit” and “loss”. It helps to find out whether or not the investment was worth it.
This article will teach you all about ROI and how it can help you make a more educated decision when considering a purchase for your business 🧐
The Definitive Guide to ROI: How Does It Work?
Return on Investment (ROI) measures the amount of money you make from an investment, relative to the amount of money you spent on that investment. In other words, ROI shows how much profit you made from something after accounting for how much time and resources were needed to produce it.
Why is it important to understand ROI?
ROI, or return on investment, is a measure of the efficiency of an investment that considers all costs and benefits. Regardless of how small or big your company is, ROI should be an important metric in order to make sure everything is running smoothly and actually working for your business.
The key point of ROI is that it is essential for both investors and business owners:
🤔 For investors: let’s imagine the situation that two promising stores are being considered for investment but the investor needs to choose only one. By comparing the ROI of both stores, the investor can decide in which case the money will get a better return.
🤔 For business owners: when going on the market, it may be wise to use the ROI figures. In such cases the higher — the better. If you have something to offer and the return can be seen in the high percentage — let the potential investors see it. By showing positive results, business owners are making their stores attractive for investment.
📌Note: if the ROI figures are very low, equal to zero or even negative, the store will not look very appealing to the investors. In this case, the business owner needs to look through the working process of the store to find the pain point.
What is a “Good” ROI?
An important consideration when evaluating an investment is whether or not it will provide a "good" ROI. But what does "good" mean? It depends on many factors, such as your personal risk tolerance, your desired level of profit, and where you are in your life cycle.
So if your ROI is 10%, it means you're making $10 for every $100 spent. However, if your ROI is 30%, then you're making $30 for every $100 spent. This may seem like a small difference, but it can add up to be quite significant in time!
📌Note: Your benchmark will vary depending on the type of campaign and your industry. There is one thing you should keep in mind though, and it is the rule of thumb for ROI — it should be at least 10%. Some organizations might see higher potential with an ROI of 20%, but 10% is the industry standard.
ROI calculation formula
ROI is important to track because it lets you know how well your business or investments are going and what you need to do differently in order to improve these numbers.
ROI can be calculated in different ways: as a percentage rate, as a dollar amount, as a percentage of profit/loss, and as a percentage of total value. Most often, ROI is indicated as a percentage. For example:
This calculation provides insight into whether the decision was worth it financially.
ROI is calculated by dividing the return by the cost of the investment. For example, if you earned $100 from an investment that cost you $10, then your ROI would be 100%.
ROI: Aye or nay?
ROI may become a lifesaver for one business owner but a headache for another. Let’s look through the main pros and cons of using ROI.
1. It identifies the strengths and weaknesses of the business
ROI can help your company analyze what has been done so that the business owner can work on improving the right spheres. For example, if you have a negative ROI on social media, then you would want to either shift focus to another marketing strategy or improve the effectiveness of your existing social media strategy to get a higher ROI on this platform.
2. It can help determine if a specific strategy was worth the money spent on it
It will reveal what kind of success the strategy generated and provide insight into how much value it brought to your company. ROI can also help you manage your budget better by helping you choose, for example, which marketing strategies are worth the investment and which ones aren’t.
3. The calculations are pretty easy to handle
All the figures used in both formulas mentioned above are easy to find. You can take them from your financial statements or balance sheet.
1. It depends on the time period of returns
ROI calculations are useful only when the time period is the same for investment and return. This means that if you invest $100 one month and generate $200 next month, your ROI will be 400%. But if you invest $100 one month and generate $300 two months later, your ROI will be 200%.
2. It counts the monetary value, not the time you’ve spent
ROI may not always be accurate, as this metric has many variables you need to be aware of. For example, you may have paid twice as much for your product as another person, but your ROI will say you made more money from the cheaper product. This is because your ROI doesn't take into account the amount of time you put into selling the product or how much money you spent to create it.
3. ROI differs per business
For different businesses, different ROI calculations are used. This makes the comparison between various businesses impossible.
Steps to follow for a higher ROI
Keep in mind that ROI calculations are specific for each type of business, but there are a few general steps to help you get started.
— Start by identifying your goals. What is the goal of your campaign? Is it to increase sales? Gain more followers on social media? Get more website traffic?
— Once you've identified your goal, think about the metrics that are important to achieve that goal. For example, if your goal is to increase sales, you might want to track how many new e-commerce orders were generated.
— Create a set of benchmarks so you can monitor your progress and measure ROI over time. Benchmarks should include a baseline number, such as the number of sales or website traffic before the campaign took place, as well as an end date for your campaign.
— Calculate ROI by taking the difference between the benchmark and your actual numbers at the end of the campaign and dividing it by the campaign cost. If you have a positive ROI, this means you’ve achieved your goal and had a positive return on your investment!
Conclusion: is it worth it?
The cost of investing in your brand is always a hot topic. But ROI is arguably more important than the actual amount you invest. You may ask yourself, "is it worth it?".
When determining whether or not to invest in something, it’s important to measure how much that investment will cost and how profitable it will be. Knowing your ROI can help you make more informed decisions.
Obviously, a bad ROI is not good and attractive for a business but you can learn from your mistakes and grow through this experience. So even if the figures after the first investment are not appealing, this is not a signal for a business owner to shut the store down. This is just a boost to analyze the workflow and the financial health of the business more meticulously.
Hope this guide helped you understand the definition and workflow of Return on Investment more thoroughly!