As companies navigate the intricacies of investments and expenditures, a favourable Return on Investment (ROI) can be the difference between a successful opportunity and a sunk cost. Read on to learn more about using ROI to make better business decisions.
Summary
- Return on Investment (ROI) is the ratio of net income to investment cost.
- ROI can guide you in improving your successful expenditures.
- A worthwhile ROI usually exceeds 100% but it's contingent on your business objectives.
- Despite its importance, ROI shouldn't be the sole criterion used when assessing investments. Considerations like customer behaviour and competition should also be included when making strategic spending decisions.
What does return on investment (ROI) mean?
Typically shown as a percentage, ROI is the amount of money your business will generate from the specific item you bought or invested in. It should be noted that not all investments will generate ROI immediately, so initial losses are sometimes to be expected. This is particularly true of large investments that take time to break even.
At Edinburgh-based herbal remedy business Napiers the Herbalists, ROI is often used to inform business decisions. As Arjun Koyappalli, General Manager, explains: “It’s very much the key metric we look at. At the end of the month, we’ll always view and analyse what money is being spent on marketing or discounts, as well as in the longer term because ROI might not be there within the first month.”
How to calculate ROI
Return on Investment is calculated by dividing the net profit generated by an investment by its cost. Multiply your answer by 100%, as ROI is typically expressed as a percentage.
ROI formula example
The fictional XYZ Widget Co. invests £25,000 in a suite of new office computers. After one month, it has generated £15,500 in net profit.
Month 1
XYZ Widget Co. ROI = (Net Profit) 15,500 / (Cost of Investment) 25,000 x 100% = 62%
After one month, XYZ Widget Co. has a return on investment of only 62%. However, after month two, net profit rises to £22,000.
Month 2
XYZ Widget Co. ROI = (Net Profit) 22,000 / (Cost of Investment) 25,000 x 100% = 88%
Over a two-month period, the company's ROI on the new computers has risen from 62% to 88%. Regularly monitoring your ROI is important because it helps you understand whether a particular investment might be returning the cost over time.
If you need to invest in new office tech, American Express® Business Platinum Card Members an annual £150 Dell Technologies credit, which can be used towards new equipment purchases¹.
Moreover, when you pay for anything using a Business Platinum Card, you earn 1 Membership Rewards® point on every full and eligible £1 spent. Points can be used to further reinvest in your business and are redeemable across travel, retail and dining².
How to use ROI to assess current business decisions
You can use ROI to check whether your current investments are working well, or if something needs to change. For example, you may be paying a company to manage your deliveries, but their prices keep rising. Seeing your ROI drop could be an opportunity to look for another provider.
Former CFO and CMO Alex Batchelor, non-executive chair at Watch Me Think, says that ROI is a very useful ‘rule of thumb’ for many decision-making processes: “It’s not really that sophisticated but it is very useful. If I work out that the ROI on my TV advertising campaign is 500% and my press advertising campaign is 150%, I know to invest more in TV in the future.”
However, ROI isn’t just used to compare the costs of different providers. By continuously calculating the ROI of existing investments, you can judge how well they’re performing and optimise them if necessary. “You want to work out what you were doing before and see whether what you’re doing now is better for it,” adds Batchelor
How to use ROI to make future business decisions
ROI is a useful tool for deciding to adopt a new strategy. Take enhancing your customer service with automation and chatbots, for example. This is a long-term investment so you might not see an immediate improvement in your annual returns. Here, you need to use ROI alongside other measurements to decide whether this will be profitable in the long run.
On top of the cost of the chatbot system, you would need to explore how well chatbots perform for other companies. Is there research that shows customers who use chatbots spend more than those who have to wait for human service agents? If so, how much more on average? You could then take this percentage and apply it to your current profit. Then, you put this alongside the cost of the chatbot system and that can give you a good idea of whether or not it’s worthwhile investing.
What is a ‘good’ ROI?
‘Good’ ROI is highly subjective. One business owner might consider anything less than 100% ROI to be a failure. However, others may feel that returning on just most of the investment is acceptable, and still worthwhile based on other criteria.
Your investment size and what you're willing to risk are key in determining a good ROI. Bigger investments generally need higher ROI due to the increased risk.
For instance, if you open a new store, the expected profits should outweigh its setup and operational costs. Conversely, smaller investments like employing an extra salesperson for a current store may only need a lower ROI to be deemed 'worthwhile.'
Also, remember that ROI is time-bound. It can vary based on whether returns are short-term or long-term. So, 'good' ROI also differs depending on your expectations surrounding timeframes.
Limitations of ROI for business decisions
“ROI was really designed to deal with building a factory or buying a machine," says Batchelor.
"Fundamentally, it’s not bad at those things. It’s also good for comparison and relativity. But it’s not so good at understanding scenarios where there are multiple factors involved in its success or failure.” He points to marketing investment in particular, where any number of influences can determine if an ad campaign succeeds, beyond simply paying for the 30-second slot.
Overall, using a simple ROI calculation can help when comparing like-for-like costs but when many factors need to be taken into consideration, it becomes only a small part of the information needed.
One way to make the case for an investment beyond mere ROI is to include its predicted impact in key financial forecasts. For example, if an investment is predicted to boost cash flow, then that may make it more attractive when deciding between two options with similar projected ROI.
“Essentially, the levers for growth are finding more customers, who buy more products, more often for more money," adds Batchelor.
"If you can make a case for your investments influencing those levers, that’s a big tick. But don’t use ROI on its own".
1. Once you have enrolled your Card Account, you’ll get up to £75 in statement credits between January and June, and the same between July and December for United Kingdom purchases with Dell Technologies on your Business Platinum Card – up to £150 in statement credits annually. Terms and conditions apply.
2. Membership Rewards points are earned on every full eligible £1 spent and charged, per transaction. Terms and conditions apply. If you'd prefer a Card with no annual fee, rewards or other features, an alternative option is available – the Business Basic Card.
