What Is Return on Investment or ROI?

How to Calculate ROI

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Return on investment, or ROI, represents the financial benefit received from a particular business investment. In other words, it measures what you get back compared to what you put in.

Learn how to calculate return on investment, why it is important, and the challenges you may encounter when trying to determine ROI.

What Is Return on Investment or ROI?

Return on investment measures how effective your investments into your business are at generating income.

Whenever you invest money or time into your business, you need to have a goal result in mind and way to measure it to ensure you're making a profit. Calculating the return on investment is a way to measure whether a business decision is paying off.

Calculating ROI can also help you understand what's working and not working in your business so you can make changes. It's a way of asking, "What will I earn by investing this time and money into my business?"

For example, if you outsource work to a virtual assistant (VA), is the money you're paying leading to an increase in income, and if so, how much? For every dollar you spend on a VA, what extra returns in income are you getting?

ROI isn't static, and many variables can change it. Therefore, you want to calculate ROI regularly and make changes to your business as needed.

How Do You Calculate ROI?

ROI is usually represented as a ratio or percentage and is obtained by dividing the gain or net benefits earned from the investment by the cost of the investment. 

ROI = net benefits / total cost

How ROI Works

For example, if you spend $1,000 per month for pay per click (PPC) advertising and generate $2,000 in revenues directly from the campaign, you'd divide the profits ($2,000 – $1,000 = $1,000) by the cost ($1,000) to find the return on investment: 1/1. Multiply by 100 to find the percentage: 100%. In other words, for every dollar you spent on PPC ads, you saw a dollar in profit.

If you spent $1,000 a month on that campaign but instead saw $1,200 in sales, your profits would be $200 ($1,200 – $1,000) and your ROI would be $200 (profits) divided by $1,000 (cost) = 0.20, or 20%. In other words, for every dollar spent on this PPC campaign, you'd see 20 cents in profit.

You should consider the ROI of any expense you have. How much will a new, faster computer contribute to your business? Does the money you spend on a virtual assistant lead to your ability to earn more than if you didn't have her? Figuring out the return of business decisions like these help you to choose investments that help your bottom line.

ROI and Time

While ROI is generally attached to financial investments, it doesn't hurt to consider your time as an investment, too. If you're making $3,000 per month, but working 60 hours a week on your business (240 hours a month), your ROI is 3,000/240, or 12.5. That means for every hour you're working, you're only earning $12.50. 

Knowing your returns on the investment of your time, you can make changes to your business model that allow you to earn greater revenue in less time.

Note also that ROI isn't the same as profit. You determine profit by subtracting your expenses from your income. If you generate $5,000 in a month and your business expenses are $3,000, your profit is $2,000. ROI measures the effectiveness of each of those investments, expressed as a ratio or percentage—not a simple dollar amount.

Limitations of ROI

The difficulty in calculating ROI lies in how well revenues—what you earn—can be tied to a specific investment. For example, if you use search engine optimization (SEO), you may not be able to accurately determine how much an increase in your revenues was a direct result of SEO because other factors (i.e. social media) may also have led to increased traffic. Social media, in particular, can be difficult to measure, although there are tools that can help. Facebook offers insights and many social media management tools also provide analytics. Even then, it can be difficult to know if clicks from social media led to sales.

Further, in most cases, customers and clients don't spend money on their first encounter with you. Perhaps they find you through a PPC ad, then they follow you on social media and sign up for your email list, and then they buy. The question is, which led to the sale? You could argue the PPC did because it introduced the prospect to you, but it's possible a social media post or email led to the actual sale. 

If you engage in a free promotional activity that results in increased sales, the denominator in your ROI calculation would be zero, which results in a mathematical error. For example, if you earn $1,000 from the result of an Instagram post, which is free to publish, the math is $1,000 divided by 0, which is 0. Normally, a zero ROI is bad, but in this case, it's good. You made money without spending money.

Free marketing often involves the personal investment of time, which does have a financial value, and you can use that to determine ROI. For example, if you know your time is worth $50 an hour and you spend an hour a day on Instagram, you can divide the income earned from your social media efforts (if you can determine that amount) by $50. In the example above, you would calculate your ROI by finding the net benefit: $1,000 in increased sales – $50 cost of an hour of time = $950. Divide $950 by $50 and get an ROI of 19.0, or 1900%, which indicates a terrific return on your investment.

Key Takeaways

  • ROI stands for return on investment.
  • It is a measure of how much financial benefit you have received from a particular investment in your business.
  • To calculate ROI, divide the net benefit of an investment by the cost of the investment.
  • It can be difficult sometimes to determine ROI because it can be tough to track exactly how much you received from a particular investment such as social media marketing.

Article Sources

  1. Small Business Administration. "Marketing and Sales." Accessed July 23, 2020.