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September 15, 2020
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Return On Investment
Return on investment, or ROI for short, is a useful and common profitability calculation for a business.
ROI is used to measure whether an investment a business has made has been profitable or not. This is done by comparing the amount of money invested and the money made from the investment.
You should always aim for a maximum return on any investment made.
Companies often use the principle of ROI to determine the financial risks and opportunities in new business opportunities.
For example, you could be on the look for a digital marketing company to help you with the marketing of your eCommerce store.
Company A’s other clients have been seeing revenues of $2000 for every invested $1000, making the return on their investment $2 for every dollar spent.
Company B, on the other hand, asks only an investment cost of $500 for a marketing campaign, but can only guarantee a revenue of around $800. In this case, the money made from the investment is only $1.6 for every dollar spent.
This means that while company B’s services seem cheaper, company A is able to make your invested dollars work for you better.
Calculating investment returns isn’t as difficult as you might think. You can even find an ROI calculator online, but learning to do the math yourself saves time.
If you want your ROI to be expressed as a percentage, you can calculate the return on your investment by dividing the net profit (your return) by the invested amount:
ROI %: (Net profit / investment) x 100
It may also be that on some occasions, you’d prefer to calculate your return on investment without a percentile. To get the real numbers, subtract the cost of investment from your gains, and divide the result by the investment cost:
ROI: (Gains – costs) / costs
Let’s say that you invested in a property that cost $250 000 to buy 5 years ago.
For the sake of this example, you won the lottery and bought the house with cash. If you’re now able to sell it for $300 000, because the neighborhood became popular, your return on investment could be calculated in the following ways:
(300 000 – 250 000) / 250 000 = 0.2
300 000 / 250 000 x 100 = 120%
So in this example, you were able to grow your initial investment by a total of 20%.
How to calculate return on investment and understand if it’s any good can be tricky at times. In order to use ROI, you need to understand why a 100% return on your investment isn’t as great as it may sound.
Let’s say that your company invests $100 in a social media ad. Lots of people see this ad and some even end up buying your product. In the end, your ad campaign makes a total of $100 and your ROI is 100%.
First of all, let’s clarify this: a 100% ROI is not a bad thing. It simply means that you were able to make the money back you initially invested. But you’re not making any extra money on top of it.
For example, if your ad campaign would’ve only totaled for $80, your ROI would’ve been 80%. You would’ve only made $80 for the $100 you invested initially. In this scenario, you would’ve lost some money.
But if your ad campaign brought in $150, your ROI would’ve been 150%. This means that for the $100 initially invested, you made an additional $50 on top.
In short, a 100% ROI is an indication that your investment has broken even: you got back only the money you invested in the first place.
A good return on investment depends on the type of investment you’re making.
If you’re investing in new computers, your return on investment will be seen best in the increase in productivity.
Or, if you’ve got your employees better office chairs and a new sofa in the break room, the ROI could be seen in employee health and reduced sick days due to back and shoulder pain.
If you’re investing in the stock market, a good ROI will depend on your investment strategy: are you looking for short-term gains or are you investing for your retirement?
In order to spend on marketing activities, you should expect a return on investment in your sales.
This means that you would want to see more orders made through a Facebook ad if you’re paying for advertising space on Facebook.
While ROI is a handy tool to use to see if you’re getting your money’s worth, it’s not everything.
Sometimes it’s not easy to understand the clear correlation between the spend and the return. The reason a social media marketing campaign worked so well could be because you were raising awareness of your brand months beforehand.
If you’re trying to define the return on investment in your SEO strategy, you might find it difficult to calculate the actual investment in time and tools. On the other hand, it’s easier to track the exact amount of new orders you’re getting through a well-ranking page.
A way to combat this could be to set up clear and systematic processes to measure the long-tail effects of your marketing strategies.
Another limitation of ROI is the difficulty of considering the time span of the investment. The basic return on investment calculation doesn’t take into account potential compounding interest.
To solve this and have a more accurate idea of the return on investment over a longer period of time, you should use the annualized ROI formula.
Let’s take the investment in a new warehouse for your eCommerce store.
You might not see a change in new orders straight away, meaning that your ROI wouldn’t seem to be great. In fact, the new warehouse could be costing you twice as much as your old one.
However, having more space to store more stock means that you can sell new products in your store. Your new products bring in lots of sales, and thanks to having a bigger warehouse, you can keep a bigger inventory and sell more.
Thanks to using the annualized return on investment formula, you will see the rate of return on your new warehouse over the course of months and years.