Chapter 11
Return on investment (ROI)
- Why: To better understand your financial performance, especially the efficiency of investments
- What: To measure the proportion of revenue that is left after removing all costs of operating the business
- When: When you want to assess or compare the efficiency of investments
- The question this indicator helps you to answer: to what extent are our investments generating a financial return?
Why does this KPI matter?
Return on investment (ROI), also referred to as the rate of return or rate of profit, is a financial performance measure that is used to evaluate the efficiency of an investment (after or during the investment period) or to compare the efficiency of a number of different investments (before capital is allocated).
ROI is a calculation of the most tangible financial gains or benefits that can be expected from a project versus the costs of implementing the suggested programme or solution. In short, it is the ratio of money gained or lost (realised or unrealised) on an investment relative to the amount of money invested.
ROI is a very popular metric within organisations because its versatility and simplicity are powerful aids to the decision-making process. By running an ROI projection, organisations can determine the likely return on an investment. If there are other opportunities with a higher ROI, then it is probable that the lower ROI-yielding investment will not be undertaken or at least will become less of a priority.
Estimating ROI for a proposed expenditure will go a long way in aiding management to make a ‘go’ or ‘no go’ decision. ROI can be separated into two categories: micro and macro ROI.
Micro ROI is focused on elements of any project or programmes a company may become involved in. Most such initiatives would have a shorter time-frame (maybe up to a year). These may include such things as:
- a direct mail programme
- a print advertising programme
- a sales promotion.
Micro ROI can include almost anything a company would spend money on where it would expect a positive financial result in less than a year.
Macro ROI concerns the overall performance of major company initiatives. These may include:
- adding a new assembly line
- creating the company’s own truck delivery system
- building a new production facility.
The payout for these types of initiative is probably more than a year and could extend for several years.
Although calculating ROI can be more difficult for intangible investments (such as knowledge development), it has been applied successfully to areas such as training.
Naturally, the ROI metric is a key metric tracked by the investment community, which looks for businesses that can demonstrate that they are adept at generating positive returns on their investments on an ongoing basis.
How do I measure it?
How do I collect the data?
The data are collected from analysis of the accounting data.
What formula do I use?
Return on investment is calculated in several ways. For example:
In the above formula ‘Gain from investment’ refers to the proceeds obtained from selling the investment or income from the investment or the products / services resulting from the investment.
ROI can also be calculated as net benefits/net costs or as profit/costs × period
How often do I measure it?
ROI can be measured at the end of a programme (such as a marketing effort, where it is straightforward to calculate the ROI based on known and complete costs and benefits).
However, ROI is also measured as a percentage of return over a period of a year (most useful for longer-term projects), thus giving a calculation of how long it will take the organisation to cover its investment and then make a profit from that investment.
If the rate of return (ROR) is 33.3% in one year, then it will take three years to recover the complete investment (100%/33.3% = 3).
If ROR is 50%, then payback is two years; if 200%, then six months.
Where do I find the data?
These data can be extracted from the accounting data.
How difficult or costly is it to measure?
The cost and effort of calculating ROI depend on the complexity of calculating the benefits of the investments. This can be complex if data for the financial benefits are not already available or when more complex formulas are being used to, for example, convert intangible benefits into financial returns. However, if simple financial formulas are used, the cost and effort will be less, as the data should be readily available in the accounting system.
How do I set targets for this KPI?
Organisations will set their own ROI targets, and where possible will base these on industry benchmarks. In general, the higher the investment risk, the greater the potential investment return and the greater the potential investment loss (such an understanding will influence the setting of an ROI target).
Moreover, profitability ratios such as ROI are typically used by financial analysts to compare a company’s profitability over time or to compare profitability between companies. The investment community might be a good mechanism for identifying benchmark targets.
Practical example
Let’s look at a simple ROI calculation. Take a parcel-mapping project that costs $50,000 to implement, and you demonstrate $25,000 in net benefits, then the calculation would appear as follows:
As a further example, consider this 90-day promotion:
- Period: 90 days
- Sales: $320,000
- Profit: $120,000
- Programme cost: $200,000
- ROI = 60% × 4 = 240% annual rate of return
In this example, the company recouped its initial investment of $200,000 from its sales of $320,000, leaving a profit of $120,000.
Since the promotion was over a 90-day period, the company got 60% return on its investment in 90 days. Annually, the return is four times the 60% or 240% for annualised ROI.
Some tips and traps to consider
It is worth keeping in mind that the calculation for return on investment and, therefore, the definition can be modified to suit the situation. Basically, it all depends on what the organisation (or part of it) decides to include as returns and costs. The defin-ition of the term in the broadest sense just attempts to measure the profitability of an investment and, as such, there is no one ‘right’ calculation.
For example, a marketer may compare two different products by dividing the gross profit that each product has generated by its respective marketing expenses. A financial analyst, however, may compare the same two products using an entirely different ROI calculation, perhaps by dividing the net income of an investment by the total value of all resources that have been employed to make and sell the product.
This flexibility has a downside, as ROI calculations can be easily manipulated to suit the user’s purposes, and the result can be expressed in many different ways. When using this metric, an organisation must have a clear understanding of what inputs are being used.
Furthermore, care must be taken not to confuse annual and annualised returns. An annual rate of return is a single-period return, while an annualised rate of return is a multi-period, average return.
An annual rate of return is the return on an investment over a one-year period, such as 1 January to 31 December. An annualised rate of return is the return on an investment over a period other than one year (such as a month, or two years) multiplied or divided to give a comparable one-year return. For instance, a one-month ROI of 1% could be stated as an annualised rate of return of 12%. Or a two-year ROI of 10% could be stated as an annualised rate of return of 5%.
Further reading and references
The ROI Institute: www.roiinstitute.net
Jack J. Phillips and Patti P. Phillips, The Business Case for ROI, Measuring the Return on Investment in Human Resources, paper by Jack Phillips Center for Research, 2001.
Patricia Pulliam Phillips and Jack J. Phillips, Return on Investment (ROI) Basics (ASTD Training Basics), 2006.