Whether in marketing or in the business itself, you cannot do without monitoring the return on investment. When you invest your money in something, you logically expect that you will not only get a return on that investment, but also get something extra. It is true that every entrepreneur must master the basic principles even without theory, but there is no harm in having some theoretical foundations so that you can understand each other, for example, with your marketer.
What will you learn in this article
- What does ROI mean
- How do we calculate ROI
- Interpretation and examples of ROI calculation
- ROI advantages
- ROI disadvantages
- Other similar metrics
What does ROI mean?
ROI (short for Return On Investment) is a financial metric of profitability. In Slovak, you will also come across the term Return on Investments, or the abbreviation NI.
It is a simple ratio of profit from an investment to its costs. ROI is usually used when evaluating the potential return on an investment under consideration or when comparing the returns of several investments.
How do we calculate ROI?
The principle of the ROI metric is very simple. As the English name says, it is the share of net income and investment costs. In other words, you subtract the costs from the revenues and divide the result by the costs.
The ROI value is usually given as a percentage. So, the formula for calculating ROI looks like this:
ROI = (return on investment - cost of investment) / cost of investment) x 100%
Interpretation and examples of ROI calculation
A positive ROI value means that the investment is profitable. For example, if you get €1,300 from an investment of €1,000, the resulting investment return will be ((€1,300 - €1,000) / €1,000) x 100% = 30%. Thus, ROI will be ((€900 - €1000) brought a 30% profit.
If, on the other hand, the returns are lower than the cost of the investment and the investment is therefore loss-making, the ROI value will be negative. For example, when with the stated investment amount of €1000 you will achieve returns of only €900, the ROI will be 9 ((€900 - €1000) c/ €1000) x 100% = -10%. The result of the investment is a 10% loss.
Thus, zero is the threshold value distinguishing profit from loss. The larger the positive ROI value, the more profitable the investment. Conversely, the more you go into the red, the greater the loss. In the extreme case, the ROI can reach up to -100% if the investment did not bring any returns at all.
To achieve the most accurate result, it is necessary to include all known revenues and costs in the calculation. For example, in the case of buying shares, it is advisable to consider, in addition to the proceeds from the sale of shares, potential dividends, or on the cost side, in addition to their purchase price, also fees to the broker when buying and selling shares. It will be more complicated, for example, in the case of an investment in an e-shop, where on the revenue side we have to clean the sales from returns and on the cost side, we have to count not only with the investment costs themselves (creation of the e-shop, purchase of goods, legal services, etc.), but also with operating costs (wages and employee contributions, warehouse rent, postage and packaging, marketing, web hosting, accounting, loan repayments, etc.).
The greatest advantage of the ROI metric is its simplicity. It is easy to calculate, intuitive and understandable. Its meaning is the same everywhere in the world and you will get the same result whether you calculate in euros, dollars, or bitcoins.
At the same time, this metric is universal enough to allow comparing investments of different nature, whether it is, for example, the purchase of securities or a marketing campaign.
A big advantage (and disadvantage) of ROI is flexibility. For a quick ROI estimate, you don't need to know all the costs in detail, nor do you need to know exactly what the investment's returns will be. You include the known values and either neglect the unknowns (if they are relatively small) or estimate them. As the saying goes, time is money - and in business it is often better to have a less accurate number at a moment's notice than to waste time analysing all the inputs for a long time.
Disadvantages of ROI
The ROI metric itself does not consider the duration of the investment, which can be a problem when comparing investment alternatives. For example, suppose investment A generates an ROI of 35%, while investment B has an ROI of 15%. At first glance, A appears to be an excellent investment until we look at the time frame of the investment. But what if we get a 35% return on investment A in five years, while we get a 15% return on investment B in just one year? Which investment is more profitable? In this case, we need to recalculate the ROI for the same period to compare the return, e.g., for 1 year.
ROI also does not take risk into account. It is a historical metric, calculated from past costs and revenues. However, these may change in the future and the actual return on investment will differ from the expected one. Therefore, when making investment decisions, we also need to consider the degree of risk, or continuously evaluate the investment according to current developments and, if necessary, update the ROI.
The already mentioned flexibility is also a big disadvantage if you have to work with the ROI value and you don't know what was included in the calculation. Therefore, only believe the ROI value that you calculate yourself, not the one that someone tells you without context. This is especially true, for example, in marketing. If someone calculates only with the trade margin and marketing costs, he will get a completely different result than the one who works with the purchase price of the goods and all operating costs. Or, for example, in the case of an investment in real estate, it doesn't matter if only the purchase price was included in the ROI calculation, or if you also count on mortgage interest, real estate tax, insurance and maintenance costs of the real estate itself, which can significantly reduce your ROI value.
Other similar metrics
- ROMI (Return on Marketing Investment) - it is a de facto simplified calculation of ROI. As the name suggests, in this case we only consider the marketing costs and the increase in profit related to the relevant marketing activity.
- ROAS (Return on Ad Spend) - the simplest marketing metric based on "peasant" mathematics: how many euros will one euro invested in advertising bring me. The calculation is very simple - you divide the revenue from advertising by the cost of advertising. A higher ROAS means a relatively higher return on advertising spend.
- ACoS (Advertising Cost of Sales) - a metric in the Czech-Slovak environment known earlier as PNO (share of cost of sales) is actually the inverted value of ROAS. You do not divide revenues by costs, but on the contrary, costs by revenues. Its use is the same as in the case of ROAS, but instead of the highest value, the goal is the lowest possible.
I'm glad if the article helped you, it served its purpose. If you feel the need to talk in more detail about measuring the performance of your business and marketing activities, stop by our agency for a coffee.