What Is ROI and Why Should You Care?
Regardless of how you plan to grow your business through marketing, employing new staff, or investing in software, one important question remains: “Am I getting any value from it?”
In this case, ROI plays its role. ROI refers to ‘Return on Investment.’ It is a very useful metric that weighs the amount gained against the funds spent.
It doesn’t matter if you are investing in advertising, hiring a sales representative, or purchasing a new piece of equipment. ROI helps assess the value of an expense and determine if it should be kept or eliminated.
The following question that comes to your mind is, “How do you calculate your ROI proceeds?”
Let’s say you spent $1000 in a campaign and earned $ 3000 back. Your ROI is not just the $2,000 profit. It includes how effectively that $1,000 was converted into $3,000.
ROI makes it easier to measure your results by showing them as a percentage, rather than trying to understand the numbers without context.
Now that we learned about ROI, the next question is, why do we care?
When decisions are made without tracking ROI, they are made blindfolded. You might be spending money on a support channel that doesn’t yield any results, or worse, discontinuing a product or service that does incredibly well, all because there was a lack of number tracking.
When we engage with business owners like you, the first step is often to determine what is effective and what is draining the budget.
Usually, ROI, or return on investment, is the easiest metric to start with. It simplifies things – instead of viewing savings as cutting costs.
If your aim is to expand intelligently while making non-speculative decisions, then grasping ROI is not something you can evade. It is essential.
In the following sections, we will explain step-by-step how to calculate it, the most common errors businesses make, and how to leverage that figure to improve future decision-making.
The Core ROI Formula
Return on Investment (ROI) is an easy calculation however, it answers the’ burning question’ for every marketer or business owner: are you gaining more money than what is being spent?
It calculates how profitable your investment is for you, and gives you a percentage of how much you make from how much you have spent.
Breaking Down the ROI Formula
Here is the ROI calculation and the breakdown
ROI = (Net Profit/ Cost of investment) x 100
Each of these terms has the following meaning:
Net Profit stands for the total revenue earned from the investment after deducting all costs attributed to it. Simply put, it’s your gain.
Cost of Investment is the accumulation of every dollar spent on the venture, including direct costs and indirect operational costs.
Multiplying by 100 shifts the decimal and converts the representation toa percen,t which is easier to interpret and compare.
If a marketing campaign yields revenue of $10,000 but costs $2,500 to run, the net profit is $7,500. According to the formula, this would obtain an ROI of 300%. There, you gained three times the amount invested.
Examples of ROI Calculation
To understand anything, examples are the best tools. Let’s give you two examples of how you calculate your ROI Proceeds.
Example 1. Return on Investment of a Marketing Campaign
Let’s say you run an ad campaign via social media platforms, spending about $1,200. At the end of the campaign, ad sales brought in $4,500 in revenue.
Net Profit = $4,500 – $1,200 = $3,300
Take ROI = ($3,300 / $1,200) × 100 = 275%
This means the ROI is 275%, which shows the great success of the campaign.
This was a product campaign calculation of a running product. But if you are launching a new product, the scenario won’t be the same. Let’s see how it goes in example 2 of the ROI calculation.
Example 2: Product Investment ROI Calculation.
Let’s say you designed a new product. The new product had a budgeted spending of $15,000 for development and manufacturing. However, in the first year alone, it brought in $20,000 worth of revenue.
Net Profit = $20,000 – $15,000 = $5,000
Take ROI = ($5,000 / $15,000) × 100 = 33.3%
This shows that the ROI was 33.3%. The value may not be impressive at first glance but it shows positive growth.
Incorporating Risk into ROI Calculations
ROI does not show you the complete picture on its own. By default, it is a snapshot in time, and certainty is the opposite of risk.
For example, let’s consider there are two campaigns, both earning you 100% ROI. One stays as it is, and the other keeps changing. Even on paper, the stable option is clearly a better fit.
Most of the time, we assist clients in considering the risk-adjusted ROI. This ROI considers result stability, repeatability, and scalability.
It’s not just about looking at the number, but rather how dependable that number truly is going forth.
Factors That Influence ROI Accuracy
How accurate your ROI is depends on several factors. Though the ROI calculation formula looks very straightforward, many factors affect the accuracy. Here are some of the important ones:
- Data Quality: Credible ROI calculation relies on strong and precise data. If you miss expenses and guess a high profit, that will make the returns unclear.
- Time Frame: The next thing is the timing. Are you looking for a short-term or long-term goal? You should balance everything.
- Hidden Costs: New business owners make this mistake very often. Always bring all relevant expenses to the table. If your aim is to calculate net profit, you should include Taxes, labor, maintenance, and any other costs that are relevant to your product.
- External Factors: Many external factors also influence your ROI. Some of those are competition, the economic status of that period, market trends, and many others.
- Overhead Allocation: Assigning common costs, such as rent or utility expenses, to particular investments creates additional work on ROI measurement, which may also reduce precision.
Advanced Financial Metrics to Enhance ROI Analysis
ROI gives you the larger picture. But sometimes, that is not enough for a detailed analysis. If you want to make a smarter decision with minimal risk then you have to use additional tools.
These are very straightforward mathematical equations.
You don’t have to be a math expert to do this. Don’t panic, we’ve got your back. We will try to simplify the formula.
The Margin of Safety Formula
Having a margin of safety in investing is like having a safety net. It shows how much sales can drop before hitting a dangerous level.
Here is the formula:
Current Sales – break-even Sales
Margin of Safety (%) = ——————————————————– × 100
Current Sales
How does this formula help you? It shows how much revenue you can lose before your business starts losing money. Let’s assume, for example, current sales are $50,000 and break-even sales stand at $40000. Let’s do the math now
Margin of Safety = ($50,000 – $40,000) / $50,000 × 100 = 20%
According to the calculation, we can assume a 20% drop in sales will bring you to the break-even point. It helps you in risk management and strategic decision-making.
Target Profit Formula: Setting Clear Goals
As a businessman, you must have set a clear profit margin. This formula helps you to achieve that profit margin. How? Simple; by calculating how much sales revenue you need to hit the margin.
Here is the target profit formula for ROI:
Fixed Costs + Target Profit
Required Sales = ——————————————————–
Contribution Margin
Breaking down this formula is easy. We presume you know your fixed costs and your target profit. You just need to know what the contribution margin is. The contribution margin is the revenue left after subtracting variable costs.
Let’s make it clearer with an example. Let’s say the product you are selling costs $10000, and your profit is $5000 (That’s huge!), and let’s say your contribution margin is 50%.
Now, let’s use the formula to bring your required sales. And that would be
Required Sales = ($10,000 + $5,000) / 0.5 = $30,000
See, how powerful this formula is? Now you know how many units you need to sell to hit your target profit. Awesome!
Break-Even Analysis, Which Helps to Understand Your Threshold
Now another critical formula that will help you to find the revenue where it equals your costs which we call the “break-even point” in business terms. Why is it important? Well, you are not going to just invest blindly in any business.
You must know when your business will start making a profit, right? This formula exactly does that. Let’s see the formula:
Fixed Costs
Break-Even Sales = ——————————————————–
Contribution Margin
We have discussed the contribution margin in the previous section, so you already know what this is. Now let’s explore the formula with an example:
Let’s say your fixed costs are $8000 and your contribution margin is 40%. Now let’s see what the formula tells us:
Break-Even Sales = $8,000 / 0.4 = $20,000
Now you know, you need $20,000 in sales to get to the break-even point and then you will start making a profit.
ROI Isn’t Just for Marketing — Use It Everywhere
Most people consider ROI only in the context of ads and sales. However, truth be told, it actually applies to almost every business decision you make.
Let’s look at a few areas where tracking ROI makes a real difference.
Tracking ROI for Software or Tool Investments
For most businesses, software and tool investments come with the promise of transforming operations. Now the question is, is this investment worth it?
To determine ROI, consider the following formula:
ROI (%) = (Gains from Investment – Cost of Investment) / Cost of Investment × 100
For instance, let’s say you spend $10,000 on a customer relationship management (CRM) tool. At the end of the year, the CRM tool increases sales by $25,000. The calculation would be:
ROI = ($25,000 – $10,000) / $10,000 × 100 = 150%
This indicates that you made 150% of your initial investment back. Think beyond the numbers and consider the savings in time, efficiency, and communication you get from using the tool. Those factors give the tool additional value even though they are harder to measure.
Measuring ROI From Hiring a New Employee
We all hire new employees and our goal is to add value to our business. But how would we know the real impact of the new employee?
Start with this formula:
ROI (%) = (Revenue Generated by Employee – Cost of Employee) / Cost of Employee × 100
Let’s say you now need salespeople, and you expect to pay $60,000 per year (salary, benefits, etc.) for that position. Assuming the new salesperson brings in an additional revenue of $150,000, the ROI return is shown as follows:
ROI = ($150,000 – $60,000) / $60,000 x 100 = 150%
Important NOTE: This value expresses how effectively the employee is contributing to the business. Don’t forget to put a value on employee satisfaction or the hard-to-measure employee morale. While these are intangible, they can become impactful over time. And for some positions measuring ROI won’t be a straightforward formula like this.
ROI for Events, Sponsorships, or Partnerships
Events and sponsorships tend to give these businesses much-needed first exposure. While this exposure might help the brand, its financial returns are not always straightforward.
Further down the line, these brand affiliations could fetch non-monetary benefits for the business. The ROI can be calculated using both monetary and non-monetary benefits.
A business spends $20,000 to sponsor a local event. They earn $15,000 from direct sales. At first glance, it looks like a loss of $5,000.
However, keep in mind the indirect benefits: the exposure, increased website traffic, and new customers that are likely to be acquired from the event.
If those indirect benefits are $10,000 (It’s an assumption), then the ROI calculation becomes positive:
ROI = (15,000 + 10,000 – 20,000) / 20,000 x 100 = 25%
Their return is positive and gives context. It can be used to compare to other marketing channels next time.
Tools and Techniques for Calculating ROI
You don’t need fancy software to figure out your ROI. A few simple tools and the right numbers are enough.
Using Online ROI Calculators
There are tons of ROI calculators online. Just go to Google and type “ROI Calculator” and you will see thousands of pages with a simple calculator that will help you to calculate your exact ROI. We suggest this process because:
- Almost zero setup time is needed, the complex formulas are already set in place.
- Numerous tools are available online for free.
- The chances of making errors are almost zero.
When should you use them?
Online calculators work best in cases where there is a clear single ROI problem, like evaluating one campaign or one investment. But if you want a more custom solution and for a longer period of time then Excel or Google sheet should be your best options.
Excel Formulas for ROI
If you’re tracking things regularly, a spreadsheet is your best friend.
Here’s a simple formula that you can use with Excel or Google sheet:
=(Return – Investment) / Investment * 100
Let’s say cell A1 is your return ($10,000), and A2 is your cost ($4,000). Your formula will be:
=(A1 – A2) / A2 * 100
This formula will work well for campaign tracking, employee performance, or monthly tool reviews.
Real-Life Example: Calculating ROI for a Marketing Campaign
Let’s say you run a Facebook ad campaign and spend $3,000.
It brings in 120 customers. On average, each customer spends $40. That’s $4,800 in total revenue.
Now do the math:
($4,800 – $3,000) ÷ $3,000 × 100 = 60% ROI (Not Really)
Actually that is not ROI. We call it ROAS. Because there are many costs involved in the campaign.
if your team spent 20 hours managing the campaign for $500, your actual profit would decrease.
Now we have the ROI:
($4,800 – $3,500) ÷ $3,500 × 100 = 37.1%
You can see a significant change here, right?
This is why we always suggest tracking all related costs. That includes staff time, software, freelance fees, or anything else tied to the campaign.
Small changes can shift the final result in a big way.
The Common ROI Traps Small Businesses Fall Into
ROI is a simple calculation. But if you use it forgetting the context or forget to use any data the result can be misleading which can impact your business pretty badly.
Forgetting to Include All Costs
It’s pretty common to forget all the costs involved in a particular task. Most businesses only consider the apparent costs that are easy to identify like, materials or advertising budgets. However, small hidden costs can add up fast.
Let’s say you run an ad and it costs 5 grand. It’s tempting to only use that number in the ROI calculation. Don’t forget the 500 bucks in design fees or the time your team spent in planning the campaign. All these elements need to be factored in as costs.
Always try and break down the list of expenses to cover everything and anything. Salary hours, software, and even indirect expenses should all be considered because they matter.
A simple error will change the result and you will ruin money in the long run.
Overestimating Return Too Early
Early on when looking at ROI, it can be quite optimistic, and that paralyzing optimism can be dangerous. It’s tempting to calculate returns as soon as sales come in, but it’s better to wait until all results are clear.
Let’s say you rolled out a new product that sells really well, let’s say 50 grand in the first month. Great! You measure ROI off that. But look at the two months after, demand goes down along with sales.
The numbers were misleading for the first two months until things balanced out.
Wait for everything to settle before tracking results. This ensures a clear view of your profit or loss.
Using ROI in Isolation Without Context
ROI alone doesn’t tell you the complete story. ROI can be misleading due to its simplicity. What is often forgotten are all the other internal factors like customer retention and brand awareness.
A campaign can have a strong ROI but also result in disastrous negative feedback. Or it can help increase sales in the short term without establishing a long-term relationship with clients.
Instead, combine ROI with metrics like customer lifetime value (CLV), conversion rates, or market share
What are the limitations of ROI?
Business is a very complicated project. From the outside it seems like just selling products, counting money, and investing in product manufacturing or whatever service one provides. But from the inside it’s very close to rocket science.
Therefore, though ROI is a very important matric to calculate your Return, if you solely depend on this you are in grave danger. Let’s discuss some limitations of ROI to warn you.
- Does not take customer trust or brand reputation into account.
- Ignores other risks and external variables that may lead to a different outcome.
- If some expenses are omitted, it can be deceptive.
- Leaves out future growth potential and long-term impacts.
- The outcome may differ depending on the application of the formula.
- Focus on pushing short-term objectives at the expense of long-term strategies.
- Doesn’t provide the entire context of a business decision.
- Can’t quantify loyalty, satisfaction, brand awareness, etc.
What are the alternatives to ROI?
ROI can be helpful, but has its limitations. Therefore, businesses often use other metrics that give a clearer understanding of performance, value, or risk. Which alternative metric you choose will depend on what you are trying to measure: long-term customer value, financial health, or the impact of a campaign.
Consider the following options:
- Return on Ad Spend (ROAS) determines revenue generated by advertising.
- Customer Lifetime Value (CLV) determines the overall worth of a customer.
- Net Profit measures total earnings after all of the expenses are accounted for.
- Gross Margin reveals profit expressed as a percentage of revenue.
- Contribution Margin calculates how sales assist in covering fixed costs.
- Cost Per Acquisition (CPA) determines the cost of acquiring a customer.
- Net Promoter Score (NPS) measures customer’s willingness to recommend a service or product, indirectly showing their satisfaction.
- Net Present Value (NPV) determines the current value of future cash flows.
- Payback Period measures the amount of time needed to recoup an investment.
- Internal Rate of Return (IRR) measures the growth of profit over a period of time.
- Profit Margin shows how much profit there is after sales are made.
- Cost-benefit analysis measures total profit against the amount of resources spent.
- Total Economic Impact (TEI) measures monetary and other implications.
- Break-even analysis determines the revenue needed to balance out costs.
- Key performance indices (KPIs) monitor a certain business aim aside from profit, for example, customer satisfaction.
Wrapping Up
So, now we hope you understand how to calculate your ROI. As a business owner, knowing your ROI is not an option; it’s mandatory. But as we discussed in this guide, only ROI won’t give you the entire picture of your business.
There are many other metrics in business that you should look after, and ROI is one of the most important among them.
