ROI: Understand it. Calculate it. Perfect it.
Understand it.Perhaps the simplest way ROI can be explained is with a lottery ticket. Say you buy a $2 ticket and you win nothing. That ‘investment,’ (the furthest thing from an actual investment but stick with me here), was a loss. If you win $1 it was a partial loss. You might win your money back and break even. Anything you win over $2 is considered a positive ROI – a fruitful return on your investment. Now imagine a friend of yours invites you to go golfing next Saturday. That same day you have an opportunity to pick up some overtime on your day off at work. Now you have a choice to have a fun day at the course or make some extra money. Both scenarios offer a positive ROI – one is recreational, and one is financial. Determining which has a higher ROI becomes personal. It’s the same in business. How you choose you to spend your time has a direct effect on your financial success. Now here’s a secret: The key to a successful business is creating the highest ROI. Possibly the most important decision involving ROI is how to spend your loan(s). Make sure whatever you spend loaned money on will make more than you borrowed. Maybe you’re replacing or updating equipment. Maybe you’re adding staff. Maybe you’re advertising. These and numerous other things are all critical needs of an expanding business. The trick is determining which will produce the highest ROI. It’s really very simple. Businesses exist to make money. Therefore, spend money and time on things that make the most money. There is no blueprint for ROI. What type of business, where the business stands, what the market looks like, and the strength of you and your team are among many factors that should help you determine how to allocate your funds. Wikipedia defines ROI as “a ratio between net profit (over a period) and cost of investment (resulting from an investment of some resources at a point in time).” In layman’s terms, ROI is how much you get back for what you put in. Now, this is all fine and dandy, but how about actually calculating return on investment? Good news: millions of informed tips exist, plus there is an actual mathematical formula to determine ROI. Bad news: you can only use the formula after the loss and/or pay-off, and risk is inevitable.
Calculate it.Thanks to InvestingAnswers, a personal finance reference site, we have a formula for calculating return on investment. ROI = (Net Profit ÷ Cost of Investment) X 100. Here are a few examples to show how different investment types create different returns:
Example 1You decide to purchase $2,500 worth of advertising for your business, half on print and half online. After one month, your total bottom line profit increases by $1,000. This would mean the ROI for the first month of advertising is (1,000 ÷ 2,500) X 100, which equals 40%. [Note: For strictly one month, the ROI was negative, but as profit continues to increase due to the ads, it can/will become positive.]
Example 2You hire a new operations manager. You determine it will cost you $40,000 for the first year, including salary, benefits, training, equipment, etc. That manager’s initiatives bring in a total of $75,000 profit. The ROI for the new manager is (75,000 ÷ 40,000) X 100, which equals 187.50%. [Note: This is an excellent ROI. Just hope your manager maintains that savvy! A lack of profit the following year could lower this percentage.]
Example 3You are in the business of pharmaceuticals and need to replace a high-end tablet press. It’s going to cost you $4,680. The press makes 900 tablets per minute, each of which net you a total profit of 1/50 of a cent. The press runs for 16 hours a day, five days a week, creating $3,456 in profit every month. For the first month after replacement, the ROI turns out to be (3,456 ÷ 4,680) X 100, which is about 73.85%. [Note: Provided you spend zero on repair for the press, month two will bring an ROI of nearly 148% but if you have to replace it again or have it repaired, that month-two percentage will plummet.]
The calculation of ROIis not an exact science. It’s more of a concept. Hopefully, in this following section, we provide enough of a foundation for you to start to maximize your ROI. Several other methods exist on how to calculate it mathematically other than the one provided above. Using profit divided by investment cost and multiplying by a hundred is merely the most prevalently used method.
Perfect it.Getting back more than you invested is a good ROI, regardless of how much. Obviously, the ROI gets better as net profit increases, but remember this: The main idea in improving ROI is to increase revenue without increasing spending. Above are three examples, but there’s an endless number of situations in which a decision affecting ROI must be made. Remember too that ROI is not just about money. It’s about the time and effort of you and your staff. Ideally, your investments will yield enough money to make it worth the time and effort. Unless you are one of the extremely rare businesses that explode immediately, a positive ROI worth the time of you and your staff could take a long time to create. Determination and efficiency become very important factors here, among myriad others. According to Entrepreneur Magazine, “For an average business, this process takes about two to three years.” How to perfect the maximization of ROI is individual to each and every business. The tricky part is that short of providing a few tips (which follow) and an equation (see above), the rest is entirely up to you. There is no user manual to maximizing your investment returns.
Tips on Maximizing ROI:
- Increases in profit come in many ways other than sales. Gaining additional customers, employee retention, and lowering production costs are three of countless ways you can maximize your return.
- Compare all areas of your business and determine which are least profitable. Start investment in those areas before working your way up to investing in the more profitable areas.
- Cut costs. Sometimes an investment involves spending less money overall in order to increase the bottom line. Even something as innocuous as the cost of plastic cutlery can be lowered with some vendor research.
- Always put the customer first. That’s where the money comes from after all. If you’re ever stuck between a handful of investments, go with the one that will make your clientele most happy.
Chris Fuller went to the University of South Florida and has worked in the financial sector for over 20 years. He has extensive experience in all aspects of personal and small business lending, from personal loans, equipment finance to cash flow based solutions for small mom and pop businesses, and large corporations.