The Return on Investment (ROI) is a way to measure how much money you make from an investment.
It helps assess different investment choices by comparing them to their starting expenses. It’s handy for both businesses, to check past and future investments, and for individuals, to weigh personal investment options, like stocks or stakes in small companies, against each other.
Learning how to figure it out can help you in different ways, like proving why a project is worth doing, understanding how well your team is doing, and deciding which projects to approve.
ROI Benefits
ROI ratios offer several advantages:
- They’re easy to calculate, requiring only a few numbers found in financial statements.
- They enable comparisons between organizations because they’re widely used and simple to compute.
- They measure the profitability of investments in a particular business unit, offering a clearer picture of profitability by company or team.
Limitations of ROI
ROI is a common way to measure how good an investment is for making money. But it has some issues:
- It doesn’t consider how long it takes to make money. A higher ROI might seem better, but if it takes a long time to get that money, it might not be as good as a lower ROI that comes faster.
- Different businesses might calculate it differently, so comparing investments between businesses can be tricky.
- Managers might only pick investments with the highest ROIs, but some investments with lower ROIs could still make the business better. Choosing only based on it might mean resources aren’t used well.
- ROI doesn’t include non-money benefits. For example, getting new computers might make workers happier, but it’s hard to put a dollar value on that. Businesses can try to calculate these benefits, called soft ROIs, but it’s not as straightforward as the hard ROIs, which use dollar amounts.
Expected ROI versus Actual Performance
There are two main types of ROI: Expected ROI and Actual Performance.
Anticipated or Expected ROI, is calculated before a project starts. It helps decide if a project is worth doing by estimating the costs, revenues, and expected profit.
Different scenarios are often considered to see possible outcomes and understand risks. These estimates help decide if the project should go ahead.
Actual Performance or Actual ROI is the real return on investment after a project is finished. It compares the actual profit with the estimated profit to see how successful the project was.
What is a Positive versus Negative ROI?
ROI helps assess various metrics to understand a business’s profitability. To accurately calculate ROI, you need to measure total returns and total costs.
When ROI is positive, it indicates profitability for the business or the metric being evaluated. Conversely, a negative ROI suggests that the business or the metric is losing more money than it’s earning. In simple terms, a positive ROI means returns surpass costs, while a negative ROI means the investment is causing a loss.
Formula to Compute Your ROI
Usually, we find the return on investment by subtracting the total costs from the income earned or expected from a project. Then, we divide that number by the costs.
The formula for ROI looks like this:
ROI = (NET PROFIT / COST OF INVESTMENT) X 100
In project management, the formula follows a similar structure but uses slightly different terms.
ROI = [(FINANCIAL VALUE – PROJECT COST) / PROJECT COST] X 100
Example of Calculating a Project’s ROI
In this scenario, you have the chance to buy 1,000 muffins at $2 each and then sell them to a bakeshop for $3 each. Apart from the cost of purchasing the muffins, you also have to cover $100 for transportation. To determine if this venture would be profitable, you must calculate your total expenses and expected revenues.
EXPECTED REVENUES = 1,000 X $3 = $3,000
TOTAL EXPENSES = (1,000 X $2) + $100 = $2,100
You should deduct your expenses from the anticipated revenue to calculate the net profit.
NET PROFIT = $3,000 – $2,100 = $900
To determine the anticipated return on investment, divide the net profit by the investment cost, then multiply the result by 100.
RETURN OF INVESTMENT = ($900 / $2,100) X 100 = 42.9%
Running this calculation shows the project will give you a nearly 43% positive return on investment, as long as things go as expected. So, it’s a smart money move. If it turned out to have a negative ROI or one that didn’t make all the effort worthwhile, you’d know to steer clear.
Just a heads-up, this example figures out what your project’s ROI might look like. If expenses or revenues change while you’re working on it, your actual ROI could be different.
For instance, let’s say you’ve bought muffins at $2 each and paid $100 for shipping. If the store only pays you $2.25 per bar, your actual revenues shrink a lot from what you expected. That leads to less profit and a lower actual ROI.
ACTUAL REVENUES = 1,000 X $2.25 = $2,250
TOTAL EXPENSES = (1,000 X $2) + $100 = $2,100
NET PROFIT = $2,250 – $2,100 = $150
RETURN OF INVESTMENT = ($150 / $2,100) X 100 = 7.1%
Things are hardly ever as simple as this example. You’ve got other expenses like overhead and taxes to think about. Plus, you never know, sometimes you might not hit the ROI you were expecting because of unexpected stuff, but the basic idea stays the same.
Final Thoughts
When you figure out how to calculate ROI for projects you want to go for, you get to check them out yourself before looping in other decision-makers at your company. It helps you make the most of the resources you have. Plus, once the project is done, knowing how to calculate ROI lets you talk about how you and your team contributed to the company’s goals.
