Most businesses have a business plan in place, whether it is a start-up or an annual or long-term planning document. These plans usually include sales revenue, expenses, gross and net profits, and other financial measurement tools. Often, however, business managers fail to calculate their business’s Return on Investment (ROI). In failing to forecast and measure a business’s ROI, managers are unsure whether they, their employees or their shareholders, are earning a reasonable return on the capital that they invested in the business. They lack the data to quantify whether they are above or below industry standards for ROI, or even if their capital would be more wisely invested if it were stuffed under their mattress.
What is ROI?
Return on investment is the incremental gain from an action divided by the cost of that action. For example, the ROI for a new marketing program that is expected to cost $250,000 over the next five years and deliver an additional $300,000 in increased profits during the same time is as follows:
ROI = (Gains – Investment Costs) / Investment Costs
= ($300,000 – 250,000) / $250,000
ROI is a measure of management’s efficiency in using available resources. Capital is a scarce resource in any business, and must be utilized efficiently. Thoughtful executives ask themselves the following question: “What rate of return have I earned on the resources under my control?” ROI may be applied to an entire organization, one product line, one unit or a chain of restaurants, or a particular investment.
Are There Other ROI Metrics?
Other financial measures are treated as ROI, such as Return on Invested Capital, Return on Capital Employed, and Return on Equity. Another ratio that has been applied to ROI and is simple to calculate is return on assets (ROA). To calculate ROA, divide operating income (income net of interest, taxes, depreciation and amortization, sometimes called EBITDA) by assets. Since assets and the entire balance sheet is merely a snapshot of a business at a particular point in time, an average of beginning assets and ending assets is usually employed.
For example, if a business had operating income of $2 million, and average assets of $16 million, ROA would be 12.5%. Likewise, ROI can be calculated by using operating income divided by the total investment.
ROI can also be calculated for employee training and development programs. First, identify the total financial benefit your organization draws from a learning program. Total benefits include money saved by the organization, money made, and anything that adds directly or indirectly to the bottom line. Next, subtract from that the total investment made to develop, produce, and deliver that program. Total costs include development costs, learner’s time away from doing something else, overhead of education department, and physical materials.
No matter how you calculate ROI, it is critical to that everyone involved defines ROI consistently and understands its limits when used to support business decisions.
Why is ROI important?
Calculating ROI is important for any business to measure its performance. If your business’s ROI is above industry standards, then you may be able to attract additional investment or receive loans at a lower interest rate. If your ROI is below industry standards, then it is critical to implement the steps necessary to increase returns.
ROI works well in situations where both the gains and the costs of an investment are easily known and where they clearly result from the action. Other things being equal, the investment with the higher ROI is the better investment. It is important to note that the return on investment measure itself, however, says nothing about the magnitude of returns or risks inherent in the investment.
In complex business settings, however, it is not always easy to match specific returns (such as increased profits) with the specific costs associated with them. This, of course, makes ROI less trustworthy as a guide for decision support. ROI also becomes less trustworthy when cost figures include allocated or indirect costs, which are not a specific result of the action or the investment.
How to Increase ROI
Financial ratios such as those listed above can be employed, expenses reduced, and other measures implemented to boost profits. Regular ROI review sessions can be conducted to ensure the capital is being spent well and plans are on track.
Whether you are managing a small, start-up business or a large, on-going concern, measuring and improving ROI is time well spent. Ignoring ROI and other key financial ratios is like driving a car without a dashboard.
–Peter M. Guyer
Peter M. Guyer is the Founder and President of ATHENA MARKETING INTERNATIONAL (athenaintl.com), an international marketing, consulting and business development firm serving food and beverage manufacturers. Tel. (206) 749-9255.