So what is a return on investment? The return on investment is a financial performance measure that is used to evaluate the efficiency of an investment.
Return on investment is also referred to as the rate of return or rate of profit.
This key performance question is an indicator that helps to answer how well are we generating sustainable profits.
Why is the return on investment indicator important?
Remember a return on investment (ROI), is a financial performance measure you use to evaluate the efficiency of an investment. It also helps to compare the efficiency of a number of different investments before capital is allocated.
ROI is a calculation of the most tangible financial gains or benefits that can be expected from a project. Versus the costs of implementing the suggested programme or solution. In short, it is the ratio of money gained or lost on the amount of money invested.
Return on investment is a popular metric
ROI is a very popular metric within organisations because its versatility and Simplicity are powerful aids to the decision-making process. By running a return on investment (ROI) projection organisation can determine the likely ROI on investment. Suppose there are other opportunities with a higher ROI. It is possible that the lower ROI-yielding investment will not be started or at least will not be a priority.
Estimating an ROI for a proposed expenditure will help management to make a decision. ROI is divided into two categories, micro and macro.
The Micro return on investment focuses on elements of any company project or programme. Most such initiatives would have a shorter time frame (maybe up to a year). These may include such things as:
- a direct mail programme
- a print advertising programme
- a sales promotion
Micro ROI includes anything a company would expect a positive financial result from in less than a year.
Macro ROI is concerned with the overall performance of major company initiatives.
These may include:
- adding a new assembly line
- creating the company’s own truck delivery system
- building a new production facility
The payout for these types of initiatives is probably more than a year and could extend for several years.
Calculating ROI is more difficult for intangible investments such as knowledge development etc.
The investment community eagerly tracks the return on investment metric which is key for them. They look for businesses that can demonstrate generating positive returns on their investments on an ongoing basis.
Return on investment is calculated in several ways. Thus, for example:
ROI = (Gain from investment – Cost of Investment)/Cost of Investment
In the above formula, ‘ Gains from Investment’ refers to the proceeds obtained from selling the interest investment.
Return on investment can also be calculated as net benefits/net costs or as profit/cost x year days/period.
A return on investment is measured at the end of a programme such as a marketing effort. Here it is straightforward to calculate the ROI based on known and complete costs and benefits.
However, ROI is also measured as a percentage of return over a year most useful for longer-term projects. Thus calculating how long it will take to cover its investment and then make a profit from the investment.
If the rate of return (ROR) is 33.3% in one year. Then it will take three years to recover the complete investment (100%/33.3% = 3).
If ROR is 50%, payback is two years; if 200%, then six months.
Source of the return on investment (ROI) data
This data is extracted from the accounting data.
Cost of collecting the return on investment data
The cost and effort of calculating a return on investment. This all depends on the complexity of calculating the benefits of the investments.
This can be complex if data for the financial benefits are not already available. Or when more complex formulas are being used to convert intangible benefits into financial returns.
However, if simple financial formulas are used, the cost and effort will go down. This type of data should be readily available in the accounting system.
Organisations will set their ROI targets, and where possible will base these on industry benchmarks. Besides, the higher the investment risk, the greater the potential investment return. And the greater the potential investment loss. This understanding will influence the setting of an ROI target.
Example Let’s look at a simple return on investment (ROI) calculation. Take a parcel-mapping project that costs $50,000 to implement, and you demonstrate $25,000 in net benefits, then the calculation would appear as follows.
As a further example, consider this 90-day promotion:
- Period: 90 days
- Sales: $320,000
- Profit: $120,000
- Programme cost: $200,000
- ROI = (Profit/Cost) x (Year days/Period)
- ($120,000/$200,000) x (360/90)
- ROI = 60% × 4 = 240% annual rate of return
In this example, the company recouped its initial investment of $200,000 from its sales of $320,000. Leaving a profit of $120,000.
The company achieved a 60% return on its investment in 90 days since it was promoted over a 90-day period. Annually, the return is four times the 60% or 240% for annualised return on investment (ROI).
Keep in mind that the calculation for return on investment can be modified to suit the situation. Basically, it all depends on what the organisation (or part of it) decides to include as returns and costs.
The definition of the term in the broadest sense just attempts to measure the profitability of an investment. And, as such, there is no one right calculation.
For example, a marketer may compare two different products by dividing the gross profit that each product has generated by its respective marketing expenses.
A financial analyst may compare the same two products using an entirely different ROI calculation. By dividing the net income of an investment by the total value of all resources to make and sell a product.
This flexibility has a downside. The return on investment calculations is easily manipulated to suit the user’s purposes. The result can be expressed in too many ways. An organisation must be clear on what inputs are used.
Take care not to confuse annual and annualised returns.
Annual or an annualised rate
An annual rate of return is a single-period return, while an annualised rate of return is a multi-period, average return.
This means an annual rate of ROI is the return on an investment over a 1 year period, such as 1 January to 31 December.
An annualised rate of return is the return on an investment over a period other than one year. Then multiply or divide to give a comparable one-year return.
Choose an investment you have made or are considering making. Calculate the ROI using the fundamental guidelines mentioned above. Once you have calculated the ROI, compare the efficiency of this investment with other investments you have made or are considering making.
Consider factors such as the length of the investment period, the initial cost of the investment, any ongoing expenses, and the potential return on investment.
Based on this evaluation, decide whether the investment is worth pursuing or if you should allocate your capital to a different investment.
Share your findings and thought process with someone you trust and ask for their input. Reflect on their feedback and use it to refine your investment strategy.
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