What is Return on Investment (ROI)? Formulas, Types & Applications

Every business decision, from launching a new product line to hiring a new employee, ultimately boils down to one question: Is this worth the money?

The universal metric used to answer this question is return on investment (ROI). ROI measures efficiency, showing exactly how much profit is generated relative to the cost of an investment. You might have used it to think about decisions in your personal life or finances. In business, though, it’s even more important. ROI guides smart resource allocation by helping you identify the most profitable ways to spend your time and money.

Here, we delve into ROI, provide formulas for calculation, and explain how to interpret the results to support your business insights.

Defining Return on Investment (ROI)

ROI is a financial performance measure used to evaluate the efficiency or profitability of an investment. Basically, it’s a way to determine the benefit an investor receives in relation to their investment cost. You can use ROI in virtually any scenario, whether you’re a small business owner trying to decide the efficiency of launching a new marketing campaign, or you’re just trying to figure out if it’s more worth it to go to the bar with your friends or stay home and eat pizza while watching Love is Blind.

ROI can be a qualitative measure, but it’s most effective as a quantitative one, expressed as a percentage or ratio. ROI relies on two core figures: the gain or return (the monetary benefit received) and the cost of investment (the total resources spent to acquire and maintain the investment). It’s an important metric for business owners for several reasons:

• Decision-making: ROI helps businesses allocate resources more effectively. If you have two project options, the one with the higher projected ROI is usually the better choice.
• Performance evaluation: ROI provides a standardized, objective metric for comparing the success of different projects, departments, or marketing campaigns.
• Justification: Positive ROI is the clearest way to justify past expenditures and plan future ones.

In business, every decision has a cost. Understanding ROI will help you determine which costs are the most worth spending.

How to Calculate ROI

Calculating ROI is straightforward once you know your numbers. Here are two simple ways to calculate ROI.

Basic ROI Formula

The most common way to calculate ROI uses net profit divided by cost of investment:

Formula: ROI = (Net Profit / Cost of Investment) x 100

Net profit is the total revenue generated by the investment minus all associated operating and production costs. Note that this number doesn’t include the cost of investment. An investment’s cost is a separate capital expenditure.

For instance, if you make soft drinks and release a new flavor, your net profit would be the gross revenue generated by sales of the new drink minus the labor, manufacturing, and operational costs to create the drink. The cost of investment would take those numbers, plus all of the research and development, market research, and marketing costs required to support the investment.

Alternative (Gain) Formula

This formula is often used for specific, one-off projects where the gain and cost are easier to isolate. Mathematically, it’s interchangeable with the net profit version.

Formula: ROI = ((Gain from Investment – Cost of Investment) / Cost of Investment) x 100

For example, imagine you spend $5,000 to launch a new digital marketing campaign. The campaign generates $7,000 in new revenue.

$7,000 (Gain)−$5,000 (Cost)=$2,000 (Net Profit)

ROI = ($2,000 / $5,000) x 100% = 40%

In this example, the Return on Investment is 40%. For every dollar invested, the company earned an additional 40 cents in profit.

How to Interpret ROI

ROI is pretty simple to interpret. There are three potential outcomes of these calculations:

• Positive ROI (>0%): The investment generated a profit.
• Negative ROI (<0%): The investment resulted in a loss.
• 0% ROI: The investment broke even.

While a positive ROI is always the goal, determining whether the ROI is “high” or “low” depends on the industry, the current economic climate, and the risk level involved. And, really, your own expectations. You might hope high-risk investments yield a higher ROI, and low-risk investments typically yield lower ROI, but the success of the investment depends on many factors.

Limitations of Basic ROI

The basic ROI calculation is simple and powerful, but it does have limitations, including:

• Time value of money: The formula doesn’t account for the duration of the investment. A 50% ROI over one year is better than a 50% ROI over five years, but the basic formula doesn’t show this. Other metrics, like Net Present Value (NPV), can be used to factor in time.
• Risk factor: It ignores the risk associated with different investments. A 20% return on a volatile stock is inherently different from a 20% return on a low-risk government bond.
• Cash flow: It doesn’t reflect liquidity or the timing of cash flows, which are vital for a company’s day-to-day operations.

Calculating ROI can get complex, which is why it’s important to work with financial experts whenever you’re planning a major investment for your company.

Types and Applications of ROI

ROI is used throughout just about every business sector, especially when looking into the success of various efforts. Here a few examples to get an idea:

• Financial ROI: Used for stock portfolios, real estate, and capital expenditure (CapEx) decisions.
• Marketing ROI (MROI): Measures the profitability of advertising campaigns or content creation.
• Social ROI (SROI): A metric used by non-profits to measure the broader value created for the community relative to the funds invested.