To succeed in any business arena, you need to know the strategic value of each action you plan to take in a period of time. Whether that’s launching a new product, starting a new marketing campaign, or pursuing a new target audience. To understand the strategic value, and your profit or loss, you must first understand what return on investment, or ROI, means.
Let’s break down what return on investment is, what it means, and how to calculate ROI so you can make the wisest decisions for your small business.
That’s why we made a small business finance glossary to help you learn all the terms, or just for a simple refresh on some of them.
A quick guide to ROI
ROI, or return on investment, is the projected or calculated value earned after spending money or time to create and market a product. For example, the money you make by selling a product you created is your return on your investment or investment gains. The investment is the initial cost or materials you expended to create or provide something to customers, or the money you spent marketing the product. The return on your investment is the money you make from those customers.
ROI can also be calculated for marketing purposes. For instance, if you want to know whether a marketing campaign is worthwhile, you might try to calculate the ROI based on projected earnings or revenue after the marketing campaign completes.
How to calculate ROI
There are multiple ways to calculate return on investment depending on your industry or focus. But in general, you can use this basic ROI formula to figure out your investment gains:
- ROI = (Revenue – Investment) / Investment
Let’s look at a basic example.
Say that you want to run a marketing campaign that will cost $1000. After you run the marketing campaign, you earn $4000 in profits that you can directly trace to your advertisements. Plug those numbers into the formula, and you get:
- ($4000 – $1000) / $1000 = 3.
You can write this answer as 3:1 or multiply your answer by 100 to get your ROI expressed as a percentage. In this case, you would have an ROI of 300%
In the above example, you receive three times the value of your initial investment; in other words, you made good returns, and the marketing campaign was a success!
Here’s another example. The average cost of a new car is $34,000; if you sell it for $30,000, your ROI is:
- ($30,000 – $34,000) / $34,000 x 100 = -11.7%
In this example, your ROI is negative, which means you suffered a loss.
Generally, the higher your ROI is over 100%, the better. If you have an ROI of just 100%, you essentially made your initial money back when accounting for costs.
What does ROI mean in marketing?
ROI means the expected value or profit you can earn after making an initial investment. Depending on the formula and ROI calculator you use, your ROI projections may take into account the cost of labor, materials, shipping, and other factors. These will be taken into account to create a very accurate number and help you make smart business decisions for your enterprise. All of this will obviously also depend on what you sell and can vary between business owners. If you primarily sell online goods, like courses or coaching, you would account for your time and any marketing efforts.
In marketing specifically, ROI tells you whether a particular marketing effort or strategy will likely pay off or be worth the effort. For instance, if you have a potential marketing strategy for your online course business ready to go, but the expected ROI is just 100%, you might be better off following a different strategy. You’d ideally want one with a higher projected ROI to get more bang for your buck.
For instance, a potential marketing campaign with a projected ROI of 500% is a much better choice. Spending the same amount of money (or even a larger amount) on the campaign with an ROI of 500% will result in greater profits than spending money on the first hypothetical marketing campaign.
ROI is a valuable metric that indicates whether a certain action or plan is wise, especially when it concerns money. Higher ROIs are better, while negative ROIs are undesirable. Business owners can use it to determine whether they should sell a specific product, pursue certain customers, or launch certain marketing strategies. You can put ROI on business documents, like marketing presentations, and business reports, if you need to explain a decision to another executive.
Limitations of ROI
Despite its value, it’s also important to remember that ROI does have some limitations. The most important of these is the focus on short-term value rather than long-term potential value.
For example, if you calculate the ROI for a brand awareness campaign, you’ll probably come up with a very low percentage. If you just look at this number, you might conclude that the brand awareness marketing campaign wasn’t worth your time.
That’s not necessarily true, though. Building brand awareness is similar to building your credit score. You won’t see immediate results after getting a credit card, as it usually takes a minimum of six months to generate your first credit score. Similarly, brand awareness campaigns don’t always result in immediate profits or significant earnings. But they do increase your company’s value over time if carried out correctly.
A good brand awareness campaign can lead to organic search traffic to your company website, more sales in the long term, and a better overall corporate reputation. All of those benefits are invaluable, even if you can’t assign a specific dollar value to them.
Because of this, you can’t just use return on investment as your only metric when determining whether one action or another is worth taking. Instead, you should use ROI as a strategic tool in conjunction with other KPIs and performance metrics.
How to increase ROI
There are lots of ways in which you can increase the return on investment for products, marketing campaigns, and other efforts.
For starters, you should try different marketing channels. Particularly when selling a product or service to a new target audience. Don’t just advertise using pay-per-click ads, for instance. Instead, you should use social media ads, video marketing, content marketing, and mobile marketing strategies to broaden your campaign’s potential reach.
Alternatively, you may be able to increase your annual ROI through strategies like A/B testing. A/B testing involves offering two similar versions of a webpage, email, or advertisement to a similar group of consumers or website visitors. You measure which of the two pages or advertisement versions performs better. Once you know this information, you swap out all your remaining pages or advertisements with the higher-performing version for more efficiency and better results.
Of course, because ROI is intrinsically tied to how much you initially invest in a project, you can increase ROI by reducing how much you spend. This isn’t always feasible. But if you can cut manufacturing costs for your brand’s staple or flagship product, you’ll make more money in raw profits each time you make a sale since each product will cost less to create in the first place.
Ultimately, return on investment is just one metric you can use when determining whether one business decision or another is best for your goals. Measuring ROI accurately is key to grasping the value of a product launch or marketing campaign; use it regularly to save on costs where possible and spend money where it adds the most value.
What is ROI in simple terms?
Put simply, ROI is how much money or value you can expect in exchange for doing something. For instance, if you can expect $10,000 in profits after spending $5,000 on making products, your return on your investment is roughly double the initial costs of investing.
You should also note that looking at the return over time can change the ROI. You might see more of a return as more and more time passes. SO it’s a good metric to measure on a regular basis instead of measuring it once and being done with it.
What is a good ROI percentage?
A good ROI percentage depends on your industry. Your good or product, the time invested, and whether a product becomes less expensive the longer it exists can all impact what a “good” ROI is. For instance, a good marketing ROI is a ratio of roughly 5:1 – in other words, you should get five times the value of your initial investment in terms of conversions, leads, purchases, etc. But that might not be the case for other types of businesses or products.