For small businesses in all industries, measuring the Return on Investment (ROI) for every major expense should be a mandatory exercise. Unfortunately, calculating this financial metric is often overlooked, so owners and managers miss out on the accompanying benefits.
Going through the process of computing the ROI for a given expenditure will help you answer the fundamental question, “Is this project or investment worth it?”
The simple formula has application to virtually any area where you’re considering allocating funds:
ROI = Return (Net Benefit) / Investment (Total Cost)
For example, let’s say you invested $2,000 in a social media ad campaign, which returned revenue of $7,000. Your gain, or net benefit, would be $5,000. So, your ROI formula would be:
ROI = $5000 / $2000 = 2.5
Since ROI is usually expressed as a percentage, this would be 250%.
Whether you’re contemplating the launch of a new product line, or hiring a new employee, or buying costly equipment, or any other major endeavor, calculating the potential ROI enables you to make data-driven decisions and prioritize projects with the best potential returns. (It’s always potential ROI because you are forecasting here, estimating what a future outcome will be.)
Another advantage of ROI analysis: It’s a risk assessment tool. You may want to set a certain ROI threshold, below which a given project is a non-starter. Additionally, if a project is identified initially as having a low ROI, you can do a what-if analysis of various inputs to see how the ROI changes, and discover how steps to mitigate the riskiness of the project impacts ROI.
The simple ROI metric is useful because it is easy to calculate and implement. However, because ROI doesn’t account for time, it does have limitations. For example, does the ROI of 250% in the example above take 12 months or 18 months to be realized?
Still, using ROI on a routine basis in your small business can be a powerful force towards better financial analysis, and ultimately better financial choices.