ROI Calculation Methods
When running a business, key investment decisions are best made by forecasting future return on investment, or ROI. Calculating ROI is an important step when starting a new business, investing in new technologies, starting an employee training program, initiating a marketing plan or implementing improved business processes. Generally, ROI calculations focus on investment return, or the impact on earnings. However, an ROI summary can also consider non-financial benefits to an investment plan.
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Calculating the Investment
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The key first step in forecasting ROI is calculating the amount of investment. As with any accounting function, it is important to include all relevant costs, or future calculations will be incorrect. The nature of the calculation will be different for a new business than for component parts of an existing business. For a new business, investment may constitute the seed capital, with gross earnings representing the return. With an existing business investing in a new capability --- for example, a technology investment --- the accounting process must consider the allocation of ongoing operational expenses related to the investment to accurately calculate return. Small business owners should also include their own time investment.
Calculating Return
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It is important to understand that return represents earnings after operational costs have been deducted. For example, we can imagine a hypothetical scenario in which a business invests $10,000 in a marketing campaign. During the next year the business sees a $50,000 increase in sales directly due to the marketing campaign. However, to earn the revenue, the business needed to spend $30,000 in operational costs. Therefore, the business received a return of $10,000 for that year as a direct result of the investment.
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Computing ROI
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The most basic way to calculate ROI is (earnings from investment/cost of investment). In the case above, earnings from the investment were $10,000 for the first year. Perhaps the marketing campaign gained a number of new customers, some of whom increased their orders during the second year, leading to earnings of $30,000 directly related to the marketing campaign, with another $30,000 during the third year. Therefore, in this hypothetical case the company increased earnings by $70,000 in three years. Given the initial $10,000 investment, the company saw a three-year ROI of 700 percent.
Other Considerations
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While an ROI calculation should be a central part of any investment decision, a full cost-to-benefit analysis will take into account a wider variety of factors. For example, a simple ROI calculation does not account for risk, or the likelihood that expected returns will not materialize. ROI also does not account for non-financial benefits from an investment. For example, significant non-financial benefits might result from investment in a training program or in a better health care policy for employees.
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References
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