Return on investment (ROI)
For a working spreadsheet example of return on investment calculations, download the free financial metrics tool (click here).
"Return on Investment" is a commonly used term that may or may not have a well defined meaning--depending on who uses the term and the context. The term implies that a single "ROI" metric will be the outcome of analysis; ROI analyses tend therefore to be narrower in scope and results than a "Cost/Benefit" analysis. Return on investment (ROI) is commonly used in different ways.
- In financial circles, the meaning of Return on Investment (ROI) is sometimes taken as "Return on Invested Capital, a measure of company performance: The company’s total capital is divided into the company’s pre-tax income (before interest, taxes, or dividends are subtracted).
- Alternatively, ROI is sometimes equated with Return on Assets: a company's income for a period divided by the value of assets used to produce that income.
- Most business people, however, use "ROI" simply to mean the "Return" (incremental gain) from an action, divided by the cost of that action. In this sense, an investment that costs $100 and pays back $150 after a short period of time has a 50% ROI. When "ROI" is requested, it is prudent ask specifically how that is to be calculated. Understand clearly, that is, how both the "return" and the "investment" are derived and what time period is covered.
- Three ways to maximize ROI are suggested by the figure shown with the business case entry above: Minimize costs, maximize returns, and accelerate the returns. A relatively small improvement in all three may have a major impact on overall ROI.
- ROI is an appealing concept because its meaning seems self-evident and easily understood. Many factors can complicate its calculation or interpretation, however, and for that reason many business cases do not attempt to present "ROI" as a quantitative result, but focus instead on financial metrics such as Net cash flow, DCF, IRR, and payback period. Problems with ROI include the difficulty of finding a truly appropriate investment cost figure (this may call for arbitrary cost allocation judgments or the addition of "opportunity costs," for instance). Other problems with ROI come from the passage of time. Investment costs typically come early, while returns may come years later. Thus, the time value of money (discounting) may need to enter the ROI equation; and, it may be especially difficult to match specific returns with specific costs. In brief, the simple ROI concept is probably appropriate only when both "Investment cost" and "Return" come over a short time period, are clearly tied to each other, and can be derived simply and unambiguously.
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