Return on investment (ROI)
Return on Investment (ROI) analysis is one of several approaches to evaluating and comparing investments. With ROI, decision makers evaluate investments by comparing the magnitude and timing of expected gains to the magnitude and timing of investment costs. A good ROI means that investment returns compare favorably to investment costs.
ROI compares returns and costs by constructing a ratio, or percentage. In most ROI methods, an ROI ratio greater than 0.00 (or an ROI percentage greater than 0%) means the investment returns more than its cost. Other things being equal, the investment—or action, or business case scenario—with the higher ROI is considered the better choice, or the better business decision.
One serious problem with using ROI as the sole basis for decision making, is that ROI by itself says nothing about the likelihood that expected returns and costs will appear as predicted. ROI by itself, that is, says nothing about the risk of an investment. ROI simply shows how returns compare to costs if the action or investment brings the results hoped for. (The same is also true of other financial metrics, such as Net Present Value, or Internal Rate of Return). For that reason, a good business case or a good investment analysis will also measure the probabilities of different ROI outcomes, and wise decision makers will consider both the ROI magnitude and the risks that go with it.
Decision makers will also expect practical suggestions from the ROI analyst, on ways to improve ROI by reducing costs, increasing gains, or accelerating gains (see the figure above).
In the last few decades, this approach has been applied to asset purchase decisions (computer systems or a fleet of vehicles, for example), "go/no-go" decisions for projects and programs of all kinds (including marketing programs, recruiting programs, and training programs), and to more traditional investment decisions (such as the management of stock portfolios or the use of venture capital).
Simple ROI for Cash Flow Analysis
Return on investment is frequently derived as the “return” (incremental gain) from an action divided by the cost of that action. That is “simple ROI,” as used in business case analysis and other forms of cash flow analysis. For example, what is the ROI for a new marketing program that is expected to cost $500,000 over the next five years and deliver an additional $700,000 in increased profits during the same time?
For more illustrations of ROI calculations and other business case financial criteria, download the Free Spreadsheet Tool, Financial Metrics Lite. For a more complete covereage of financial metrics such as ROI, including strengths, weaknesses, and working templates, see Financial Metrics Pro.
Simple ROI works well in situations where both the gains and the costs of an investment are easily known and where they clearly result from the action. In complex business settings, however, it is not always easy to match specific returns (such as increased profits) with the specific costs that bring them (such as the costs of a marketing program), and this makes ROI less trustworthy as a guide for decision support. Simple ROI also becomes less trustworthy as a useful metric when the cost figures include allocated or indirect costs, which are probably not caused directly by the action or the investment.
Business investments typically involve financial consequences extending several years or more. In such cases, the metric has meaning only when the time period is clearly stated. Shorter or longer time periods may produce quite different ROI figures for the same investment. When financial impacts extend across several years, moreover, the analyst must decide whether to use discounted (net present value) figures or non discounted values (for more on the consequences of calculating ROI with discounted cash flow figures,
Other ROI Metrics
Other financial metrics are also treated as ROI figures at times.
In financial statement analysis—where analysts assess the financial health and business performance of companies—“Return on Invested Capital,” “Return on Capital Employed,” “Return on Total Assets,” “Return on Equity,” and “Return on Net Worth,” are sometimes called “return on investment.”
In still other cases, where the focus is cash flow analysis, the term ROI has been used to refer simply to the cumulative cash flow results of an investment over time, such as shown in the figure above. Some people also refer to other financial metrics as "ROI," such as "Average Rate of Return" or even Internal Rate of Return (IRR).
In brief, several different return on investment metrics are in common use and the term itself does not have a single, universally understood definition. Therefore, when reviewing ROI figures, or when asked to produce one, it is a good idea to be sure that everyone involved:
- Defines return on investment the same way
- Understands the limits of the concept when used to support business decisions
For more practical guidance on building a business case and other financial metrics, see Business Case Essentials or the Business Case Guide, or the spreadsheet-based teaching tool, FInancial Metrics Pro
Getting Your Budget Approved Learn how to calculate the ROI of so-called "soft" benefits and find out how to cut your Business Case preparation time in half!
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