Return on Investment, or ROI, is a common business calculation, expressed as a percentage, that measures the profitability of a monetary investment.
ROI is used to help businesses understand how much they’ve spent on an investment compared to what they’ve gained from it. It helps to calculate the efficiency of business investments, to measure performance, and aid in future decision-making by forecasting potential profitability.
What does ROI mean?
ROI is a simple calculation for businesses both small and large. It measures whether expenditure is contributing towards the earnings of a business. ROI is most frequently used in the context of:
- Marketing: Marketing ROI measures the success or failure of campaigns and initiatives by calculating marketing spend against marketing revenue
- Buying new assets: An ROI calculation shows whether investing in a particular asset has helped increase returns for the business or fallen short of expectations
- Research and development: R&D ROI gauges the profit generated from research and development projects over a specific period compared to the development spend
ROI is not without its limitations. It’s sometimes difficult to determine the exact contribution of an investment, as factors outside the investment cost also impact sales and revenue.
ROI also doesn’t account for time, which means that if an investment or expenditure takes longer to pay off and generate revenue, the calculation might misrepresent the actual value of the investment or expenditure. Annualised ROI helps overcome this challenge by looking at the average gains and losses over a year-long period rather than just a point in time.
How to calculate ROI
To calculate ROI, simply divide the amount of profit or loss from an investment or specific project by the original cost.
You first need to know the initial cost of the investment, which is found in the company financials such as cash flow statements, P&L statements, and balance sheets.
The other part of the equation is the current profit or loss of the investment. You determine what amount of revenue is attributable to the investment in question up to the current period, subtract the costs to get the net profit, and use that information to finish the ROI equation. The higher the ROI, the more efficient your investment is at generating revenue.
A small kombucha company is trying to determine the ROI of a recent marketing strategy. They invested in a paid advertising campaign, hoping it would boost their visibility and sales. To calculate ROI, the company would need to determine the value of kombucha sales generated from the campaign, subtract the costs to get the net profit, and divide it by the campaign’s overall spend.
Let’s say the company spent €4000 in one month on paid advertisements. In the same month, they attributed €6500 more in sales than previous months to new customers who clicked on ads. With a net profit of €2500, that gives the company a positive ROI of 62.5% and shows the campaign was effective at boosting their sales.
What is a good ROI?
ROI can either be positive or negative, and there is no one standard for what a good ROI percentage is. Different industries and investments will have varying benchmarks for ROI, but the goal should be to net a positive and earn more than the investment is costing you.
However, sometimes the ROI doesn’t turn out positive for the business. Let’s use the same example, but say the kombucha company only made €3000 in new business sales compared to previous months. With a €1000 loss, that leaves them with a negative ROI of -25%. They may want to consider a different strategy.
See related terms
This glossary is for small business owners. The definitions are written with their requirements in mind. More detailed definitions can be found in accounting textbooks or from an accounting professional. Xero does not provide accounting, tax, business or legal advice.