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Calculating Return on Investment (ROI)

When is an expenditure an expense and when is it an investment?  By one way of thinking, an expense is an expenditure that you are required to make in order to maintain the status quo.  An investment, on the other hand, is one that will enhance your business and bring a future economic benefit.  But how do you determine which of those things a given expenditure is?  If you know it’s an investment, how do you decide if it’s worth making or not?

One way to determine if an expenditure is a good investment is to determine its return on investment, or ROI.  Return on investment is the return from an investment stated as a percentage of the cost of the project.

ROI = Additional profit/Investment

For instance, if you buy a new machine that costs $100,000 and realize $12,000 in ADDITIONAL profit from that machine, your ROI is 12% ($12,000/$100,000).

Making Decisions with ROI

You can use this number to help in decision-making in a couple of different ways, depending on your circumstances and preferences:

1. If it’s a positive return, make the investment.
2. Choose between multiple options by adopting the one with the higher ROI.
3. If you have to borrow the money, or otherwise have a minimum cost of capital you’d like to exceed, only choose those investments whose ROI is higher than your minimum rate.

Limitations of the ROI

1. Like any projection, the result is only as good as your inputs.  Projects can cost more than we initially think or the expected revenue increases can fall short of expectation.
2. ROI doesn’t account for the time-value of money.  One dollar five years from now isn’t the same thing as one dollar today.  If you are trying to project over longer time periods, or want to account for inflation, you may want to use some sort of discounting method, like the NPV or IRR.
3. All ROI’s are not created equally.  The ROI doesn’t consider the riskiness of an investment.  Normally, higher returns are required for more risky projects.  Consider your ROI in the context of the risk involved. Would you risk losing all of your investment for the chance of making a 2% return?

Inputs to the ROI

1. Cost of the investment
2. Additional revenue from the investment
3. Additional ongoing expenses related to the new investment
4. Net cost or revenue from disposing of any existing equipment
5. Impact of any expenses avoided by making the new investment and/or getting rid of old equipment

Things to Consider

Sounds easy, right?  But there are a couple of things at play here. For one, how did we determine for our example that the new machine will increase profit by $12,000?   Well, unfortunately, there’s no magic formula for that.  You will have to make that projection yourself using your knowledge of the business, including market demand and your own capacity to support the initiative.  Forecasting that number is beyond the scope of this post. But stay tuned for it to be discussed at a later date.

The other half of the equation is the cost of the machine.  To compute the ROI, you need to consider not only the purchase price of the machine, but also the related costs of installation, setup, and any training requirements.  In addition, you should also take into consideration any changes in required working capital, such as inventory and supplies.  These are outflows directly related to using the new machine.  Finally, to calculate your initial costs, subtract any cash inflows from disposing of any existing equipment.  You may be able to sell this equipment to offset the money spent on the new equipment.

Once you know how much the machine will cost, including ongoing expenses, and you can project the increased revenue, then you can calculate your ROI.  If your ROI is positive, all other things being equal, then you should make the investment.  If it’s negative, you may want to reject the project.  However, there may be good reasons to accept a project that has a negative ROI, such as regulatory requirements or competitive reasons.

The way we calculate and use ROI in this post, it’s useful as what’s called a holding period return or an annual return.  A holding period return is the return over the life of the investment.  Whichever way you use it, just make sure your costs and other inputs match the period of time over which you are evaluating.