Making Better Business Decisions Using the Return on Investment Calculation
One of the great challenges we face as entrepreneurs is how to deal with all of the choices we face. How should we spend our money, our time, and use available resources to serve our customers best and achieve success? Fortunately, there’s an app for that… well, not an app, but a tool that anyone can use to guide decision-making to improve the odds of making the right choice. And that tool is the Return on Investment calculation. Admittedly return on investment, frequently referred to by the initials ROI, is bantered about a fair amount, especially by companies touting their products’ benefits to potential buyers. But what does it really mean, how is it calculated, and most importantly, how can small companies use this tool?
At its simplest form, return on investment means the increase from an investment, typically expressed in percentage form. Back in the day when bank interest rates at least beat inflation, a $100 deposit in the bank that gave the account holder $105 at the end of the year gave a return on investment of 5%. This gives us our basic formula, which is:
For example, let’s say that a poster store buys 100 limited edition prints for $50, and the owner sells 95 of them for $200 each. The key values are:
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Of course, labor is frequently part of the cost too, and sometimes the return is money saved instead of money earned. Let’s say that a business might need to grow out of its space, but can save $1,500 a month for the next six months if the owner (who makes $60 / hour) spends two days initiating and administering a cleanup project, and a staff member (who costs $30 / hour) spends five days executing it. Thus, the key values are:
Before getting to how to implement, there are two other factors to consider: time and risk. Let’s say that a pharmaceutical is has two options for developing new drugs, both of which will generate a 1,000% return. But one starts making revenue in three years while the other won’t reach production for six years. Yes, the one that brings money sooner is the more valuable project! Now let’s say that the company has identified a third product option that it estimates to have a 1,200% return on investment, but thinks that there is a 70% chance of success since it might not be approved by the Food and Drug Administration. In this case, the return on investment (1,200%) is multiplied by the estimated success rate (70%), which gives an adjusted return on investment of 840%.
Small businesses can take advantage of this tool in two ways. The first is simply by basing daily time and expense decisions based on getting the most for our effort, and keeping focused on the high reward tasks. The second way to take advantage of this tool is by going through formal investment decision exercises. Large companies will do this periodically. The way to do it is to list all the possible options that your company can pursue, estimate the numbers (initial investment, gross return, timing, and risk), rank the options from greatest return to least return.
Once the exercise has been completed, the company can pursue the highest ROI project confidently, knowing that the right decision has been made and that profitability will be achieved.