How to calculate ROI and why it matters

Many business owners focus intently on revenue to gauge their company's financial health or success, but return on investment (ROI) is often a better measure. This is especially true in rapidly growing ventures, and that's because ROI reflects the payback, or additional value generated, from any financial investment.

Find out what ROI is, how it's calculated, why it's an important figure to keep track of, and how it can tie to business success.

How to calculate ROI

In mathematical terms, ROI = (Revenue generated – Cost)/Cost x 100

So if you spent $250 on Facebook ads last month, for example, and you landed $1,000 in new business, your ROI would be calculated as:

ROI = (1,000 – 250)/250 x 100 = 300%

That is, for every $1 you spend in Facebook ads, you earn $3. That's a great ROI.

Reasons it's important to track ROI

Kristen Bolig, owner of Security Nerd, lays out three big reasons to track ROI:

1. Better decision-making. "To see how your decisions impact your bottom line. ROI gives you that, connecting the financial outcome of a decision or action with the cost of the same."
2. Comparing apples to apples. "You can line up the ROI of multiple campaigns or efforts, then compare them to see which project is most effective."
3. Fast to calculate. ROI is a commonly used tool that most people understand and can relate to, making it a useful universal metric.

The good news is that ROI can be used in many different functions within your company.

How to use ROI in your business

There are many ways to use ROI in your business in order to assess whether you are making the best use of your money in various departments.

Equipment or asset acquisition. Within companies, ROI can be used to decide where to allocate available funds. As Edgar Arroyo, president of SJD Taxi, a taxi service, explains, "We need to know ROI to help us make decisions on new vehicles to lease or acquire and whether we need to find ways to increase utilization rates for certain fleets." Knowing the ROI on various vehicles in his fleet, Arroyo can "make decisions on which business lines to cut losses on, and which ones to invest more money into and scale."

Marketing pay-off. Zeshan Jeewanjee, CEO of One Day Event Insurance, uses ROI to track monthly marketing spending and results. His company places ads on Google, Facebook, and LinkedIn and when any changes to the company's website, services, or products are made, he compares the results each generates and shifts his budget to the platform generating the highest ROI. "We repeat this routine regularly to help optimize our marketing campaigns."

Employee performance. Chris Kaiser, founder and CEO of Click A Tree, says, "We even track the ROI of each employee. Since we are a small team of four, we can track quite precisely which employee accounts for how many trees are being planted, and can hence also offer incentives."

Funding. Many venture capitalists or angel investors calculate a potential ROI for their proposed investment in a business before making funds available. Essentially, they want to know how much $1 of investment will yield when the company is sold. The larger that number—the return on their investment—the more appealing the opportunity.

Soft skills. You aren't limited to applying ROI to quantitative measures, however, as brand and marketing consultant Rachel Weingarten points out. "For me, relationship-building is the biggest investment of all, and as corny as it might sound, that's priceless. So finding ways to connect and interact that go beyond a traditional spend is for me the prudent investment in your business of all." The trick here is converting qualitative data to quantitative so that it can be calculated and compared. So you might compare hours spent building a LinkedIn network and the new connections you've built, versus hours spent on Facebook and the new friends you've attracted there, for example.

Limitations of ROI

Although ROI can be useful for comparing different opportunities, Abdulaziz Alhamdan, positioning expert with Story Bonding, cautions that using it may be at odds with long-term growth.

Short-term focus. "For small business owners who desire long-term success, ROI will drive them to make the wrong decisions," he says. Alhamdan cites an example of two companies: one startup that discounts its price on a first sale to establish a client relationship that results in future sales, versus a second that is unwilling to lose money—meaning, generate a negative ROI—and maintains a higher price that new customers are unwilling to pay. In the long run, the first company has the opportunity to build a steadily increasing revenue flow, while the second has created a barrier that may be more difficult to overcome long-term.

"If used religiously, ROI can lead to making decisions that are too focused on short-term results and, in the process, sacrificing the long-term projects that can be initially negative in their ROI yet can lead to the biggest impact and transformation for the financial future of the business."

In addition to a short-term focus, another weakness is that ROI fails to account for time as a resource.

Time-value of money. Rina White, owner and CEO of Laundry South Systems and Repair, also points out that ROI "doesn't take into account the time-value of money." She explains, "An investment that yields $100 tomorrow is worth much more than an investment that yields $100 ten years from now."

Consequently, White uses internal rate of return (IRR) more than ROI. "We use IRR to compare an investment we're considering to its alternatives. Will the business earn a higher return by investing in a new piece of capital equipment or hiring a new employee versus paying off existing debt or placing its funds in a CD?" she says.

Despite its limitations, ROI is still a quick and easy method for comparing different business opportunities.