Return on investment
Return on Investment (ROI) is the benefit to an investor resulting from an investment of some resource. A high ROI means the investment's gains compare favorably to its cost. As a performance measure, ROI is used to evaluate the efficiency of an investment or to compare the efficiencies of several different investments.[1] In purely economic terms, it is one way of relating profits to capital invested.
Purpose
In business, the purpose of the return on investment (ROI) metric is to measure, per period, rates of return on money invested in an economic entity in order to decide whether or not to undertake an investment. It is also used as an indicator to compare different investments within a portfolio. The investment with the largest ROI is usually prioritized, even though the spread of ROI over the time-period of an investment should also be taken into account. Recently, the concept has also been applied to scientific funding agencies (e.g., National Science Foundation) investments in research of open source hardware and subsequent returns for direct digital replication.[2]
ROI and related metrics provide a snapshot of profitability, adjusted for the size of the investment assets tied up in the enterprise. ROI is often compared to expected (or required) rates of return on money invested. ROI is not net present value-adjusted and most school books describe it with a "Year 0" investment and two to three years income.
Marketing decisions have obvious potential connection to the numerator of ROI (profits), but these same decisions often influence assets usage and capital requirements (for example, receivables and inventories). Marketers should understand the position of their company and the returns expected.[3]
In a survey of nearly 200 senior marketing managers, 77 percent responded that they found the "return on investment" metric very useful.[3]
Return on investment may be calculated in terms other than financial gain. For example, social return on investment (SROI) is a principles-based method for measuring extra-financial value (i.e., environmental and social value not currently reflected in conventional financial accounts) relative to resources invested. It can be used by any entity to evaluate impact on stakeholders, identify ways to improve performance, and enhance the performance of investments.
Risk with ROI usage
As a decision tool it is simple to understand. The simplicity of the formula allows to freely choose variables, e.g., length of the calculation time, if overhead cost should be included, or details such as what variables are used to calculate income or cost components. To use ROI as an indicator for prioritizing investment projects is risky, since usually little is defined together with the ROI figure that explains what is making up the figure.
For long-term investments, the need for a Net Present Value adjustment is great. Similar to Discounted Cash Flow, a Discounted ROI should be used instead.
Calculation
For a single-period review, divide the return (net profit) by the resources that were committed (investment):[3]
- return on investment = Net income / Investment
- where:
- Net income = gross profit − expenses.
- investment = stock + market outstanding + claims.
or
- return on investment = (gain from investment – cost of investment) / cost of investment[1]
or
- return on investment = (revenue − cost of goods sold) / cost of goods sold
Property
Complications in calculating ROI can arise when real property is refinanced, or a second mortgage is taken out. Interest on a second, or refinanced, loan may increase, and loan fees may be charged, both of which can reduce the ROI, when the new numbers are used in the ROI equation. There may also be an increase in maintenance costs and property taxes, and an increase in utility rates if the owner of a residential rental or commercial property pays these expenses.
Complex calculations may also be required for property bought with an adjustable rate mortgage (ARM) with a variable escalating rate charged annually through the duration of the loan.
Marketing investment
Marketing not only influences net profits but also can affect investment levels too. New plants and equipment, inventories, and accounts receivable are three of the main categories of investments that can be affected by marketing decisions.[3]
RoA, RoNA, RoC, and RoIC, in particular, are similar measures with variations on how 'investment' is defined.[3]
See also
- Bang for the buck
- Rate of profit
- Rate of return (RoR), also known as 'rate of profit' or sometimes just 'return', is the ratio of money gained or lost (whether realized or unrealized) on an investment relative to the amount of money invested
- Return on assets (RoA)
- Return on net assets (RoNA)
- Return on capital (RoC)
- Return on capital employed (ROCE)
- Return on invested capital (RoIC)
- Return on marketing investment (ROMI) is "the contribution attributable to marketing (net of marketing spending), divided by the marketing 'invested' or risked
- Return on modeling effort (ROME)
- Return on equity (ROE)
- ROI for Information Technology is used to evaluate applications portfolios and information systems
- Public ROI is used to evaluate initiatives in the public sector
- Marketing plan
References
- 1 2 "Return On Investment – ROI", Investopedia as accessed 8 January 2013
- ↑ Joshua M. Pearce. (2015) Return on Investment for Open Source Hardware Development. Science and Public Policy. DOI :10.1093/scipol/scv034 open access
- 1 2 3 4 5 Farris, Paul W.; Neil T. Bendle; Phillip E. Pfeifer; David J. Reibstein (2010). Marketing Metrics: The Definitive Guide to Measuring Marketing Performance. Upper Saddle River, New Jersey: Pearson Education, Inc. ISBN 0137058292. The Marketing Accountability Standards Board (MASB) endorses the definitions, purposes, and constructs of classes of measures that appear in Marketing Metrics as part of its ongoing Common Language in Marketing Project.