Return on Investment
The return on investment (ROI) puts the profit in relation to the capital employed. The return on investment is one of the most important key figures in business administration, marketing and controlling. The ROI provides a statement about the point in time at which the capital employed by a company actually yields profits.
Even the literal translation of the term return on investment provides a good definition: the “return on investment” means that the capital invested pays off – and this is ultimately what all areas of business are about. An investment – in a marketing campaign, for example – must pay off. The return on investment shows when the time has come. Other terms for return on investment are profitability, return on investment or return on capital.
According to a definition by David Pearce in the “MIT Dictionary of Modern Economics,” return on investment can be understood as an expression that sees profit as a percentage of the amount invested. The prerequisite for this is, of course, always that the costs of an investment and its return can be precisely assigned.
The return on investment can be expressed as a percentage or as a factor.
Example: 120% corresponds to a factor of 1.2. 50% corresponds to a factor of 0.5.
The ROI here always refers to a specific period of time, for example, one year. An example of this:
An entrepreneur wants to buy a machine that costs 1,200 euros. This machine would enable him to sell 100 copies of a product every month, generating a profit of 1 euro per piece. The calculation of the ROI is as follows:
Profit: 1,200 euros (100 euros x 12 months).
Capital employed: 1,200 euros (price of the machine)
ROI = capital employed / profit = 1,200 / 1,200 = 1.0
Here the calculation is very simple: within one year the investment has completely “returned” to the company, because the return on investment here is 1.0.
If the machine costs 2,400 euros, the calculation results in a value of 2 (2,400 / 1,200).
The investment would only have paid off in two years.
ROI for companies
The above example is deliberately chosen to be simple. The reality is usually much more complex. For example, various factors influence the return on investment. ROI can also be used to determine the profitability of an entire company to an objective figure. The formula for calculating return on investment can be more precisely formulated for this purpose:
Return on Investment = Return on Sales × Capital Turnover.
In detail, this means
How much turnover is generated with the assets (fixed assets and apportioned assets)? The figure indicates the ratio between net sales and total capital. A high value indicates a profitable company.
Return on sales
What percentage of sales remains as profit? A low value indicates a highly competitive market. Very high returns on sales indicate companies that have a unique selling proposition. They can charge high prices.
An important key figure in marketing
ROI plays a particularly important role in marketing. In marketing, it is important for an advertising budget to turn a profit in the shortest possible time. Especially for performance campaigns, whose successes can be constantly monitored during the runtime, the return on investment proves to be practicable.
For branding campaigns, where the focus is on the long-term image of a company or brand, calculating the return on investment is regularly very difficult. This is because many factors come together here that cannot always be clearly assigned.
PBP and ROI
As a relative indicator, ROI allows the comparison of dissimilar investments or dissimilar operations. The return on investment expresses which investment share flows back as profit in a fixed period. This makes it possible to calculate the period of time until an acquisition is amortized. In the context of corporate planning, ROI shows whether or not an operation is meeting its set profit targets.
Many companies use attractive ROI figures as a sales promotion tool. However, return on investment is less suitable for certain forecasts. For example, ROI does not provide information about the risk of an investment. If an investment in expensive software results in an ROI value of 300% (or 3.0), this says nothing about the probability of realizing this return on invested capital.
Another formula that is very similar to ROI is also helpful in controlling: the Payback Period (PBP). This formula is used to calculate the period of time until the so-called break-even point is reached. The break-even point is the point at which revenues exceed expenses. So this formula is based on actual cash flow. The PBP is better able than the ROI to provide information about the financial risk of a project.
The formula for PBP: cost / cash flows per year.
If two alternative projects are equally urgent and have a similar ROI, in case of doubt, one will choose the one that has a shorter PBP. This is because with a longer payback period, the risk that the basic assumptions will change negatively over the course of the project is higher.
Other key figures in the ROI environment
The difficulty in calculating prospects for investment success using the ROI formula lies in representing the constraints as accurately as possible. The more complex the circumstances, the less accurate the ROI becomes – even when powerful software is used to calculate it.
This is especially true for projects that are scheduled for a longer period of time. In contrast, return on investment is very well suited as a marketing tool for small and manageable projects or marketing campaigns. Other helpful key figures in the environment of return on investment are, for example:
- Net Present Value (NPV) can be used to calculate the actual time value of an income. This value also takes into account interest and the devaluation of money.
- The Internal Rate of Return can also be calculated. The IRR shows the highest interest rate at which a project still achieves a positive NPV.
- The Switching Costs calculation captures follow-on costs of an existing technology or costs to replace it.
- Opportunity Costs should also not be ignored. Costs for a specific project prevent the opportunity to invest in other projects.
Ratios such as ROI, IRR or NPV are classic methods for calculating and forecasting the profitability of investments. However, especially in forecasting, reliability always depends on the extent to which the basic assumptions are correct.
Return on investment is a fairly reliable metric for checking whether an investment is worthwhile or not. ROI puts investment and profit in a measurable relationship and allows forecasts in business and marketing about the time periods within which investments are worthwhile. The key figure can be applied across all industries. However, using ROI exclusively for investment decisions is risky, especially for larger projects. Other key figures should therefore also be included in the considerations.
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