Tips and Tricks to measuring Return On Investment

What is Return on Investment?

Return on Investment is a mathematical formula that investors use to evaluate potential investments and their attractiveness in comparison to alternatives ways of using that capital/resource.

Dependent upon the nature of the investment proposal, returns could be more than just a simple profit/cost saving calculation and can stretch to areas such as realising efficiencies, gaining market share and building infrastructure. The calculation therefore is not always as simple as net income divided by the cost of investment and can get a little complicated when there are multiple facets of return versus the cost (e.g. cost efficiencies, additional market share and higher social media traction). However calculating a form of ROI will allow you to ensure you are putting your capital and resource to the best use, on projects that are going to return profits at a rate that is acceptable to you and any of your investors/partners.

How To Calculate Return on Investment

The formula to calculate Return on Investment is as follows:

The answer is then multiplied by 100 in order to express the value as a percentage. Such a percentage can be positive or negative and represents the percentage rate of return of a particular investment proposal.

With return on investment, we ideally want this number to be as high as possible, or at least greater than or equal to a risk free (bond or fixed savings account) investment rate. A negative percentage indicates that the investment, from a financial perspective, will lose money and consequently it will be unlikely to be put forward unless it held some qualitative aspects that were not picked up in a purely financial ratio.

Comparing ROI rates

We would typically use Return on Investment to consider a number of alternative projects/investments in order to decipher which one was the most attractive from a financial return perspective. For example, let us consider two investments: Investment A and Investment B.

  1. Investment A – Has a cost of £8,000 and returns £10,000 meaning our return would be £2.000
  2. Investment B – Has a cost of £500 and returns £900 meaning our return would be £400

Looking at the figures purely from a return perspective, we would believe that Investment A was the most attractive as it returns 5x that of Investment B. However our ROI calculation is designed to express this as a percentage in order to give us an idea of the most efficient use of investment, so if we apply our formula to the above two scenarios:

  1. Investment A = (£10,000-£8,000)/£8,000 = 25%
  2. Investment B = (£900-£500)/£500 = 80%

From an ROI perspective therefore, investment B is actually more attractive with an 80% return versus investment A which only returns 25%.

In reality both investments are positive percentages, so both will generate a financial return on the investment and the organisation may therefore move forward with both. However, if the organisation had multiple projects in the pipeline and a finite budget then a large £10,000 outlay for only a 25% return may not be deemed attractive amid smaller projects with higher percentage return.

Taking into account the Time Horizon

In the event you are comparing projects with different time horizons you will need to adjust the calculated percentage return by the time that the investment takes to realize. For example If Investment X returns 10% in one year and Investment Y returns 25% in 2 years in order to accurately compare the two you need to adjust Investment Y to the same time horizon as Investment X.

We do this by using the following formula to calculate the average annual rate of return:

Where:

X= Annualized rate of return

T = Time horizon

So for investment Y the formula is:

(1+X)^2 -1 = 25%

Solving for X

(1+X)^2 = 1.25

1+X = 1.118

X = 0.118 or 11.8%.

Investment Y therefore has an annualized rate of return of 11.8% in comparison to Investment X with 10%.

See, all that Algebra at school came in useful after all!

Return On Investment – Marketing

Measuring Return on Investment concerning marketing is a notoriously difficult concept and often the competing views of finance and marketing clash within an organisation. Marketing and promotion is a big investment and with such an extensive outlay you will need to track and measure exactly what you are getting for your money.

At a basic level you should measure the return on investment, which in its simplest form can be calculated as follows:

As with any ROI calculation you want to be looking at a positive number and ideally as high as possible, this would then indicate that the investment is worthwhile.

However despite the equation looking relatively straightforward the reality of a calculation is difficult. Whilst the cost of the marketing investment can be calculated relatively easily (and should include staff time and resource) the reality of measuring its return is a little more difficult. This is because tying a particular purchase to a particular marketing activity is almost impossible, many organisations attempt to do this through targeted questions at the time of purchase (the where did you hear about us question), but these could be inaccurate or usually left blank as the customer is really just interested in completing the purchase as oppose to filling in any sort of questionnaire.

The reality therefore is that you need to set objectives for your marketing spend and tie them to a specific time horizon. For example if the goal of your promotion is to gain 20,000 more visitors to your website within 3 months then this becomes something you can track in order to measure success. So when putting together a marketing strategy you should have a specific set of objectives, all tied to realistic time horizons, which you can measure in order to ensure that your marketing efforts are returning to the level you expect.