Table of contents:-
- What is Return on Investment (ROI)?
- Calculation of Return on Investment
- Why should ROI be calculated?
- Benefits of ROI
- Shortcomings of ROI
What is Return on Investment (ROI)?
Return on investment (ROI) is a measure of the profitable effect of any action by comparing the investments- financial, resources or others with the output profit.
The return on Investment is a profitability metric usually determined by dividing the net income by capital Investment costs. Investment also refers to the appropriated costs of efforts and resources given to any activity.
Calculation of Return on Investment
For ROI calculation, the benefit (or return) of an investment is divided by the cost of the investment
The formula for calculating return on investment is given as?
ROI is equal to :
[Current Value of Investment?Cost of Investment]/Cost of Investment
The current value of investment is the value gained from the actions or investment. Subtracting it from the cost of investment gives the return.
In other words, ROI calculation is to divide the benefits or gains with the cost incurred in pursuing it.
ROI is measured as a percentage that makes it easy to compare.
For example, a company intends to enhance the sales and customer experience by adding a new feature to the product.
For this project, the process will follow phases of user analysis, needs, R and D, feature development, etc. The investment of resources and capital all appropriated to financial units make up the net investment costs.
Now, after the completion of this project, the monetary gains from the project are realised.
The investment costs are subtracted from the gains and we get the value of return.
The ratio of return with investment cost is the final return on investment (ROI).
Though it looks straight and simple, ROI should be assessed carefully.
Determining the costs and returns can turn out to be a complex task.
Why should ROI be calculated?
ROI can be seen as a fundamental measure of efficiency of a certain plan of actions centralised to a specific goal. It is basically the answer to the question– How well did a certain method work?
ROI calculations help investors and stakeholders on matters of investment opportunities. ROI indicates how the various investments have performed. Thus, the investors or stakeholders can sort out the performing and non performing investments which will give them a clear idea of the product’s and company’s potential.
Benefits of ROI
- Simple calculation and results: The ROI formula is simple and straight with minimal inputs. Output calculation is easy and straightforward.
- Diverse application: ROI works for varied fields of investment such as marketing projects, stocks trading, services from different machines and any other field where you want to measure the profitability.
- Broad utility: ROI can be examined for various factors like efficiency, profitability, and more aspects of activities and approaches.
- Tracking specific investment: ROI is easy to track and it focuses on the outcomes of single project investment so the profitability of specific projects can be tracked.
Shortcomings of ROI
(i) Overlook time factor
The time that is invested is overlooked in ROI calculation. It doesn’t take account of wasted or saved time even though time management reflects in profitability.
(ii) Can be manipulated
ROI calculation varies from person to person. The cost determination can be different for different approaches. Thus, the ROI data has to be studied in accordance with the procedure of calculation. Different accounting methods are used by different departments.
Q: What is a good ROI?
A: A good ROI depends on the way an investor measures the ROI. It is the investors opinion and what they value. Time required to provide a return is also significant, you may have a high ROI score, but if the time that the investment took to provide the returns is more than enough, then it’s not a good ROI.
Q: What is the Rate of Return?
A: Rate of return (RoR) is a measure of an investment’s returns over a period of time. This metric considers the time period for which the investment is made and returns are achieved.
Q: What is positive or negative ROI?
A: If the investment has profited then the ROI will give a positive return that means returns are greater than investment cost. If a loss is incurred the ROI value will be negative indicating that the investment costs are more than the returns.