Although accounting may be your least favorite thing about running a small business, there are a few simple mathematical rules you absolutely must understand to be successful in the business world. These rules are used time and again, and influence decisions that might drastically affect your business.
One of the most important mathematical formulas for businesspeople to understand is how to calculate return on investment, or ROI. Having a firm understanding of how return on investment works could save your project or business untold money and time, and possibly make the difference between success and failure.
What does Return on Investment Mean?
Put simply, return on investment is a measure of how much profit you made from selling products or services after your costs have been removed. If you spend $200 (in materials and labor) to make $400, you’ve made a 100% return on your investment; for each dollar you spent, you earned an extra dollar.
Knowing how to calculate return on investment can make or break your investment decisions, but it can also be easy to overlook important factors when performing such calculations.
Many entrepreneurs just starting out fail to recognize the many ways their costs can quickly devour their profit margins. Say you have a retail store selling electronics. You buy a computer for $300, mark it up 100%, and two months later sell it for $600 (giving you a 50% profit margin). You’ve calculated your ROI, and think you’ve earned $300 in profit. Not bad, right? But that only covers the initial cost of the computer; there are other factors that could decrease your return on investment, like the cost of renting a building to store it in.
Because of this, it is imperative to accurately calculate all your costs, and weigh the pros and cons of every alternative, in order to make intelligent investment decisions. Once you factor in all your variables into your ROI calculations, don’t be surprised if your $300 profit has dropped to $100! This $100 now represents a 33% return on investment rather than a 100% return on investment (or 16% profit margin instead of the 50% profit margin).
What Goes Into Determining Return On Investment?
Sometimes the variables involved in calculating your ROI might surprise you. For instance, retailers searching for the best price will sometimes order from wholesalers, who often require large minimum orders. In order to get that computer for $300, you had to purchase $2,000 worth of computer equipment from your supplier. After you sell the computer, you still have $1,700 worth of inventory sitting on your shelves. Shelf space costs money, and every item on your shelves must pay rent. Each day those computers sit unsold, they’re taking up space and decreasing your return on investment. If they don’t sell, the cost of owning them has to be subtracted from your profits, so don’t be surprised if your $100 profit has now dropped to $50.
Let’s say someone took $2,000 and bought a used car that was in pretty good condition instead of buying computer equipment. They spend a Sunday afternoon cleaning it up and making minor repairs, and put it in their front yard with a $2,500 asking price. Two months later the car sells. They only marked the car up 25% (as opposed to your 100%), but even if you calculated their time as an hourly wage, the car buyer / seller still winds up making a huge ROI compared to the computer retailer. How? The biggest reason is the difference between the cost of doing business for the retailer vs. the car trader; computer stores need power and lights, but a shade-tree mechanic might already have everything needed to sell the car for a profit.
Why Tracking Your Return On Investment Matters
No matter what products or services you offer, you still have costs that impact your ROI. You’re paying bills. Rent, utilities, phone and internet service, wages, display units and shelving, credit card processing and merchant services, advertising, website maintenance, insurance, the list goes on and on. Each costs money, and you pay each one because you expect a return on your investment, but are you including all of them as costs when determining your return on investment, or forgetting to include something that could mean the difference between success and failure?
Every buying and selling decision should be analyzed or compared to other investments. By paying rent, you get a building to sell your products or services from. By marketing, you can attract new clients. But if nobody visits your office, is paying rent a good investment? If no one uses your coupons, or reads your expensive newspaper inserts, should you continue to pay for them? Are you better off taking your money and putting it somewhere that earns a higher rate of return?
Advertising and marketing decisions should be put through the same process. Does every dollar spent on radio or magazine advertising bring in two dollars worth of sales? Compare that to the cost of having and maintaining a website or sending out post cards. Which form of marketing and advertising is bringing in the most return?
How often does your new customer or current customers purchase? Knowing the “Lifetime Average” of you customer’s spending habits is part of the “Cost of Acquisition”. The “Lifetime Average” must be figured when trying to determine the ROI on any marketing campaign.
If you spend, on average, $5 to attract each new customer, and they, on average, only spend $5, are you actually making any money, or simply keeping your marketers in business? Don’t forget to take into consideration your time or your employees time of recording and tracking the customers, any follow up communications or customer service, refunds, returns, restocking time or cost, and the dozens of other hidden cost that are associated with dealing with clients.
Keeping track of your investment’s return ratio allows you to know if you’re spending time and resources as effectively as you could, or if there is room for improvement.
Knowing Your Return On Investment Ratio Could Save Your Company
Whether you have a 10-thousand square foot retail space or you sell website hosting online, you need to understand your costs to be successful in business, and you need to know how to calculate your ROI if you want to take advantage of good investment opportunities or avoid disastrous mistakes. Every facet of your business, from rent to taxes to light bills, plays a part in determining your return on investment, and understanding how all the different pieces fit into your particular puzzle could be critical to your success.
By Eric S. Streeter & David Tower