Will the Real ROI Please Stand Up? - The Power is in the Purity
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The real ROI equation is one of those rare mathematical formulas that are pure poetry in their simplicity yet produce powerful results. In fact, according to the “Dictionary of Modern Economics” from the MIT Press, the definition of ROI is "A general concept referring to Earnings from the Investment of Capital, where the earnings are expressed as a proportion of the outlay." Basically, it means that ROI is a measurement of Profitability that takes into account the Profit from an activity in reference to the capital invested in the activity itself. Or, in an equation style format:
Isn’t that beautiful? I know, I know, it’s nothing you would want to take to the prom, but you really can’t ask for a more simple way to measure your Profitability. The results are easy to interpret as well: Just like when looking at a result for Profit, the closer your ROI is to 0%, the closer you are to simply breaking even. The farther the number is away from 0%, the better the return. Think of ROI in the same way you would a regular bank savings account’s interest rate. Alternatively, if your ROI is less than 0%, then you’re losing money, as you probably already knew from the negative Profit number. So, for example, if you partake of an activity of some sort that results in $100 in Profit that only cost you $100 in Invested Capital, then your ROI would be 100%, that is, you got an additional $100 back from your investment of $100, thus doubling your money.
Now, since a lack of knowledge with these terms is usually one of the reasons the ROI equation is abused so often, I would be remiss if I didn’t fully explain the two major parts of the equation in detail. Profit, in its simplest form, is the gain from a business activity after subtracting all of the expenses used in the activity. Invested Capital refers to all capital (that is, cash or goods), used to generate the Profit in the aforementioned activity, such as advertising costs, physical plant, and so on.
It is important at this point to bring up the value of accuracy and consistency. In both halves of the equation, to get as accurate an ROI result as possible, you need to make sure you are really taking into account all of the expenses and capital used in the activity. Otherwise, your results will be a lot better than reality and you stand the chance of possibly continuing an activity that does not warrant continuing while your company slowly bleeds cash. Additionally, you should make every effort to be as consistent as possible when calculating your ROI value, that is, using the same methods to determine Profit and Invested Capital each time. This little precaution will ensure that a comparison from one activity to another is not biased because in one instance you counted one aspect of the activity, say a set-up fee or other expense, and the other you did not.
By the way, while we’re discussing things like Profit and Invested Capital, I should bring up that the financial world is a tad wishy-washy when it comes to what to call the variables used in this equation. So, if you see terms like “Net Income”, “Net Profit”, or “Net Earnings”, in this instance, it is the same as “Profit”. On the other side of the equation, if you see terms like “Assets” or “Total Assets”, in this instance, it is the same as “Invested Capital”. There are instances where these terms do have alternative meanings, but when calculating ROI for something like advertising, just stick to these definitions and you’re golden.
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