Return on Investment - ROI Defined

What is ROI and What Does I Mean for Your Home Business

Return on Investment ROI
Know your ROI to insure you're spending wisely in your business. Credit: hh5800 | Getty Images

Definition of Return on Investment:

Return on investment - or ROI - represents the financial benefit received from an investment. It's used in many areas of finance, as well as in business. In business, it's used a great deal to measure the effectiveness of marking, although that's not the only area you can measure ROI. Other business investments such as equipment and services should have a favorable ROI.

 

Calculating ROI

The goal is to have a high ROI, which is indicative of your investment leading to gains. It is usually represented as a ratio and obtained by dividing the gain earned from the investment by the investment amount. For example, if you spend $1,000 per month for Pay Per Click (PPC) advertising and generate $2,000 in revenues directly from your PPC campaign, you divide $2,000 by $1,000 to get $2. The ROI would then be $2 or 2 to 1. In other words, for every $1 you spend on PPC ads, you earn $2. You should measure ROI on all you marketing efforts so you can be sure to spend your time and money on activities that generate the best results.

Challenges to Determining ROI

The difficulty in calculating ROI lies in how well revenues can be tied to a specific investment. For example, if you engage in a search engine optimization (SEO) campaign, you may not be able to accurately determine how much an increase in your revenues was a direct result of that campaign because other factors (i.e. social media) may also have led to increased traffic.

 Social media in particular can be difficult to measure, although there are tools that can help. Facebook offers insights and many of the social media management tools, such as Hootsuite, also provide analytics.

Further, many times, customers and clients don't spend money on their first encounter with you.

Perhaps they find you through  a PPC ad, then they follow you on social media, next they sign up for your email list, and then they buy. The question is, which led to the sale? You could argue the PPC did, because it introduced the prospect to you, but it's possible a Tweet or email led to the actual buy. 

Additionally, because you're dividing by your expense, if you engage in a free promotional activity that results in increased sales, the denominator would be zero, which results in a mathematical error. With that said, free marketing often involves the personal investment of time, which does have a financial value, and you can use that to determine ROI. For example, if you know your time is worth $50 an hour and you spend an hour a day on social media, you can divide the income earned from your social media efforts (if you can decipher that amount) by $50. 

How to Use ROI In Your Home Business

Anytime you invest money (or time) into your business, you need to have a goal result in mind and way to measure it to insure you're receiving a gain. Ask yourself, "What will I earn by investing this time and money into my business?" For example, if you outsource work to a virtual assistant, is the money you're paying to a VA leading to gains in income and if so, how much (ROI).

For every dollar you spend on a VA, what extra returns (if any) are you getting?

ROI isn't static. Many variables can change your ROI. For example, even if you don't change anything about the PPC ads, it's possible they could drop in ROI (not perform as well) or improve (generate better results). So you want to calculate ROI regularly and make changes to your investments as needed.

Note that ROI isn't profit. You determine profit by subtracting your expenses from your income. If you generate $5,000 in a month and your businesses expenses are $3,000, your profit is $2,000 ($5,000-$3,000). ROI differs in that it measures how effective your investments into your business are at generating income. Using the PPC example above, you'd learn that for every $1 spent, you'd earn $2. 

Also Known As: return on investment, investment return rate or ratio, marketing ROI

Update June 2016 Leslie Truex