An Economist Explains ROI: Return on Investment

You’ve invested in a business, started to make profits, and now need to step back and reevaluate: are you getting enough bang for your buck?

Return on investment (ROI) is a straightforward metric you can use to concretely answer that question. By calculating ROI, you can figure out what percentage of your initial investment turned into profits or loss.

This guide will explain what exactly return on investment is, how to calculate ROI, and why it’s useful. I’ll also discuss some factors that make return on investment a more complicated analysis than it appears at first glance.

To start, let’s establish a working definition of ROI.

 

What Is Return on Investment?

What is ROI? Return on investment tells you what percentage of your investment turned into profits. To figure out the ROI calculation, you simply divide your net profit (profits minus costs) by your total investment. Then multiply the resulting decimal by 100 to turn it into a percentage.

ROI = net profit / investments x 100

Another way to write this ROI formula is ROI = profits / costs x 100.

For example, let’s say you made $110 on a project that cost $100. Your net profit is $10 ($110 – $100). The return on your initial $100 investment is 10% (($10 / $100) x 100 = 10%).

What if you made all your money back? If you got a net profit of $100, then your return on investment would be 100% (100 / 100 x 100 = 100%). If you made no profits, then your ROI would be zero.

You could also have a negative ROI if you lost money. Let’s say you only made $90, so your net profits are -$10. Of course, this is a loss of $10, but we want to keep it as a negative number so we end up with a negative return on investment. With a loss of $10, your return on your $100 investment ends up at -10%.

Any return on investment below zero indicates an overall loss of money. An ROI of -100% means you lost all the money you put in.

Let’s consider a more in-depth example with Jane, a rising star in the lemonade stand industry.

 

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Return of investment is always measured as a percentage.

 

Calculating ROI Example 1: Jane’s Lemonade Stand

When summer rolls around, Jane is an unstoppable force in the roadside lemonade stand community. Not only does she make a great lemonade from the secret recipe that’s been in her family for generations, but she also keeps a close eye on her business expenses. Jane wants to make sure that she’s getting a good return on all her lemon, sugar, and ice investments.

To prepare for opening day, Jane puts in a total of $10 into her stand (she’s very economical). By the end of the launch, Jane has sold $15 in lemonade to friends, neighbors, and thirsty passersby.

Before she packs up to go home, Jane takes out her calculator to figure out her return on investment. Her net profit is $5 ($15 profits – $10 costs). Then she calculates her return on investment by dividing her $5 net profit by her $10 initial investment.

Jane’s ROI: $5 / $10 x 100 = 50%.

Jane’s return on investment is a respectable 50%. Besides ensuring her continued dominance in the lemonade business community, why is it useful for Jane (or anyone else, for that matter) to calculate ROI at the end of the day?

 

lemonade-stand
As a savvy businessperson and master mixer of lemonade, Jane always has a high ROI.

 

Why Is ROI Useful?

Calculating your return on investment on any business venture is a useful way to figure out where your costs are going and whether a project is worth the investment. Jane can use her ROI calculation to see if the money she puts into lemons is worth the profits she gets from selling lemonade. With an ROI of 50%, it looks like Jane is skilled at turning lemons into lemonade.

If your ROI is lower than you anticipated or even negative, then you’ll need to figure out a way to reduce costs and increase profits. If it’s too late to switch up your business model, then you might have to switch to a new project completely.

Return on investment can also be a useful metric if you’re deciding between investments. You can compare their ROIs to see which would yield the best bang for your buck.

Jane is doing just that as she thinks about her future as a seasonal entrepreneur. Should she keep selling lemonade, Jane wonders, or should she try her hand in the growing orange juice market? Read on to see how Jane uses ROI calculation to make an informed business decision.

 

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Two roads diverged in a wood, and I – I took the one with the higher ROI.

 

Calculating ROI Example 2: Jane Compares Businesses

Jane is getting restless. She’s more or less reached the pinnacle of success in the lemonade industry, and she’s looking for a new challenge. As a savvy businessperson, though, she will only make a change if the numbers make sense. Fortunately, Jane can rely on the hard data of return on investment to make her decision.

To get a sense of costs and profits, Jane closes up shop on the lemonade stand for a day and starts selling orange juice. Her costs are the same as the lemonade stand, $10, and she makes $17 at the end of the day for a net profit of $7.

Jane’s orange juice ROI, then, is 70% ($7 / $10 x 100 = 70%). This ROI is higher than the 50% returns she made selling lemonade. Since Jane has a limited amount of money to put toward her businesses, she should invest all of it into the lucrative orange juice stand.

For each dollar she invests, she’ll get more profits back selling orange juice than she would selling lemonade. ROI is an especially useful analysis for Jane because her ratio of costs to profits never changes. For every $10 she invests, she sells $15 of lemonade or $17 of orange juice.

Of course, this model isn’t necessarily realistic for many businesses. Let’s consider what happens if the proportion of costs to profits doesn’t stay on a linear scale.

 

Costs to Profits: Linear Scale vs Non-Linear Scale

Because Jane’s proportion of costs to profits always stays the same for both her businesses, she can easily use ROI to choose between investments. This constant proportion can be called a linear scale.

In most circumstances, though, profits don’t scale linearly with costs. For instance, what if Jane’s lemonade stand generated $5 in profits for every $10 in cash, but $8 in profits for every $20 in cash? Is the ROI on her lemonade stand 50% or 40%?

The answer is both and neither. If her costs and profits don’t match up on a linear scale, then her business can’t be said to have a single ROI independent of costs. Because of its variability, return on investment is no longer the best criterion for Jane to use when making important juice-related business decisions. This brings us to some of the major limitations of the ROI calculation.

 

lemon-and-orange
Because her costs scale linearly with profits, Jane can use ROI to compare the lemonade stand with the orange juice stand.

 

Limitations of Return on Investment

Return on investment is a relatively static analysis that misses one huge variable: time. It provides a snapshot of a business’ profits at a single moment in time, and the percentage assumes that costs correspond to profits in a linear way. When using ROI, you should keep in mind that it doesn’t represent changes in costs or profits over time.

A second complicating factor is the exact definition of “costs.” What if Jane got all her ice and water for free, plus she has free use of a plastic pitcher? Should she put a value on these materials when figuring out her initial investment, or does the fact that they were free mean they don’t count as costs?

Whether or not free materials count as costs is a matter of debate among economists, who may or may not consider them to be “opportunity costs.” If Jane doesn’t count the water, ice, and pitcher as costs for her lemonade stand but does count them as costs for her orange juice stand, then her ROI calculations aren’t directly comparable.

By not counting free materials as costs, Jane’s ROI makes her lemonade stand appear more profitable than it would be in the future, if she had to buy her ice, water, and pitcher herself. Then, her ROI becomes a very specific calculation that may not apply to future endeavors in the lemonade stand industry.

To further complicate Jane’s life, she just found out she needs to buy a $5 business license from the city council. Does this one-time fee count as a cost when she is calculating ROI? If she’s deciding whether to continue any business, then this license fee should count as a cost. If she’s simply deciding between businesses, then the fee shouldn’t count toward her investment costs.

There are other metrics that people use to account for variables like time, free materials, and one-time startup costs. The details of those other methods of financial analysis will be saved for another guide. The point in considering these complicating variables is this: ROI, while a useful and important metric, is not a hard technical formula.

 

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ROI does little to account for changes in costs and profits over time.

 

Return on Investment: A Matter of Debate

Return on investment is a useful and easy-to-use metric, but its simplicity means it has some major limitations in real-world use. It’s important to understand these variables so that you can be wary of any advisors trying to “fudge the numbers” to make a venture appear more profitable or risky than it really is. Because of the disagreement among economists, it’s hard to have a single, precise interpretation of a business’ return on investment.

What can people agree on? For the most part, everyone is one the same page that ROI is a percentage and that higher ROIs mean an investment is more worthwhile. ROIs above 0% make money, while ROIs below 0% lose money. If you end up with an ROI of 200%, then you’ve made back twice as much as your initial investment.

In closing, let’s go over the key points you need to remember about what return on investment means and how to use it to evaluate or compare investments.

 

ROI: Final Thoughts

Return on investment is a useful place to start when you want to compare the costs of a project or business venture with its profits. It’s an easy way to reveal what percentage of the initial investment you made back or lost.

ROI is most useful when profits scale linearly with costs, i.e., when the money you make remains in a constant proportion to the money you spend. Since the profits of her stands scaled linearly with costs, Jane could use ROI to decide between businesses. Thanks to her ROI calculation, Jane will be getting a 70% return on investment selling orange juice, and other lemonade sellers will be able to step out of her shadow and rise to the top.

If your main constraint when deciding between investments is the cost of the investment, then doing a return on investment analysis can help you make an informed decision about which project would be the most profitable.

 

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