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What does ROI mean and how to calculate it

In this article, we shall explore what ROI means, how to calculate it using a simple formula, its significance in decision-making processes for businesses and individuals, and considerations for improving ROI metrics.

What is a return on investment?

As a business owner you may hear the term ROI or return on investment, but what does it actually mean and how do you calculate it?

When you make an investment , ROI helps you understand the profit or loss the investment has earned as it is the calculation of the value of an investment versus its cost. 

ROI is a good measurement of the potential profitability of a particular investment, marketing campaign or when creating business plans for a new business. Another common term that may appear is ROAS, which stands for return on ad spend, which focuses on specifics such as individual advertisement campaigns to grow a business.

As ROI is presented as a percentage increase, it allows you to compare the figures of different investment types, which you can use again to increase your profitability and effectiveness of future investments. 

How to calculate ROI?

To calculate ROI you need to calculate:

ROI = (net profit / cost of investment) * 100

This can also be seen as:

ROI = (present value – initial investment cost / initial investment cost) * 100

If you are not confident using the equations, there are ROI calculators available, these can also be useful for checking that you have gotten the right figures and calculated them correctly. 

Scenario 1 

If you have £500 net profit from an investment cost of £500 you would use the following calculation:

(500/500) * 100 = 100

Meaning that an ROI of 100% has been achieved. 

Scenario 2

Another example would be if you had £1500 as your current value, with £1,000 spent as an initial investment you would use the following calculation:

((1500 – 1000) / 1000) * 100 = 50%

Meaning that an ROI of 50% has been achieved.

How to increase your ROI?

You may already know your ROI but want to increase it. Here are some helpful tips to increase your ROI. 

Use data: When you are looking at your spending and what it returns, look at the data available to you. This might be using your financial reporting such as balance sheet or profit and loss account. Alternatively, accessing data in your accounting software. Approach the data with an analytical mindset, this will allow you to see what is doing well and what isn’t. You can use this information to either change your spending to focus on what is doing well, or you can improve the areas that aren’t doing as well, by seeing what is successful about the investments that are doing well. 

Be willing to take risks/experiment: There is no set way to make a good ROI, you will have to look at new ways of improving it and this can be done by experimenting. It is recommended to start small when experimenting and if it is successful then increase the investments if it is worth expanding. The longer you experiment the more likely you are to find new ways of approaching it and you will have a refined approach to experimenting. When experimenting you can look at methods such as A/B testing to test two different versions against each other, running your initial investment idea alongside your experiment method to allow comparisons between the two.

Understand the market and your target customers: What is the size of the market – e.g. your potential customers – that you’re trying to target? For example, is it a small niche audience with a focused interest or does your product/service have wide appeal? Go further and slice the audience into distinct segments based on demographic (age, location, gender) and/or behavioural (interests) characteristics. This exercise will help to tailor your business proposition and target new customers more effectively, increasing the likelihood of generating a strong ROI.

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