A man and a woman sit at a long desk or table, which holds various papers, a few salmon-colored post-it notes, and an open laptop with a screen showing several different types of graphs. The man is wearing a blue plaid shirt; he uses a pen to point at a paper in front of him on the table. The woman wears a brown-and-white patterned shirt and has her hair held up with a clip. Her face is turned away from the viewer to look at the man.
ROI is a useful way to quantify the revenue brought in through a certain action, investment, or expense. — Getty Images/Drazen_

Return on investment (ROI) is a percentage or ratio comparing your costs of an investment to the revenue generated. Often, small business owners will forecast their expected ROI before making a business decision, such as a technology or equipment purchase. Marketers also use ROI to determine if a technique or campaign earns more revenue than it costs.

Although the ROI formula is simple, some expenses are harder to define, and you may need to measure additional metrics to get a complete picture. However, ROI is an invaluable metric for understanding the impact of an investment. Learn what ROI is and how (and why) to use it.

ROI: meaning and formula

ROI calculates your return on investment compared to what you put in (your total costs). It’s a profitability metric expressed as a percentage or ratio. ROI doesn’t analyze a time period, which differs from the rate of return (ROR) metric that looks at a specific time frame. The standard ROI equation is: net profit (profit minus cost) divided by the total investment cost. Alternatively, you can look at your gains and expenses. This ROI formula is: (gains minus costs) divided by costs. Multiply the result by 100 to get a percentage.

The ROI formula is flexible, and many vendors offer interactive calculators for measuring different returns. PageUp focuses on performance management for human resources (HR). It helps you calculate the ROI of increased workforce productivity, turnover reductions, and time saved. HubSpot’s ROI calculator shows the benefits of using its software, and financial comparison services like Bankrate provide calculators for long-term investment goals.

You can use ROI to estimate your expected return and again after the project is completed to see your actual return. Another way to look at your ROI for marketing purposes is to calculate the benefits minus the cost, then divide it by your total expenses. In all cases, a positive number means you got your money back and then some, whereas a negative figure shows a loss.

[Read more: Small Business KPIs: What Are the Numbers That Matter?]

Although the ROI formula is simple, some expenses are harder to define, and you may need to measure additional metrics to get a complete picture.

When to use the ROI metric

Can upgrading equipment increase your capacity, profit margins, or competitiveness? Did your latest social media campaign generate enough leads to cover your marketing expenses? How much money will installing energy-efficient windows in your office save you? Although a cost analysis is critical for each objective, the ROI metric can give you a quick estimate and help sell your idea to stakeholders or leaders.

The bottom line is that you don’t have money to spend on endeavors that don’t pan out. ROI is a simple way to see if you’re losing financial resources. Calculating the return on investment is relatively easy and flexible. You can compute the return for your business as a whole or focus on specific activities or departments. Small businesses also use ROI for prioritizing investments.

For example, you can spend $500 to increase sales of a high-value product or $500 to generate leads. Your staff estimates the product campaign will yield 10 sales totaling $2,000 within the first week. Conversely, the lead generation promotion will add 70 new sales leads, equaling $2,800 — based on the estimate that one lead equals 20% of the net profit on a sale. In this case, generating leads has a return of 406%, whereas product sales have a 300% return.

[Read more: 7 Ways to Build An Effective Marketing Strategy On a Budget]

Constraints of using ROI for analysis

Although ROI benefits businesses, it doesn’t give a complete picture, nor is it as precise as other metrics. First, ROI doesn’t specify a time frame. Therefore, your ROI for 30 days can be significantly different from an annualized figure. Secondly, your pre-investment ROI will be less accurate if you don’t fully understand your future business expenses. Newer companies with more variables may have trouble calculating their return on investment.

And most importantly, ROI estimates your project’s financial success but doesn’t account for other factors, such as employee satisfaction rates. There are certainly cases where your ROI may be low or nonexistent, but the venture still has value. Completing a cost-benefit analysis allows you to factor intangible benefits and costs into your investment decision.

CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.

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