By CFO Brew Staff
less than 3 min read
Definition:
Business leaders know it costs money to make money. But it’s worthwhile to know exactly how much money a company made from a specific strategy. Being able to see the quantitative results helps companies make better decisions in the future and champion the ventures that will precipitate profits.
Return on investment, or ROI, is a simple way to evaluate the success of a project. ROI is the profit generated by an investment compared to its cost. It’s calculated as a percentage using the formula below:
Investment’s current value - costs of investment
Cost of investment
The cost of investment should include the initial capital expenditure and ongoing maintenance costs. While a relatively simple formula, ROI can give you the tools to put data behind the strategic decision to spend or not spend money. If the ROI is positive, that’s usually a sign it was a good investment. If it was negative, that might be an indication to cut your losses. ROI is a tool that should help investors and business leaders understand what investments panned out, where to invest more money, and eliminate cost centers that aren’t creating worthwhile profits.
ROI can be used to evaluate everything from a marketing campaign, to AI, to building a new factory.
- What ROI doesn’t factor in? ROI is a rudimentary calculation. It doesn’t factor in a whole host of other important data points. One of these is the investment duration—the time it takes for the investment to start returning value. Longer-term investments will usually require more money and will take longer to see a return, but their returns might be higher, justifying the cost. Shorter-term investments might require less lift, be more flexible and easier to unwind if they don’t turn out to be successful. But they also might have less of an upside.
ROI also doesn’t take into account a company’s risk tolerance. Some companies might want to prioritize stable, predictable investments, even if it means settling for smaller returns. Others might be comfortable trading security for higher gains, knowing their investment could be a failure.
ROI also does not factor in opportunity costs, or the costs of pursuing a different course of action with the funds set aside for this project.
Social return on investment. Sometimes it’s not about the money. A social return on investment has started to gain traction with some companies. These are investments that, while they might cost more or not bring in higher revenue, are worthwhile for environmental, social, governance, or reputational reasons. They might not bring in more profit, but they provide a non-monetary value. Examples of social investments are using recycled water or replacing a gas fleet with electric vehicles. These outcomes are better for the planet and might never bring in more money.
