One of the reasons I really enjoy writing about ROI (Return on Investment) is because this ranks as one of the most important strategic decision-making skills a business owner can have. Without it your decision-making isn’t rooted in science and you tend to follow a lot lesser decision-making drivers including something being trendy, your gut or instincts etc. And let’s examine the idea of making purchases based on your gut or instincts, because I don’t want to say there is anything entirely wrong with that. Lots of successful entrepreneurs point to making intuitive decisions as part of their success. However there are times when this approach makes more sense than others. Like using intuition to decide between two options when all your analysis says both options are similar. Or choosing a riskier choice out of two options because your feel confidence in being able to navigate the risk involved. What you’ll find is that a lot of the clarity in decision making comes from data, and how we calculate data, and there are times when doing this process can rule out bad decisions. Let’s say we’re about to making an investment and we imagine the returns will be “really great, because I’m so excited about this direction”. Well, maybe your excitement is having a shiny new toy to play with, like the time I invested $7,000 into a milling machine for turning logs into lumber. Although it was a nice idea, and could have paid off financially in the long-term, short-term it meant spending more money than I had ever spend on lumber and in fact I could have bought all the lumber I needed for building my tiny home, at a store 20-minutes away for a couple of thousand dollars. The ROI if it was there at all, was a long-term ROI. Short-term, I had created a lot of new costs, sunk funds into something that didn’t have an significant upside, and created a new job for myself as a unpaid miller risking his limbs for $0 per hour. It was a nice shiny toy to play with though, and if only I could have monetized the videos of holding up slabs of walnut freshly milled maybe it would have worked out. Instead I sold the equipment a few months later at half cost as I abandoned the entire failed project.
Learn from my mistakes friends, don’t skip ROI calculations even in situations where you’re driven by enthusiasm for a direction. Doing ROI calculations isn’t about completely shutting down a direction, it can often be about making the right choices inside of an overall direction. For instance I might say I’m planning to expand our focus on SEO, I want to do that, I see benefits to doing that… but the question is what tools are worth buying in that space? There are vast differences in the costs of tools, and what about services in that area, should we be hiring a specialist, a consultant, a full-time or freelance SEO focused marketer to join our team? The costs can range here from very minimal all the way to taking on thousands of dollars per month in new expenses over the long-term. It’s hugely important to weight each option using ROI calculations.
A simple introduction to ROI calculation
In it’s simplest form ROI is your total profit divided by your investment. If your profit is $50,000 and you’re investment was $100,000 then we divide the profit (P) by investment (I) to get the return (R).
P / I = R
We can then multiple R (return) by 100 to get this as a percentage which is how ROI is often presented and communicated in reports. Let’s run our 50K profits on a 100K investment using this formula:
$50,000 (P) / $100,000 (I) = 0.5 (R)
Then 0.5 (R) multiplied by 100 equals 50% ROI.
Factoring Expenses Over Time into ROI Calculations
The textbook explanation of ROI can be frustratingly unhelpful in the real world. Because the simple formula P/I = R or ( P / I = R ) * 100 = ROI, this simple formula only helps us if we know the value of P and I with some level of precision. In the real world we often have difficulty calculating these figures even for an existing business, let alone for a projected investment. And what about when you’re trying to isolate one investment decision that is part of a larger business?
Before we think about too many problems at once let’s focus on expenses that increase our investment. This is very common. We start with let’s say a piece of equipment or a new software license. Then we hire somebody to consult or help us do part of a project. Then we have some ongoing costs associated. All these need to be tracked if we are to be able to say definitively, this is the accurate value of “I” in our ROI calculation. And if we’re going back in time to examine an investment, we have to do our best to aggregate all applicable costs accurately.