What is return on investment (ROI)?
Return on investment, also known as ROI, is a metric that expresses the profitability of an investment relative to its cost. Expressed as a ratio or percentage, ROI shows how much profit is gained for each dollar a company invests in a project.
ROI helps businesses evaluate a project’s success and compare the returns of different investments to discover which ones are the most lucrative. Companies calculate and analyze ROI for a wide range of investments, from developing new products to purchasing equipment.
Many companies turn to financial analytics software to track and manage their investments. This tool helps them monitor ROI and other financial data and build comprehensive portfolio reports.
How to calculate return on investment
When calculating ROI, a business divides an investment's net profit or loss by its initial cost. In other words, the formula for calculating ROI is (Net Profit / Cost of Investment) x 100%.
ROI = (Net Profit / Cost of Investment) x 100%
A business subtracts the cost of the investment from its final value to find the net profit. The final value includes income generated by the investment and any appreciation in value.
For example, a clothing company invests $1,000 in pay-per-click (PPC) ads and makes $3,000 in sales as a direct result of those ads. Their net profit is $2,000. Then, they divide $2,000 by $1,000 to get an ROI of 2, or $200%. This means that for every dollar they spent, they made $2 in profit.
Benefits of calculating return on investment
Businesses calculate return on investment to evaluate the success of investments and steer their decision-making process on future outlays. Specific advantages of calculating ROI include:
- Quantifying effectiveness. To optimize their growth, companies need to evaluate which projects and investments are “moving the needle” the most. Return on investment provides a clear measure of how well a company’s investments generate profit. This helps businesses determine whether investments are worth it and if they should continue investing in similar projects.
- Comparing opportunities. Companies can use return on investment as a benchmark to evaluate the potential returns of each initiative and compare them. For example, if a company is considering investing in two projects, it can estimate the ROI of each and then prioritize the one that will be more lucrative.
- Allocating resources. ROI helps companies make informed decisions about resource allocation. By analyzing the ROI for different departments or projects, a business can identify areas that require more investment and adjust its budget accordingly.
Best practices to increase return on investment
Every business hopes to boost its return on investment by reducing costs or increasing revenue. In many industries, that’s difficult, especially when margins are already tight. Organizations of any size can try:
- Automating more processes. Automating tasks and functions with software saves time, which means decreased labor investment, often one of a company’s highest costs. For instance, companies can use marketing automation software to send automated email campaigns, texts, or digital ads and evaluate their effectiveness with built-in analytics.
- Reaching more of the right customers. One way to see a better ROI is to acquire new customers. A business might allocate a portion of its existing marketing budget to new channels, moving from digital ads and engagement on social media. Or, a company might work to improve targeting, ensuring they aim their ads at customers in a specific demographic or stage of readiness.
- Cutting materials costs. For e-commerce stores and direct-to-consumer retailers, materials costs add up fast. Companies may be able to negotiate with suppliers for a better deal or switch to a new supplier altogether.
Return on investment vs. return on equity
Return on investment and return on equity (ROE) are both financial metrics that measure a company’s performance, but they measure different things.
Return on investment measures the profitability of an investment in general. The metric shows how much profit is earned per dollar invested in a project or initiative. A company uses ROI to evaluate performance in various areas – from the collective profitability of a quarter’s investments to returns on specific projects.
On the other hand, return on equity shows the profitability of shareholders’ investments. To calculate ROE, a company divides its net income by the average shareholders’ equity during a specific period. The resulting figure shows how much profit the company generates for each dollar of equity that shareholders invest.
In summary, ROI measures an investment’s profitability, regardless of how it’s financed, while ROE measures the specific profitability of shareholders' equity.
Dig even deeper into shareholders’ equity and how to calculate return on equity.
Kelly Fiorini
Kelly Fiorini is a freelance writer for G2. After ten years as a teacher, Kelly now creates content for mostly B2B SaaS clients. In her free time, she’s usually reading, spilling coffee, walking her dogs, and trying to keep her plants alive. Kelly received her Bachelor of Arts in English from the University of Notre Dame and her Master of Arts in Teaching from the University of Louisville.
