Tuesday, October 26, 2010

Calculating Return on Investment for Small Business

Do you know what ROI is? If you’re managing a small business, then you definitely should! ROI stands for Return on Investment, or the benefit (or loss) that your investment has returned to you. Usually this is calculated in dollars and it’s figured over a certain amount of time. As I talk to more and more students and young entrepreneurs, I am often surprised and how many of them don’t know what a return on investment is or how to calculate it. ROI is business 101!

Let’s look at an example, say I started a business with a loan from the bank of $15,000. For now, don’t worry about the interest on the loan or when it has to be paid back, let’s focus on the ROI you’re getting from your investments in the business. Let’s say you use $1,000 to build a website and another $2,000 in the first month to advertise online and bring traffic to your small business via the website. What’s your ROI for that investment?

To figure it out, we first need to know how to calculate a Return on Investment. Well, it’s quite simple actually. Take the profit generated by the investment and divide it by the cost of the investment. (The profit generated by the investment is not the revenue. You must subtract the cost from the revenue to get the profit.) For additional help in the calculation, a really good definition can be found on Investopedia’s ROI page.

Now that we know how to calculate it, let’s break it down and find the ROI in our example. In order to find the ROI, we need to know how much business the website actually generated. So, let’s say you had a system in place that tracked where your leads came from and showed that $4,000 in sales closed because of the website. Now we can find the website’s ROI.

To calculate this month’s ROI, simply take the revenue generated from the website in the month ($4,000), subtract the cost of the website in the month ($2,000) and divide the result of that by the cost of the website in the month ($2,000). So you get something like this:

($4,000- $2,000)/$2,000 = 1 ROI

Now, what does 1 ROI mean? Well, notice how the dollar symbols are on both the top and bottom of the equation, so they cancel each other out leaving only a percent as a unit. This means that 1 ROI is a Return on Investment of 100%. That makes sense because you spend $2,000 and you got your money back plus another $2,000.

You may be wondering now why we didn’t include the original cost of $1,000 to build the website when we subtracted website costs. Well, the reason we didn’t is because of the way we figured our timeline and how we did our accounting. I don’t want to spend a lot of time in this small business article talking about accounting. But, I will say that I decided not to include it because that $1,000 was a cost that will continue to provide benefit well beyond the first month I run the website. Some people may want to include it but I find it more relevant to focus on the current costs that generated the current revenue. Because come next month, I won’t have to pay that $1,000 to build the website again.

I hope this small business article has been useful and if you have any questions about calculating return on investment, please leave a comment below. Please send this small business article to your friends and colleagues using one of the social media or email link buttons below!

(Image: Some rights reserved,  Keith Ramsey.)  

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