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How to Calculate Return on Invesment (ROI)

Return on Invesment as the name suggests is a financial valuation method that determines the percent of return investors are getting from their portfolio of investments. Return on Investment is probably one of the most important ratios that companies need to keep track of in order to determine the viability & continuity of their business.Measuring profit margins of products being sold is not enough to continue doing business, companies have to ensure the amount of capital that is being put in to the business is attracting sufficient sales & providing a good return on capital invested.

As a rule of thumb, if the ROI is too low, this means the product lines are not generating enough sales worth running the business and deploying overhead costs, thus in the long term the product line is deemed to fail. The formula for Return on Investment is:

 ROI = Net Income / Book Value of Assets

An alternative formula for ROI is:

 ROI = Net Income + Interest (1 - Tax Rate) / Book Value of Assets

Another formula that small investors use to calculate ROI is:

 ROI = (Gain from Investment - Cost of Investment) / Cost of Investment

For instance, assume you are the VP of a long distance phone company that does a marketing campaign to generate new buyers of its long distance phone cards. The company sells each phone card for \$5, and does an advertising campaign on the radio/television worth \$500,000. This campaign helps the company sell an additional 155,500 long distance phone cards off its distribution networks. What is the ROI?

 ROI = (Gain from Investment - Cost of Investment) / Cost of Investment Gain from Investment = 155,500 cards x \$5 = \$777,500 Cost of Investment = \$500,000 ROI = (\$777,500 - \$500,000) / \$500,000 ROI = \$277,500 / \$500,000 ROI = 55.5%

That's a pretty impressive number hey, 55.5%? Well most small business managers forget to factor in the costs they incurred to produce that extra revenue generated from the advertising campaign. For instance, say this long distance phone company incurred an extra \$200,000 in costs to produce those 155,500 phone cards which includes phone network fees, vendor distribution expenses, selling & general admin expenses, etc. How will this additional information change our ROI calculation?

 ROI = (Gain from Investment - Cost of Investment) / Cost of Investment Gain from Investment = 155,500 cards x \$5 = \$777,500 Cost of Investment = \$500,000 + \$200,000 ROI = (\$777,500 - \$700,000) / \$700,000 ROI = \$77,500 / \$700,000 ROI = 11.1%

Now see how drastically our ROI number changes? It drops from a whopping 55.5% to 11.1% thanks to the additional information we input. The lesson here is always be careful when calculating your Gain from Investment because most business managers forget to include the Cost incurred to obtain that gain, in our case the additional \$200,000 of fixed costs incurred on top of the \$500,000 we paid to radio/broadcasting networks for the advertising campaign.