The Purpose of the Return on Investment

The Purpose of the Return on Investment

Return on investment (ROI) is a ratio between the net profit and cost of investment resulting from an investment of some resources. A high ROI means the investment’s gains favorably to its cost. As a performance measure, ROI is used to evaluate the efficiency of an investment or to compare the efficiencies of several different investments. In purely economic terms, it is one way of relating profits to capital invested. Return on investment is a performance measure used by businesses to identify the efficiency of an investment or number of different investments.

Purpose 

In business, the purpose of the return on investment (ROI) metric is to measure, per period, rates of return on money invested in an economic entity in order to decide whether or not to undertake an investment. It is also used as an indicator to compare different investments within a portfolio. The investment with the largest ROI is usually prioritized, even though the spread of ROI over the time-period of an investment should also be taken into account. Recently, the concept has also been applied to scientific funding agencies (e.g., National Science Foundation) investments in research of open source hardware and subsequent returns for direct digital replication.

ROI and related metrics provide a snapshot of profitability, adjusted for the size of the investment assets tied up in the enterprise. ROI is often compared to expected (or required) rates of return on money invested. ROI is not net present value-adjusted and most schoolbooks describe it with a “Year 0” investment and two to three years income.

Marketing decisions have an obvious potential connection to the numerator of ROI (profits), but these same decisions often influence assets usage and capital requirements (for example, receivables and inventories). Marketers should understand the position of their company and the returns expected.

In a survey of nearly 200 senior marketing managers, 77 percent responded that they found the “return on investment” metric very useful.

Return on investment may be calculated in terms other than financial gain. For example, social return on investment (SROI) is a principles-based method for measuring extra-financial value (i.e., environmental and social value not currently reflected in conventional financial accounts) relative to resources invested. It can be used by any entity to evaluate the impact on stakeholders, identify ways to improve performance and enhance the performance of investments.

Risk with ROI usage 

As a decision tool, it is simple to understand. The simplicity of the formula allows users to freely choose variables, e.g., length of the calculation time if overhead cost should be included, or details such as what variables are used to calculate income or cost components. To use ROI as an indicator for prioritizing investment projects is risky since usually little is defined together with the ROI figure that explains what is making up the figure.

For long-term investments, the need for a Net Present Value adjustment is great. Similar to Discounted Cash Flow, a Discounted ROI should be used instead.

One of greatest risks associated with the traditional ROI calculation is that it does not fully “capture the short-term or long-term importance, value, or risks associated with natural and social capital” because it does not account for the environmental, social and governance performance of an organization. Without a metric for measuring the short and long term environmental, social and governance performance of a firm, decision makers are planning for the future without considering the extent of the impacts associated with their decisions.

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