Return on Investment (ROI) - Explained
What is a ROI?
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Table of ContentsWhat is Return on Investment?Example of Return on InvestmentHow is Return on Investment Used?Academic Research on Return on Investment
What is Return on Investment?
Return on investment (ROI) is a profitability ratio used for measuring the amount of profit generated by an investment relative to its cost. It evaluates the cost efficiency of an investment and is expressed as a percentage or ratio. It is calculated as the return of an investment divided by the cost of the investment. The formula for computing the ROI is,
ROI = Profit Margin / Cost of Investment
ROI = (Gain from Investment - Cost of Investment) / Cost of Investment
The gain on investment is the increase in value of an asset. The gain on investment minus the cost of investment is known as the profit margin.
If the investment is in products to be sold (rather than a single asset), then you will need to know the total quantity of goods purchased for sale and the total sales volume. This is important, as the cost of investment will include all products purchased. Your profit margin will be determined based upon how many items you sell.
Example of Return on Investment
For example, if an individual invests $1000 for 100 units ($10 per unit) of inventory. After a year, he or she sells the inventory at retail for $15 each of $1500 if all are sold. Then the profit margin is $5 per unit ($15 - $10 = 5) above the value of the initial cost or investment. Thus, the return on investment is $5/$10=0.5 or 50% per unit. To calculate the ROI for the entire investment, you will need to know the sale volume.
If you sell all of the product, your RIO is 50%. If you sell less than the entire amount of inventory, the ROI will be less. For example, if you sell 90 units, the gain on investment is $1350 (90 x $15 = $1350). The ROI is then 350/1000 = .35 or 35%.
How is Return on Investment Used?
ROI is used for comparing returns from various investments that allow the investor to invest their capital efficiently. It is the most common indicator used across different types of investments. It is easy to calculate the ROI because of its simplistic nature; although, for companies it is a bit more complicated when there are several inputs. The investors compare the ROI of different investments and it is always better to go for a higher ROI. Negative ROI depicts a loss, so those investments should be avoided. ROI allows the investors to make an informed decision when investing their money. It is important for investors to use the same inputs for calculating ROI while comparing different investments. One shortcoming of comparing ROIs of similar project is it doesn't take time into consideration.
Suppose, an individual invests $2,000 to buy stocks of a company. One year later he sells it at $2400. The profit from the investment is ($2,400-$2000) = $400 and ROI is $400/$2000= 0.2 or 20%. Then the same individual buys stocks of a company with $4000 and sells those shares in the market 3 years later at $4800. His profit from the investment is ($4800-$4000) = $800 and the return on investment is $800/$4000=0.2 or 20%. So apparently the ROI is the same for both the investments, but in the first case it took only one year and in the second instance it took three years. So, the first investment is more profitable than the second one although the ROI is the same for both.
Thus, ROI provides a simplistic estimate of the profitability of an investment. As such, other indicators must also be taken into account when comparing different investments. The Rate of Return or Net Present Value can be used along with ROI to get a more accurate estimate.
Academic Research on Return on Investment
- Expatriate return on investment in the Asia Pacific: An empirical study of individual ROI versus corporate ROI, McNulty, Y., De Cieri, H., & Hutchings, K. (2013). Journal of World Business,48(2), 209-221. This paper presents return on investment (ROI) as a critical aspect of expatriate management and majors mostly on the organizational perspective of this phenomenon. It uses interviews with 31 long-term expatriates in 10 Asian countries to examine the extent to which individual ROI influences corporate ROI. It also investigates the challenges and opportunities to individuals and organizations alike that arise from expatriation in the Asia Pacific.
- Measuring return on investment(ROI) of organizations' internal communication efforts, Meng, J., & Berger, B. K. (2012). Journal of Communication Management,16(4), 332-354. This study investigates how the senior communication executives compute the effectiveness of the internal communication efforts of organizations and link them with business performance. The results suggest that a majority of the business communicators and organizations realized the importance of measuring internal communication initiatives. However, the study uses limited metrics in the assessment process.
- There turn-on-investment(ROI) process: Issues and trends, Phillips, J. J. (1998)...Educational Technology,38(4), 7-14. This article takes a rational approach to ROI and implements a relevant mix of evaluation strategies after understanding the drivers for the ROI process and its inherent weaknesses and advantages. It also explores its use in education and training. It also investigates the various perspectives of individuals towards ROI where some regard is as very flawed and inappropriate while others regard it as the answer to accountability.
- A new model for measuring return on investment(ROI) for safety programs in aviation: an example from airline maintenance resource management (MRM), Taylor, J. C. (2000) (No. 2000-01-2090). SAE Technical Paper. This paper develops a new ROI model to compare and evaluate the new and quickly evolving aviation maintenance resource management (MRM) programs. This model is easy to understand and apply and is essential since it will allow airline maintenance employees to identify the financial advantages of these safety initiatives and therefore plan accordingly.
- What's the return on ROI? The benefits and challenges of calculating your library's return on investment, Matthews, J. R. (2011). Library Leadership & Management,25(1). This study details how various libraries have tried to improve the discussion of the value of the public library by preparing a return on investment (ROI) analysis. This ROI is used in the estimation and the comparison of the costs and benefits of a particular undertaking. ROI calculates the total value of the public library to the residents of a community by summing up the use and non-use benefits.
- The effect of return on equity (ROE) and return on investment(ROI) on trading volume, Ichsani, S., & Suhardi, A. R. (2015).Procedia-Social and Behavioral Sciences,211, 896-902. This paper presents Return on Equity (ROE) and ROI as indicators in profitability ratio. This is because these two utilize net income as a benchmark when measuring profitability. ROI and ROE also affect the volume of trade but give weak results. However, the paper also states that the investors don't only look at the profitability factor which is presented by the ROE and ROI.
- Strategies to optimize return on investment(ROI) through effective reverse supply chain programs, Lee, J., & Lund, M. (2003, May). InElectronics and the Environment, 2003. IEEE International Symposium on(pp. 335-340). IEEE. This is a study that shows that companies spent over $35 billion a year in handling reverse supply chain challenges and issues back in 2000. The results can reduce the profit margin on the cost of goods when failed to be managed effectively and efficiently. The study presents a model that maximizes the OEM's return on investment.
- Return on investment(ROI): Calculating the monetary return of a leadership development program, Rohs, F. R. (2004). Journal of Leadership Education,3(1), 27-39. This article discusses the ROI of the Southern Extension Leadership Development (SELD) program that was implemented in the University of Georgia. The ROI model that was proposed by Phillips is used. The results from data analysis suggest that the employee turnover rate for the participant group was lower than for the non-participant group.
- Corporate Reputation andReturn on Investment(ROI): Measuring the BottomLine Impact of Reputation, Kim, Y., & Yang, J. (2013). The handbook of communication and corporate reputation, 574-589. This article focuses on economic returns as the meaning of bottom-line contribution. It discusses the need for ROI measurement of communication in terms of communication evaluation. It also presents the results of a replication study with the current data. The article suggests that future empirical research should be broadened to include the preventive effect of reputation and how it is essential to the bottom line.
- Return on Investment(ROI) training evaluation in Malaysian SMEs: factors influencing the adoption process, Satiman, L. H., Abu Mansor, N. N., & Zulkifli, N. (2015).Development and learning in Organizations,29(2), 18-21. This research majors on the importance of return on investment within various training programs in Malaysian small and medium enterprises. The research attempts to identify the determinants that may influence the adoption and application of Return on Investment in the present training evolutionary practice.
- Return on investment(ROI), Sandborn, P. (2013). InCost Analysis of Electronic Systems(pp. 329-348). This paper explains that forming an ROI is accompanied by investing money in a financial instrument but that calculating ROI involves the generation of an increase in the customer base, cost savings or future cost avoidance and this is not easy to do. The paper discusses the formulation and also the application of ROIs to various activities that are essential to the management and manufacturing of electronic systems.
- The Use ofReturn on Investment(ROI) in the Performance Measurement and Evaluation of Information Systems, Andru, P., & Botchkarev, A. (2011). This study shows a broad variety of approaches to computing ROI of an information management system. It also presents various strong examples of the application of ROI. The study states that despite the focus of the presentation being made on the information systems, a majority of considerations of ROI use are generic and can be applied in all fields.