Improving Return on Investment (ROI)

ROI is a measure of financial performance used to gauge the profitability of an investment. It’s often referred to as the rate of return. ROI is usually expressed as a ratio (or percentage) of the money gained or lost on an investment divided by the cost of that investment. For most businesses, the gain is normally called net income or profit. The investment cost is usually called capital, principal, cost basis, or asset value.

The beauty of ROI is that you can adapt its calculation to your specific business. The danger is that the calculation can be manipulated to produce a distorted picture of reality. Because of this, it doesn’t make sense to compare your business’s ROI against those of your competitors, unless you know the methodology the competition is using.


There’s no “right way” to do the calculation, but the overall goal should be to achieve the most favorable returns possible over time. In broad terms, you want the output to accurately portray the profitability of an investment.

Examples

Marketing – One way to measure the success of a marketing campaign is to divide a product’s profit by its marketing expense. This allows you to compare the ROI for two different products to see which campaign produced the best results.

Financial Analysis – Another way to compare the same two products is to divide the profit by the cost of all resources used to manufacture each product. This provides a measure of how efficiently you are using your company’s resources. By making this comparison, you might decide to produce greater quantities of one product and smaller quantities of the other.

The second example can be modified by altering the makeup of the “costs” used in the calculation. This is why it’s crucial to understand the inputs to the calculation and what they represent.

Big Picture

The goal of any business is to maximize profit while minimizing the amount of investment required to produce that profit. There are three basic approaches for improving ROI.

1. Increase sales/revenues

This is accomplished by increasing the quantity of products sold and/or raising their prices. If you can make and sell more products without investing more money, then those added profits go straight to your bottom line. If additional investment is needed for space and equipment, then there’s a tradeoff between the additional return and the added cost to gain that return. If you need more space to expand, only rent what you need and negotiate aggressively for the best terms possible.

Any price increases must address the law of supply and demand since increasing the price may decrease the quantity sold. In fact, decreasing the price could actually produce more revenues because of higher sales volume.

2. Reduce costs

Since every small business is different, you should look for creative ways to cut your expenses and increase productivity. One area to seriously consider is technology. Use teleconferencing to reduce travel costs. Create a standout website that offers online ordering and payment options. Online marketing campaigns are easy to set up and relatively inexpensive when compared to traditional marketing. Use social media to promote your business and network with potential customers.

Go paperless to the extent possible. Maintain electronic files and back them up continuously. Services available for automated backups cost about $50 per year. Your invoice and payment systems should be completely digital to avoid the cost of paper, ink, and postage. Only purchase software that you know you will use.

Pay down your debt on a regular basis. While debt makes sense to get your business going and expand capacity, your long-range plan should be to pay it off to reduce interest costs. Pay off high-interest debt like credit cards first.

Instead of buying new equipment, search for quality used equipment that’s usually far less expensive. Many companies also sell discounted, refurbished equipment that comes with a warranty. This is a good way to obtain furniture, tools, and other items you need to run your business. Explore bartering as a way to reduce actual cash outlays.

Perhaps most important is to prepare a budget and track actual performance against it. If you don’t know where your money is coming from and where it’s going, it will make it very difficult to control costs effectively.

3. Reduce operating assets

These are long-lived assets that facilitate your business and are not for resale to customers. They are commonly known as property, plant, and equipment. Minimizing the amount and size of plant or fixed assets is beneficial to the bottom line.

The major cost drivers are land and all improvements, fences, buildings, parking lots, driveways, signs, furniture, vehicles, and factory and office equipment. By owning fewer operating assets, you also save the cost of maintenance, repair, and replacement.

Summary

ROI is a popular and useful metric because of its simplicity and versatility. Unless an investment generates a positive ROI that exceeds other possible investments, it’s probably not a good idea to proceed. It’s a useful decision-making tool because it provides an objective, numerical comparison of investment options.

Another factor to be considered is your time. For any small business owner, time is money and it represents a huge investment in your business. Smart investments that allow you to spend most of your time on important things are likely to produce a high return.


Michael Sanibel is a freelance writer specializing in business, marketing, personal finance, law, science, aviation, sports, entertainment, travel, and political analysis. He graduated from the United States Air Force Academy and is also licensed to practice law in California and New Hampshire. Michael wrote this feature article exclusively for Debbie May.com (www.DebbieMay.com), an organization dedicated to helping small businesses succeed.