Understanding ROI ( Return on Investment ) and the ROI – Return on Investment which is often abbreviated as ROI is a profitability ratio that measures the efficiency of an investment by comparing net income with the total cost or invested capital. In other words, the Return on Investment or ROI measures the profit or loss resulting from an investment against the amount of money invested.
Please to also read What is Profitability Ratios and its types.
Return on Investment or ROI is one of the most commonly used approaches to evaluate the financial consequences of a business investment decision and action.
The ROI can be used for personal financial decisions, comparing company profitability or for comparing investment efficiency. If the results of the calculation of Return on Investment on an investment plan are positive and there is no chance of getting even higher ROI results then the investment can be done.
Basically, the Return on Investment or ROI is an important financial ratio for:
- Make asset purchase decisions (buildings, computers, vehicles and production machinery)
- Make funding decisions for projects and various types of programs (for example recruitment programs, training programs, and marketing programs)
- Make a stock investment decision or investment in venture capital
How to Calculate Return on Investment (ROI)
The following is a way to calculate Return on Investment (ROI) along with the formula and case examples.
Return on Investment (ROI) is calculated by subtracting investment costs from Total Revenue and dividing them by total investment costs. The results of this ROI calculation can be in the form of a percentage or ratio. The following is the equation or return on investment (ROI) formula:
ROI = (Investment Return – Investment Cost) / Investment Cost x 100%
Keep in mind that the definition and the formula for the rate of return on investment can be modified to suit the circumstances and basically is dependent on what is included as a return and cost.
For example, a production manager might use this ROI formula to calculate the rate of return for a production machine to be bought while an investor might use this ROI formula to calculate the Return on Investment in Shares. So in other words, the ROI formula can be very flexible depending on what you want to measure or what you want to show to your users.
Example of Calculation of Return on Investment (ROI)
The following are two examples of the calculation of Return on Investment or ROI.
An investor buys 50,000 shares at a price of $ 10 per share. A year later the investor sold his shares worth $ 25 per share. What is the ROI on these shares?
Investment Income = $ 1.250.000 (from the calculation of 50,000 x $ 25)
Investment Cost = $ 500.000 (from the calculation of 50,000 x $ 10)
ROI = (1.250.000 – 50,000) / 50,000 x 100%
ROI = 1.200,000 / 50,000 x 100%
ROI = 0,24
Return on Investment or ROI on the shares purchased by the Investor is 0,24.
A Production Manager wants to buy a packing machine for $ 160 million. With the packing machine, the production can save labor as much as 9 people. The salary for each worker is $ 3 million. What is the ROI for the packing machine for a year?
Investment Income = $ 324,000,000 (from the calculation of 3 million x 9 people x 12 months)
Investment Cost = $ 160,000,000,
ROI = (324,000,000 – 160,000,000) / 160,000,000
ROI = (164,000,000) / 160,000,000
ROI = 1,025 or 102.5%
So ROI or the return on investment of the Packing Machine is 1,025 times or 102.5%.
Analysis and Assessment of Return on Investment (ROI)
Generally, any investment that has a positive ROI value can be considered as an investment that gives a good return.
A positive ROI indicates that the total investment cost can be returned and can also make a profit from the remaining investment costs. While negative ROI shows that the income earned cannot cover the total investment costs incurred. Thus, it can be said that a higher rate of return or ROI will be better than a low rate of return or ROI.
The ROI calculation is very flexible and can be used for any investment. Company management can use the ROI to measure the return on invested capital, Investors can use it to measure the performance of the shares they invest while Individuals can use this Return on Investment to measure the return on their assets.