Business Finance
ROI Methodology
Return on investment (ROI) is a valuable business decision-making tool. But before you can calculate ROI, you need to understand basic ROI methodology.
Whether they realize it or not, most business leaders incorporate some level of ROI analysis into their decision-making processes.
For example, no leader in his right mind would commit resources to hiring a new employee unless he believes the new worker is capable of providing a financial benefit that is at least equal to the cost of the new hire's salary and benefits.
As the stakes increase, the value and complexity of ROI analysis rises dramatically. It's not unusual for leaders who engage in high-risk decision making to spend days or even weeks calculating the potential return on a single investment decision.
But whether you're making multi-million dollar business dealers or choosing a new office copier, the methodology behind ROI analysis remains the same. As a cost-conscious small business owner, you can't afford to remain in the dark about ROI - here's what you need to know.
Basic ROI Formula
ROI is designed to calculate the net benefit of a decision as a factor of its total cost. In its simplest form, the ROI formula is: (Benefit - Cost)/Cost. To express ROI as a percentage, you then multiply the result by 100. So for something with a 40 unit benefit and a 20 unit cost, the formula would look like this: (40-20)/20*100 for a total ROI of 100%.
The advantage of translating ROI into a percentage is that you can use it to compare decisions with diverse units of measurement. For example, if one decision is based on dollars and another is based on labor hours, you can use an ROI percentage to accurately assess their relative impact.
ROI Variables
The effectiveness of ROI methodology depends on the accuracy of the inputs or variables that are applied to the formula. This can be challenging because it is sometimes difficult to forecast and quantify benefits and/or costs. For example, let's say you have to make a decision whether or not to increase the size of your staff by one additional employee. Quantifying the cost of the decision is relatively straightforward; it's a simple tabulation of the cost of the new worker's salary and benefits.
Calculating the benefit will be more challenging. Although you hope the new worker will generate at least enough additional revenue (or reduce enough costs) to justify his cost to the business, that may not be an accurate assumption. For the sake of accuracy, ROI analysis is often accompanied by productivity studies and other analyses that produce accurate variables and inputs.
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