What is ROI?
Definition of ROI
Return on investment is defined as the measurement of gain generated by an investment relative to the original cost.
To put that in simple language, if you make an investment you will be hoping that to make a gain on that investment. ROI is a way of calculating that gain.
When is ROI useful?
Calculating ROI is useful in many business situations.
For projects it can be useful in several scenarios.
#1 Developing a business case
It can be useful to calculate ROI when developing the business case for a project. A business case is all about justifying the need for the project, providing options and demonstrating benefits. For more on business cases you can read our post http://easyprojecthub.com/what-is-a-business-case-and-why-do-i-need-one/
#2 Comparing investment options
ROI can be used to compare investment options or options within the business case. By calculating ROI for each option you will have a measure that you can compare.
#3 Input into strategic decisions
ROI can be an input into strategic decisions. It can also be implemented as a performance indicator, in other words used to measure whether a project met its objectives in terms of delivering gain on original investment.
How to calculate ROI
ROI is expressed as a percentage.
ROI = 100 x [Net Profit / Cost of Investment]
Net profit is the total worth of an investment at the point of sale, or at the point you are calculating the ROI, minus the original cost of investment
Net profit = [Total worth of investment at point of sale] – [Original cost of investment]
Limitations of ROI
#1 Does not consider the time element
ROI does not consider the time element. In other words, if your net profit is £500 and your cost of investment was £100 after 1 year your ROI would be 500%. If you had the same figures after 30 years it would still be 500%.
#2 Does not take into account non-monetary investments
ROI does not take into account non-monetary investments, for example, investments that increase the business value
#3 Does not take into account differing accounting methods
Accounting methods can significantly affect ROI, which makes it difficult to make comparisons across companies. It is good to be explicit about what accounting methods and numbers you have used when calculating ROI. If you are using ROI to do a comparison ensure the figures are equivalent. For example, does cost of investment refer to the initial outlay or does it include costs incurred through the duration of the investment, such as ongoing support or fees?
In summary, ROI is a useful calculation that can be used to drive decision making and measure relative success. Be clear on how you are using it to ensure that you are getting meaningful figures.
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