One of the important things that every business owner must have is to understand the meaning of ROI or Return On Investment or what is known as the overall rate of return on investment in a business that they do. In this article, we will discuss the meaning of ROI and how to calculate ROI and the formula that needs to be used.
The main reason for the importance of understanding ROI is because ROI is the most appropriate measure of business profits. By knowing the rate of return on investment, all operational activities can be evaluated for the rate of return on investment. Even some financial experts in Indonesia consider ROI as money or assets that are gained or lost in the investment process of a business.
In this case, investment refers to the purchase of assets, capital, and also the budget needed as an investment style. For a more detailed explanation, let's look at the information below:
What is ROI (Return On Investment)?
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Return on investment or ROI is the ratio of profits and losses from an investment which is then compared to the amount of money invested. Simply put, this understanding of ROI is the percentage of profit that can be obtained from the total amount of assets invested. Return on investment is a fairly effective way to see the effectiveness of a business.
ROI here is used to calculate how much funds are needed for investment. For example, if investors want to invest, then the ROI percentage can be used to convince investors to want to invest. In addition, ROI also calculates the company's actual financial potential to be able to divide income or profits by the amount of investment earned.
Calculation of ROI or return on investment is needed by investors. Indirectly, ROI will describe how much profit investors get when investing their capital in a business. For example, if we want to invest in a business with a minimum ROI percentage of 5 percent, then at least we can get the same profit percentage, or higher than what we invest.
ROI here is also used to measure the success of a project. For example, our company invests funds for a campaign program. The company will analyze the results from the sales obtained with the money spent on the campaign to determine the return on investment.
If the money generated is more than the amount of money spent, it can be concluded that the campaign program is profitable. However, if it's the other way around, it can be concluded that the campaign program is not effective and needs to be evaluated.
What Factors Affect Investment Returns?
There are two factors that influence the ROI calculation. Where changes in the value of one or both of these factors will also change the resulting ROI. These factors include the following:
1. Turnover Rate of Operating Assets or Operating Assets
The assets calculated here are those that are useful for operational activities or what are called operating assets. For example, buildings, equipment, money. to intangible assets such as patents. Meanwhile, assets in the form of investments and the like that do not directly impact operations are not operating assets.
Calculating the turnover rate of operating assets has a goal to see how far the company can utilize the various types of assets it has. In addition, this calculation can also help consider business development towards a more advanced direction.
2. Profit Margins
Meanwhile, profit margin can be interpreted as the ratio between net profit and net sales. That means, the two variables that are calculated are not included in the tax burden or the like. With this profit margin, the efficiency of a company will be known. The results of this profit margin calculation show how much profit is earned in 1 dollar of sales.
For example, the profit margin value is 25 percent, which means that 1 dollar seller contains 0.25 dollar profit. Therefore, the greater the calculation of the profit margin, the greater the profit obtained.
What is Benefit in ROI?
After understanding the meaning of ROI and several factors that influence ROI, now is the time to understand what the actual benefits of this return on investment are:
1. Efficient Use of Funds
The first benefit of this ROI is that when a company has implemented good accounting practices, management using this ROI analysis technique can measure the efficiency of the use of working capital, production efficiency, and also the efficiency of the sales department.
2. Knowing the Company's Weaknesses
The next benefit of ROI is being able to compare the efficiency of the use of capital in the company with other similar companies. So that it can be seen whether the company is below, the same, or even above average. That way, it will be known where the weaknesses are and what is already strong in the company compared to other similar companies.
3. Measuring the Profitability of a Company or Product
If a company uses a good product cost system, then from the calculation of capital and also costs can be allocated to various types of products produced by the company concerned. Then it will make it easier to calculate the profitability of each product produced.
4. As a Control Tool
The last function of ROI is as a control tool to see how current prospects are. So that you can get an idea of what steps the company can take next.
When Should ROI be Used?
The use of ROI can provide benefits as well as usability. But apart from that, there are also disadvantages that must also be considered. In doing calculations, we need to understand both so that there is no misunderstanding about the meaning of ROI itself.
1. Usability
Some of the uses of ROI that are quite useful for considering investment plans include:
- Companies can measure the efficiency of various aspects because of the comprehensive nature of ROI. These uses can be maximized if the accounting has been carried out properly.
- Can be used as a comparison with other companies if the industry ratio is known.
- As a basis for making investment decisions, be it in the form of purchases or funding.
2. Weaknesses
Apart from the uses mentioned above, ROI also has weaknesses. This needs to be considered so that the use of ROI does not make the company ignore other considerations. Some of the disadvantages of this ROI include:
- It is difficult to compare rates of return between companies that may have different accounting practices. This difference can lead to comparison errors.
- Fluctuations in the value of money can affect the profit margin calculation. This is because there is a difference in purchases made during inflation and when there is no inflation.
- Its effectiveness cannot be ascertained because it does not take into account the cost of capital. In fact, the cost of capital is also quite important to see the level of use of capital.
How do we Increase ROI?
The following are several ways that can be done to increase the value of ROI within the company, including:
1. Use A/B Testing
This A/B Testing is a method used to compare whether the strategy undertaken is in accordance with consumer needs or not. In increasing company or business ROI, we can do this A/B Testing on consumers.
So that we can test which types of campaigns have the potential to be developed and which campaigns need to be improved. The first thing we can do is to create several campaign strategies that will be carried out. The following are examples that can be used:
- Landing Pages
- Newsletters
- Content Marketing
- Business websites
Because, the most effective way to increase ROI is to increase brand awareness to potential new customers about our business and the products to be sold.
2. Set ROI Goals and Make a Well-Defined Plan
The second way to increase ROI is to set goals and also have a well-thought-out plan about future business prospects. Make smart, solutive, relevant, and innovative business goals so you can develop your business further and expand your target audience. The results of this ROI calculation can also be used as a guide in making projections and business strategies.
The ROI calculation value is quite important for marketing activities to consider and adjust profits with greater business potential. Apart from that, we also have to pay attention to details such as tax calculations and inflation estimates that will occur in the previous period with the data we currently have.
3. Determine Unique Selling Products (USP)
Find and define Unique Selling Products from the products and also the business that we run. It should be understood that this USP will be very helpful in attracting new investors or potential customers to our business.
The more relevant and solutive our USP is, the more helpful it will be in differentiating our business from competitors. This will certainly help in increasing the value of ROI in the business.
For example, when we have a Cloud Kitchen business, where this business trend is indeed on the rise and many people are interested in investing in this business. Steps that can be taken is to create new innovations and not yet owned by other competitors. For example, we add a place to dine in or other innovations so that our business has more USP value than competitors.
4. Explore Other Marketing Channels
The ideal strategy that can be used to increase ROI is by using other marketing channels. For example, it can be like using a website, creating a newsletter, doing offline marketing, to using social media to attract new audiences.
We can try exploring these marketing channels and then find out using analytical data, on which platform our business gets the most impressions or conversions. If we have found the right platform, then we can immediately study the platform and develop an appropriate content strategy so that we can achieve the desired goals.
How do you Calculate ROI on an Investment?
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To better understand what ROI is, it's important to understand how it's calculated. This ROI calculation can be done with a simple formula. That is enough to know how much the investment costs to be incurred and the income to be received.
Even though it's simple, you have to be more careful when entering numbers into the formula. It could be in practice, there are differences in terms. Even though the point is the same. Below is a formula that can be used to calculate ROI.
ROI= (Investment Income-Investment Cost)/Investment Cost X100%
In addition, also determine the time to pay back the fee. It is useful to provide limits on the calculations performed. Revenue estimates can also be known more clearly.
What is an Example of a Return On an Investment?
To further clarify regarding the formula mentioned above, it is necessary to have an example of its application in a particular case. The following are some examples of cases that have similarities to the real cases being faced, including:
1. First Case
Company A wants to buy a tool that can do the work originally done by 12 human workers. The price of the tool is 250 million dollar, while the salary of each worker who wants to be eliminated is 3.6 million dollar. To calculate ROI for one year, the calculation is:
Investment income is the amount of salary that can be eliminated. This means that the calculation is 12 x 3,600,000 x 12 = Rp. 518,400,000.-. While the investment cost is the purchase price of the equipment, which is USD 250,000,000.
ROI = (518,400,000-250,000,000)/250,000,000×100%= 268,400,000/250,000,000×100%= 107.36% or 1.0736.
The ROI value above exceeds 100 percent, which means it can cover the capital spent on the tool. This means that the purchase of the tool can be considered. Because, according to ROI calculations, this tool can provide benefits.
2. Second Case
Company B invests 200 million dollar in the business of selling musical instruments. The profit from the sale was 280 million. Thus the ROI calculation is as follows:
ROI = (280,000,000-200,000,000)/200,000,000 x 100%= 80,000,000/200,000,000×100%= 40% or 0.4.
3. Third Case
Company C spent 5 million dollar to advertise its product. From the ad, there were many positive responses and 150 of them were interested in buying it. The company also received sales proceeds worth 8 million dollar.
Here we can see that the investment income is 8 million dollar and the investment cost is 5 million dollar:
If entered into the formula, then:
ROI = (8,000,000-5,000,000)/5,000,000 x 100%= 3,000,000/5,000,000×100%= 60% or 0.6.
Conclusion
This is an explanation of the meaning of ROI (return on investment) and how to calculate it. For those of you who want to know more deeply about other investment sciences, you can read related books about ROI.
So, that's a complete explanation about the ROI that Erzedka's team has summarized this time. Hopefully this article can add to your insight on this matter. Thank You