Return on investment is the gain from a spend, divided by the spend. Put a thousand in and get twelve hundred back, and the return is twenty per cent.
It exists to make unlike things comparable: a van, a hire, an advertising campaign and paying down a loan can all be expressed the same way.
Gain means profit, not revenue
The most common error. A campaign producing ten thousand in revenue on two thousand of spend has not returned five times, because the work still has to be delivered.
On a thirty per cent gross margin, that ten thousand carries three thousand of margin, so the return is fifty per cent — real, and nothing like five hundred.
The advertising-specific version of this is return on ad spend, and the same trap applies there.
Time has to be in it
A twenty per cent return over one month and over three years are not the same thing, and the bare figure does not distinguish them.
Either state the period, or use a measure that has time built in — see payback period and net present value.
What it is compared against
A return is only good relative to the alternatives. The threshold a business will accept is sometimes called a hurdle rate, and for a small business the honest hurdle is usually one of:
- what paying down existing debt would save in interest — see debt schedule
- what the same money would return in the part of the business that already works
- what it costs to borrow it
An investment returning less than the interest on existing debt is worse than simply repaying the debt.
What it leaves out
Risk. Two investments at the same return are not equivalent if one is certain and the other is not.
And capacity. A return assumes the business can absorb the work, which is growth capacity.
Where it misleads in a small business
Owner time is rarely counted. An initiative returning twenty per cent while consuming the owner's attention has a cost that never appears in the calculation, and it is usually the scarcest resource in the business.