Business Tip of the Month: How to Correctly Calculate ROI
Turnover is vanity, profit is sanity and cash flow… well, that can be a whole different problem.
That’s why, when investing, we need to make sure that we are making a profit!
More importantly, we need to calculate that profit correctly.
Luckily, there’s a handy little formula to calculate our return on investment (ROI).
But it does get a little more complicated than that – learn how to calculate ROI, how to factor in time, how to make sure you’re not missing essential costs, marketing ROI and customer lifetime value.
ROI is a useful way to determine the value of your investments.
After finishing your calculations, you will get a decimal which you can use to compare projects.
For example, an ROI of 0.1 corresponds to a profit of 10%.
ROI = (gross profit from investment – cost of investment) / cost of investment
It’s that simple!
Factoring in time
Well, it’s not quite that simple.
We’d like to think an 0.9 ROI is better than 0.5, right?
Not necessarily, time is not always on your side.
We need to take timescale into account.
Annual ROI = [(1 + ROI) ^ (365.25/total number of days)]- 1
If the ROI of 0.9 was achieved in four years and the 0.5 was achieved in two:
- The ROI of 0.9 in four years will have an annual ROI of 0.18
- The ROI of 0.5 in two years will have an annual ROI of 0.22
If you don’t like the look of the maths here’s a handy annual ROI calculator.
Accounting for costs
There is one point where your calculations can become unstuck – calculating gross profit of the investment.
Gross profit = gross revenue – cost of goods sold
Gross profit = gross revenue x profit margin
We need to cover all possible costs associated with a project, and I mean all!
We always see businesses forgetting to factor in costs, here are some we see commonly missed:
- Customer services
- Overheads including energy, council tax, rent
- Time invested by employees
- Promotions and offers
Finding ROI after investing in marketing is a little more complicated.
We must consider average organic profit for the period the campaign covered.
Marketing ROI = (gross profit – average organic gross profit – Marketing cost)/Marketing cost
Don’t forget to adjust values from previous years to meet your annual organic growth model!
You can then input your marketing ROI into the annual ROI formula to compare marketing campaigns.
Although profit should always be the primary goal of a marketing campaign, other benefits such as boosting brand awareness may take time to convert to sales.
Lifetime value of a customer
As customers may often return for your products/services, considering the customer lifetime value (CLV) may be a more appropriate way of calculating ROI for a marketing campaign.
CLV = [(average monthly transactions x average order value) x retention rate in months] x profit margin
If your marketing campaigns are targeting specific customers, don’t forget to calculate the segment specific CLV values.
You can then input your CLV into the ROI formulae to calculate the CLV-ROI.
We hope we have helped you get to grips with ROI.
If you’re struggling to calculate your ROI for your PPC campaigns take a look at our blog Common PPC metrics: Which are the best?.