Appendix – Return on Investment (ROI)

roi

What Is ROI?

Return on Investment (ROI) is one of the two most basic metrics used to measure a business’s profitability, and can be calculated for any part of your business at any given time. It’s extremely important as it relates to marketing, since it gives you a quick peek into just how well certain marketing strategies are performing.

What Qualifies As An Investment?

In everyday language, an ‘investment’ can be defined as: putting money into something with the hope of ending up with more money. Playing the tables in Las Vegas, buying shares on the stock market, buying government or private bonds, buying property – these are all types of investments (all with varying levels of risk, of course).

In business, however, an ‘investment’ refers to a variety of things. Money spent on new office space or equipment qualifies as an investment. Purchasing inventory is also an investment.  Accounts receivable – payments made to or promised to your company – are investments too.

So, to keep this nice and simple, just remember this… in business, there are 3 types of investments:

  • Buildings and equipment
  • Inventory of goods
  • Cash coming in

In marketing, your ‘investment’ is the cost of labor and materials of any particular activity. So, for example, if you’re going to exhibit at a trade show, your investment would be the total cost of renting the space, sending staff to the event (so travel to and from the event, meals, etc), and staff salaries and wages during the event, as well as the cost of your booth, printed material and promotional items you’re planning to hand out. This grand total is your investment. After the trade show is over, you’ll then want to calculate how many leads – and more important, sales – were generated from that investment.  This number is the basis of ROI.

Of all the metrics that are used to measure success as it relates to marketing, ROI is invaluable in determining the actual profit (or loss) of your activities since it compares your initial investment with the total profit generated. Unfortunately, however, many people fail to accurately calculate their ROI.

Determining Your ROI

We already looked at the general equation for ROI in Chapter 1, when we looked at metrics and analytics.

    • Here it is again:

    • ROI = [net profit ÷ total investment] x 100

By using this formula, you’re presented with a percentage.  Some marketers prefer to work with the ratio of profit to investment, however, which yields a number expressed in a ratio-style format… so, for example, 2:1.

    • To convert from a percentage format to a ratio format, write the percentage over 100 and take away the percentage sign. Now reduce this to its simplest form by dividing both parts by the largest possible number.

    • Example: 20% = 20/100 = 1/5 = 1:5

    • To convert a ratio format into a percentage format, first write the ratio as a fraction. Now multiply by 100.

    • Example: 6:5 = 6/5 = (6/5 × 100)% = 600/5% = 120%

You can apply this metric to your company as a whole, to each department, to a particular activity, and all the way down to a single employee.

Using The ROI Equations

For the purpose of this course, we obviously want to use ROI that relates to our marketing activities.

Consider this example:

You structured a marketing campaign to inform people of your latest product. You invested $25,000 into your marketing efforts and you made $50,000 in sales.

Most people would take our basic equation and come up with something that looks like this:

ROI = [(50,000 ÷ 25,000] x 100 = 200%

Then they say, “Well, I made $50,000 in sales and therefore I have an ROI of 200%. This is AWESOME!  I doubled my money and did really well!”

Unfortunately, they are very wrong in their analysis.  And here’s why…

Look at our equation again – it says ‘net’ profit.  So what does that mean exactly?

Net refers to your profit AFTER you take away all the costs, not just the basic investment.

So did you rent a venue, like a hotel suite or conference room?  If so, then that is a cost.  Other costs may include printed handouts, the coffee and donuts you provided, and the wages you paid your workers at the event.  Oh, and let’s not forget the time spent by full-time employees who could have been doing something else had they not been in attendance.  It’s EXTREMELY important that you are tracking all of these things since if you don’t, you’re going to end up with a false sense of security as it relates to your ROI.

    • To try and simplify this a little, let’s use a clearer formula (note that this is the same base formula we were already using, just with some added information tacked on for good measure)

    • ROI = [(gain from investment – cost of investment) ÷ cost of investment] x 100

    • ROI = [(sales revenue − cost of goods sold) ÷ cost of goods sold] x 100

Now let’s assume that all those costs, including the venue, salaries and expenses adds up to $25,000.

Using our updated ROI equations, we wind up with something that looks like this:

ROI = [(50,000 – 25,000) ÷ 25,000] x 100 = 100%

So, instead of an ROI of 200%, you’re actually only at 100%.

So in the grand scheme of things, what does this mean?  It means that you only got back what you put in. An ROI of 100% means that you just broke even. You need an ROI greater than 100% if you are going to show profit on your books.

Why It’s Important to Calculate An Accurate ROI

After looking at this example, it should be pretty darn obvious why your ROI needs to be accurate. In the first calculation, it seems as though you made as much money as you invested – a 200% ROI. That would be a good profit to turn from a single event.

In reality, however, after considering all of your costs, you made no money at all. You went in to this event with $25,000 and you left with $25,000.

An accurate ROI tells you how well your company is REALLY doing. If you’re consistently calculating your ROI incorrectly, you will naturally assume your company is doing better than it really is.  When you assume this, I can tell you with 150% certainty that you won’t be nearly as motivated to make changes.  From a marketing standpoint, this translates into inefficiency and overspending.

Case in point, let’s go back to our example above.  Imagine if your real costs had been $30,000 instead of $25,000.  This would leave you with only $20,000 in sales.  Now your ROI looks like this:

ROI = [(50,000-30,000) ÷ 30,000] x 100 = 67%

You lost one-third of your assets on this one single activity – a disaster.

Hopefully NOW you can see why it’s so important to calculate your ROI accurately!

calcutor

If this is how you feel right now, here is a set of ROI CALCULATORS that will eliminate a lot of the stress and headache associated with properly calculating such a key marketing metric.

Other ROI Formulas

Each of the calculations listed below is a variation of the basic ROI equation, and can further track the performance of your marketing investments.

Profit to Investment

This formula uses the gross profit of whatever was sold during a specific marketing campaign and the investment you put into the campaign. Now, a word of caution with this calculation.  ALWAYS remember that 200% is the break-even point, otherwise you’re going to give yourself a false sense of security (like in our example above).

    • Gross Profit – Marketing Investment
      Marketing Investment

Customer Lifetime Value

CLV is a metric that represents the total net profit your company will make from any given customer. It’s a projection that estimates a customer’s monetary worth to your business after factoring in the value of the relationship with that same customer over time.

    • Customer Lifetime Value – Marketing Investment
      Marketing Investment

Revenue to Cost Ratio

Some people find all of these calculations too complex and instead choose to simply compare gross revenue to cost. This is not really an ROI calculation at all, but is used for the same purpose – to track the success or failure of your marketing activities. This method is so simple you might think that it has no real value, but many marketing managers, even in big Fortune 500 companies, use it as a baseline for measuring success.

To calculate this, simply look at the money generated from your marketing activity and divide it by the cost. So, for example, let’s say you spent $50 sending out text messages to all the prospects in your database. You didn’t give them anything special, however.  You simply invited them to visit your site to see what you have to offer.  Only 5% of the people you messaged actually visited your site, but all together, they spent $500.  So your revenue to cost ratio would be 500/50 = 10:1.

It’s important to note that when using this formula, only incremental costs of marketing are included as ‘costs.’ Salaries are not included because they are fixed costs.

When using the revenue to cost ratio, examples of marketing costs that WOULD be included in your calculation are:

  • pay-per-click costs
  • display ad costs
  • media advertising expenses
  • content production costs
  • outside marketing and advertising agency fees

Most experts agree that 5:1 is a good return, so in our example here, a 10:1 return is great. You need a return of about 5:1 because there are many other costs that have not been taken into consideration in this type of calculation, including things like overhead.  At a 5:1 ratio, history shows that for most businesses, it’s more than enough to cover ALL costs, and still have something leftover as a profit.

So in our example here, whatever it was that we did, we should definitely do more of it – and in a much bigger way next time.

See? That was easy, and no fancy math involved!

Interpreting the Results

There are several different approaches you can use as it relates to tracking your ROI. The important thing – and this cannot be stressed enough – is that you should choose only one method AND stick to it.  You cannot compare apples to oranges and calculate a social media marketing campaign one way and an email marketing campaign a different way.  The value of ROI calculations lies in consistency.

Regardless of the method you decide to use, please make sure you take the time to properly analyze your results AFTER you’ve identified what a ‘good’ number should look like.  Don’t fall into the trap of calculating your results and then telling yourself they are ‘good.’  Identify what ‘good’ is and then compare your results to that number.

Using ROI Metrics

The information you pull from all of your ROI calculations will be useful in justifying your marketing spend, as well as identifying what’s working well – and what isn’t.  Keep in mind, however, that some marketing campaigns simply won’t show results in the short-term, so you’ll need to keep this in mind when you’re analyzing your results.
return

Conclusion

If you want to ensure your business’s long-term success, you need to:

  • Calculate the ROI for every marketing investment you make
  • Use metrics to justify your marketing investments
  • Modify under-performing campaigns (and in some cases, pause them indefinitely)
  • Strive to generate the best return possible from ALL of your marketing campaigns