It’s no secret that a positive Return on Investment is good for business. Every business owner or leader wants a significant Return on Investment (ROI) for their business.
Invented by Donaldson Brown in 1914, ROI is a formula for monitoring business performance. It combines working capital, earnings, and investments in plants and property into a single formulaic measure.
In business, ROI calculators are one of the most efficient ways to measure your profitability. Do you want to know more about ROI calculation formulation and how it came to be? Do you want to learn how to calculate ROI?
Here’s a guide that’ll calculate it all for you.
The History of the ROI Calculation Formula
Donaldson Brown was a young electrical engineer. He had a sharp mind and completed his graduate work at Cornell. He began in electric motor sales for General Electric but quickly moved on to work as a sales rep for DuPont in the explosives department.
It didn’t take long for Brown to move into the position of administrative analyst. It was in this role that he impressed Dupont’s President at the time, Coleman DuPont. He wrote a report on the accomplishments and performances of several DuPont departments.
Even though Brown was without a background in finance, Coleman recommended him for a position in the Treasurer’s Office. In 1914, Brown developed a formula for monitoring business performance as DuPont’s Assistant Treasurer. That formula Brown developed was Return on Investment (ROI).
Also known as the “DuPont Method for Return on Investment,” the measure was quickly adopted by business schools and companies as a way to benchmark the financial health of their businesses and products.
Donaldson Brown was promoted to Treasurer a few years later but was later recruited by GM to act as their VP of Finance. Though he retired from DuPont, he stayed on the Finance Committee and Board of Directors. He took ROI to a whole new level by introducing the concept to many other companies and even evolving his method into a pricing method for GM’s car fleets.
That idea in itself was revolutionary. It enabled every car brand to establish a multi-year average ROI target and a standard production volume. They based their operating costs on these numbers, which then back-calculated the average fleet prices needed to achieve the predetermined ROI target.
What Is Return on Investment (ROI)?
Brown’s discovery, ROI, is a calculation that demonstrates how an asset or investment has performed over a certain period. It shows losses or gains in percentage terms.
Essentially, ROI is a returns ratio as it allows businesses to calculate how efficiently their company uses its total asset base to continue generating sales.
Total assets include all current assets, such as:
- Accounts receivable
- Fixed assets (such as equipment and plant buildings)
Calculating the ROI values on potential opportunities can lead business owners as to which investments will incur the best return, especially when a company or investment doesn’t have a good ROI, to begin with.
Most people agree that an ROI of 5 to 12 percent is considered to be good, with 12 and over being excellent. A 5:1 ratio is considered to be strong for most businesses, whereas a 10:1 ratio is excellent.
How to Calculate ROI
Here’s a simple formula for calculating ROI:
(Current Value – Beginning Value) / Beginning Value = ROI
The current value can be an amount the company or investment was sold for, which is it’s realized value. The current value can also be what the asset is worth in the present (like the market price of a stock).
The beginning value is the price that was originally paid for or invested in the company or asset in question.
Here’s another way you might see it written:
Investment Gain (Net Income) / Cost of Investment (Total Assets) = X%
It can be a quick and simple calculation, especially when you grab net income from the income statement and total assets from the balance sheet.
ROI Calculator in Excel
Best practices for ROI encourages calculations to be transparent and easy to audit. When you pile all of your calculations into a formula, it’s hard to check back at those individual numbers.
Creating an Excel document is an excellent idea, as it keeps all the data in one table, and breaks down calculations line by line.
Leave ample space for your starting and ending values, and use cell references to determine the ROI each time you want to recalculate.
Steps for Your ROI Calculator in Excel
Take a look at these steps for calculating a simple ROI in Excel.
- Type “Investment Amount” in A1 and widen your column
- Type “Money Gained from Investment” in B1 and widen the column
- Type “ROI” in cell C1
- In cell A2, type “$” and then the amount of your investment
- In cell B2, type “$” and then the amount of your financial gain (above the amount you invested)
- In cell C2, type “=B2/A2” and click the “check” icon to accept your formula
- Click the “%” icon on the ribbon to change your result in cell C2 to percentage format
Now let’s take a look at some of the many benefits of using an ROI calculator for your business or investment!
Benefits of ROI Calculation
Every business person should be aware of the many benefits of using an ROI ratio calculator.
It’s Easy and Simple to Use
One of the many benefits of calculating ROI is that it’s easy to do. All you need are 2 numbers to calculate your ROI for an asset or business in question.
Plus, even though the idea of a “return” can mean different things to different assets and investments, the calculator itself is universal.
It’s an Excellent Measure of Profitability
Any division manager knows that their performance will be judged in terms of how they’ve utilized assets to earn a profit. An ROI ratio calculator encourages business professionals to make optimum use of those assets.
Plus, it ensures that they only acquire assets when they are projected to give returns according to the company’s policies.
One important purpose of ROI is to look at the required levels of investment. For every business at any given time, there’s an optimal level of investment for each asset that helps to maximize earnings for that company. Knowing how to calculate ROI provides a cost-benefit analysis that helps managers to figure out the rate of return that they can expect from a variety of investment proposals.
From here, they can pick an investment that enhances both divisional and organizational profit performance. They can also measure and utilize profitability in existing investments.
ROI Calculation Enables Comparative Analysis
While ROI calculators can be used to calculate the overall ROI for a business, they can also be used to compare how different units are profitable or maximizing their assets.
It can also be used for inter-firm comparisons, as long as those firms are of the same industry and are comparable in size. From here, it’s easy to determine which investments are best for business compared to the related cost of capital.
It’s Great for Achieving Goal Congruence
Using the ROI calculation formula ensures goal congruence between the firm and its different divisions. Any increase in divisional ROI, for example, will bring overall improvement in ROI for the entire organization.
In turn, you can use other aspects of the business like CRM to asses how your ROI will help to boost sales.
It Measures the Performance of an Investment Division
The investment division of a business focuses on earning maximum profit. It also focuses on making appropriate decisions regarding things like acquisition and disposal of capital assets. ROI plays a significant role in measuring the performance of a given company’s investment division.
Likewise, an investment division manager can also be assessed using an ROI calculation formula.
It Sheds Light on Other Performance Aspects
Knowing how to calculate ROI can help shed light on other performance aspects of a business or business unit. The better the ROI, the more of an indication it is that an investment center has positive results in other fields of performance, including:
- Effective asset utilization
- Selling price strategy
- Marketing and promotional strategy
- Cost management
ROI Goes Hand in Hand With Traditional Accounting
Another benefit of ROI calculators is that they match up with financial accounting methods accepted in traditional accounting. You don’t have to learn a new accounting measurement to generate the information required for calculating ROI. All the numbers should be easily accessible in the company’s financial statements, especially through secure cloud-based storage.
While some adjustments in existing numbers may be required to compute a sector’s ROI, it doesn’t pose any issues as these adjustments are all routed in traditional accounting measurements.
Disadvantages of ROI
Even though the advantages outweigh the disadvantages of ROI calculation, let’s take a look at what those cons are.
Calculating ROI Doesn’t Regard Time
When comparing investment options, a higher ROI doesn’t necessarily point to a better investment. For example, say one investment has an ROI of 60%, while another has an ROI of 50%. The ROI of 60% isn’t necessarily the better investment, because it’s essential to include the element of time in one’s consideration.
If the investment with an ROI of 60% will take 5 years, but the investment with an ROI of 50% will take 2 years, it’s important to consider that the investment that’ll generate an ROI of 50% might be the better option.
The ROI Calculation Formula Is Susceptible to Manipulation
Two people might perform an ROI calculation but generate different results, depending on which ROI formula they use in their calculations.
An investor should always look at the true ROI, as it accounts for all potential costs incurred as each investment increases in value.
A marketing manager, however, might use a calculation that doesn’t account for additional costs such as property taxes, maintenance costs, etc. Plus, they could opt to choose investments based on the highest projected return, without taking into account factors that could hurt the overall enterprise.
It’s essential to stay consistent as a company and to assess the ROI as it is while taking into account additional factors and potential costs.
Compared Companies Must Share Similarities
If you compare the ROI of different companies, those companies must use similar accounting policies and methods.
When it comes to the valuation of stocks, the valuation of fixed assets, the apportionment of overheads, treatment of research and development, and expenditure, compared companies should use the same methods so that results aren’t skewed by inconsistencies.
Tips for Building Your ROI Calculator
We touched on a couple of different ROI calculators, including how to build yours in Excel. Here are some quick tips for ensuring you develop an ROI calculator that benefits you and your business.
- Keep in mind that it’s a work in progress
- Make sure you use the right team
- Keep it practical by using easily measured activities
- Stick to benefits that can be quantified
- Build-in variables to gain credibility with prospects
- Continuously break down numbers
- Provide guideline numbers when necessary
- Don’t forget to account for factors in time
- Document all your assumptions
ROI Calculators Are Universal for a Reason
There’s a reason why Brown’s original ROI formula had such an impact on the car industry and the business world as a whole.
ROI calculators provide sound insight into a company’s financial situation. Plus, they enable business executives to analyze potential investments to determine which options will be the most profitable.
The ROI calculation is routed in traditional accounting methods, so it isn’t difficult to create an ROI ratio calculator and apply it to your business.
Just remember to play around with the numbers and take into account additional factors, such as time. When you’re building your ROI team, pick members that are well-versed in finance terminologies so that you always generate numbers that apply to the whole picture.
Do you want to learn more about how to increase profitability and improve your business? Get started here, or contact us with any questions or concerns.