ROI For Small Business

ROI! We’ve all heard of it. It’s not the latest buzzword. It stands for RETURN ON INVESTMENT and it is actually a financial concept that evaluates the efficiency of an investment.

In simple terms, think of it as COST vs BENEFIT or rather how much benefit you are deriving from your input cost. It can applied to anything in business. More recently many pundits are spruiking Marketing ROI, SEO ROI etc… but the traditional financial measurement is calculated by dividing NET PROFIT over TOTAL ASSETS. For example, if the net profit of your business is $50,000 and the total assets are $200,000, the ROI would be 25%. Wikipedia’s definition of ROI is “the benefit to an investor resulting from an investment of some resource”. A high ROI means the investment’s gains compare favorably to its cost. As a performance measure, ROI is used to evaluate the efficiency of an investment or to compare the efficiencies of several different investments. In purely economic terms, it is one way of relating profits to capital invested.

In a small business, ROI could be used to measure the performance of:

1. The investment in capital equipment such as machinery
2. Evaluating the return of investing in holding 3 months worth of inventory vs 1 month
3. A new pricing strategy targeted at acquiring new customers or higher volume sales
4. A new marketing strategy such as digital marketing with a higher than usual budget
5. Analysis of the lease vs buy decision for all your office equipment that needs updating

ROI is the tool that helps decide between investment alternatives.

ROI is affected by 3 variables:

• Which is the net of 2 of the variables because Profit is the resulting amount after taking into consideration REVENUE and EXPENSES.
• And initial INVESTMENT cost.

Therefore ROI is more favourable when:

1. Revenue is increased
2. Expenses are decreased
3. Investment is lower

Accountants calculate the expected ROI of a project before advising their client whether or not to invest or in selecting which investment option is more favourable. They usually set a hurdle rate such as 20% when considering investment proposals. At the very least you will want to know that your investment will return a better rate of return than simply putting it in the bank. Usually investments of a sizable nature carry risk. Risk should have some payback associated to it to make it attractive. Assigning a hurdle of 20% means that unless there is potential to make a minimum of 20% return on the investment, you may wish to reconsider the proposal.

Another important factor to consider is your current business ROI%. If your current business ROI is 15% and you are considering an investment proposal to purchase new machinery to add a new product line for a new customer and the proposal ROI is 7%, you may want to think about this further before committing. Stop and think to yourself. The additional profit from this new investment will return less than what you are already doing in your existing business. It will dilute your profit whilst committing your funds to a longer term payback and increasing your risk profile. You can always go ahead if it makes business sense and it is part of your longer term strategy, but it pays to consider this scenario carefully before taking the plunge.

This short article is an introduction to the world of business improvement strategies aimed at providing long term benefit to organisations. I hope you have found some benefit in reading this article. Should you wish to find out more, I invite you to get in touch with me.

Peter Katsos CPA

Based in Melbourne, Peter Katsos, founding Director of BIS Consulting can assist you with building shareholder value. With 20+ years commercial experience gained in MNC’s, local manufacturing & FMCG distribution SME’s, he has a wealth of financial experience aimed at transforming businesses into high cash generating sustainable profit making enterprises.

Visit us at www.bisconsulting.com.au.   Or better yet call Peter on 1300 577 309. We are here to help grow your business.