To take your small business to the next level, you need to make each financial investment count.
That is why Return On Investment (ROI for short) is so important. In terms of financial investments, ROI is the analysis we use to measure financial performance. At the most basic level, ROI compares the amount of money you spend on a project with the amount of return or revenue you gain from it.
In business, investments result in one of three ways:
Gain — A gain may appear as an increase in profits, more efficient use of time, or decreased production costs.
Loss — A loss could be lower productivity, higher production costs, or a decrease in profits.
Break-even point — A break-even point would be when your total cost and total revenue are equal, meaning no gain or loss in your investment.
To calculate Return on Investment, you can use this simple equation:
ROI = Net Income / Cost of Investment
Net income is the total income you receive from your investment. This income could be anything from sales from a marketing campaign to saved time for your employees.
Your cost of investment is the time, money, and resources it takes to achieve your income. It could be anything from the cost of materials to how many employees you're hiring.
ROI calculations can be very simple or become complicated and confusing. But at their core, they are a great tool that can help you scale your business.
How to utilize the Return on Investment Equation:
Now that we've explained what ROI is let's dive into some examples.
Imagine for a moment that Small Business Mentor owns a pizza parlor. One pizza costs us $5 (in ingredients) to make, and we sell it for $10. Therefore, our ROI would be ($10 - $5) / $5 = 100%. We make $5 of profit or 100% on our initial investment for every pizza we sell.
This sounds great, doesn't it? But before we continue, let's pause for a second. As great as this sounds, something essential to our business's success is the rest of our costs associated with making the pizza and running our business that isn't as obvious. The price to make your pizza is not just the cost of the ingredients.
We also need to factor in other costs, such as the salaries of the employees making the pizza, how much it costs us to bring in one customer (marketing/acquisition costs), the cost of rent, electricity, other utilities, etc.
This is where businesses ROI Calculations can get complicated and confusing. Despite the messiness, you must take the time to run the numbers to calculate the most accurate ROI estimate. Leaving out just a few expenses can turn a profitable business into a failing one.
To show an example of this, let's start by adding the costs of employees. Let's say we hire someone to make pizzas for $12 an hour. It takes them 10 minutes to complete the pizza. Not including healthcare or other associated costs with employees, that employee adds $2 to creating that pizza.
Your equation is now:
($10 for the pizza) - ($5 for ingredients) - ($2 for employee costs) / ($7 The total cost of making the pizza) = 43%
Instead of making $5 per pizza, we are making $3.
A 100% return on investment turned into 43%.
As you can see, forgetting to add expenses to your calculation can make a huge difference.
Let's take it a step further.
What if our employee isn't making a pizza every 10 minutes? Or, we forgot to factor in a supervisor or an additional employee who isn't making a pizza?
If your employee earns $12 an hour and makes three pizzas an hour, your employee cost is now $3 for one pizza instead of $2. If it is a particularly slow day and you have two employees working, making three pizzas an hour, your costs double. Those employees now cost you $6 per pizza.
($10 cost of the pizza) - ($5 for ingredients) - ($6 for employee costs) / ($11 The total cost of making the pizza) = -9.09%
We are losing $1 every time we make a pizza, and our business model is broken. Our ROI percentage is now in the negatives.
These are slight changes, but the result switches from doubling our money to losing money. Many businesses don't succeed because they forget variables in their ROI or miscalculate.
In the example above, our most substantial error had two employees working at the same time when only one was necessary. But this doesn't mean we need to reevaluate the entire business.
Small Business Mentor Pizza Palace could implement a policy to ensure a specific number of pizzas are purchased every hour. If this threshold is not met, the supervisor sends employees home.
The example above is still a relatively simple ROI calculation. We haven't factored in rent, marketing costs, taxes, promotions, or utilities. But it's a significant first step!
Before you panic and decide you weren't cut out for this, we can group different expenses and simplify things. It takes a little bit of work initially but makes things a lot easier down the line.
Simplify Things By Categorizing:
One way to minimize the risk of forgetting a variable in your ROI calculations is to group your expenses. For example, you can group your building costs, employee costs, and materials.
If we go back to the pizza example, we can use this equation.
Cost of Pizza - (Building Costs + Employee Costs + Materials + Tax) / (Building Costs + Employee Costs + Materials + Tax) = ROI
This equation makes things a little easier on you as a business owner because some of the costs will remain relatively constant.
Costs that Will Remain Relatively Constant:
- Cleaning Crews
- Keeping Bathrooms Stocked
- Sales Tax
- Certain Material Costs
- Kitchen/ Supplies
- Employee Costs (Full-time & regular part-time staff)
You can adjust these numbers slightly to get your desired return on investment. Maybe you buy toilet paper in bulk or find a new supplier for your ingredients.
Continuing with The Small Business Mentor Pizza Palace example. We have the following expenses:
Building Costs: $500/month (The Small Business Mentor Pizza Palace is open an average of 40 hours/week. This averages out to 174 working hours per month or $2.87/hour)
Employee Costs: $12/hour
Materials to make the pizza: $5
Sales Tax: $0.72 (7.25% of $10 )
Assuming one employee is making four pizzas an hour, our equation will be:
($10 cost of the pizza) - ($5 for ingredients) - ($3 for employee costs) - ($2.87 for building costs / 4 pizzas) - ($0.72 in sales tax) / ($9.44 The total cost of making the pizza) = 5.95% or we are making $.56 per pizza.
It's not pretty. But if we double the cost of our pizza, things look a little better:
($20 cost of the pizza) - ($5 for ingredients) - ($3 for employee costs) - ($2.87 an hour/4 pizzas = $0.72 for building costs) - ($0.72 in sales tax) / ($9.44 The total cost of making the pizza) =
10.56/9.44 = 111.86% return on our investment or we are making $10.56 for every $9.44 we spend.
Now, all we need to do is find our supply and demand point of equilibrium. Or in other words, at what price can we achieve the highest ROI while also selling the most pizza.
Speaking of getting more sales, One of the ways we can increase our sales is by marketing.
Separating marketing costs is another great way to simplify your ROI calculations. For example, you can hone in on individual marketing campaigns like a particularly special or an ad campaign. After finding your investment return for each marketing campaign, you can calculate an average and add it into your equation.
To do this, you'll use the same equation we used before.
Return on Investment = Net Income / Cost of Investment
Let's keep things easy and keep using our Small Business Mentor Pizza Palace example. We know it costs us $9.44 to make and sell the pizza, and we are selling it for $20.
We are making an average of $8.41 profit on each pizza we sell.
Experts have different opinions of what a good ROI for marketing campaigns is. However, you'll want to aim for a return on investment that is scalable. Spending $20k to make $22,200 doesn't make a lot of sense for a small business, even if you are profitable. However, spending $200 to make $20k is phenomenal.
Return on Investment Marketing Example:
It's a good starting point to aim to double your marketing spend. If you spend $500 on marketing, you want to make at least $1000.
To do this, we will need to test out different strategies. But at least we have a goal in mind instead of, "We are happy as long as we are profitable."
Calculating how effective a marketing campaign is will need a whole article within itself. Unless you are using direct customer acquisition channels like Google or Social Ads, calculating how effective your campaign is isn't black and white.
The same rules apply for calculating marketing ROI as with the examples we talked about earlier. Your marketing campaign's cost is not only the money you spend but the cost of the employees it takes to carry out those campaigns.
In other words, if you purchase 1000 magazine ads, but it costs you 8 hours of work to put together the ad, you need to factor in the cost of the work as well.
As you test different strategies, we will need to track as much data as we can. Sure, you could spend money on a billboard without much planning, but it would not be easy to know who came to you after seeing your ad. Alternatively, you could send postcards to local addresses and have customers give you the postcard for a discount. This way, you can quantify the results instead of guess.
The bottom line is, if you have a certain amount of money to spend, you at least want to get data on how to improve your customer acquisition costs rather than shouting as loud as you can.
Determining ROI When It Isn't Obvious:
We just mentioned that spending money on a billboard without the proper strategy isn't the best use of your funds. This is especially the case if you don't know who your ideal customer is or how much it costs to acquire one customer.
However, if you have a solid marketing foundation, you can take steps to get a relatively accurate estimation of your return on investment.
Let's take a look at the billboard example. The Small Business Mentor Pizza Parlor has been running for a couple of months now, and we can accurately predict the average number of customers we get per day. It's about 200 customers. (Our pizza is delicious.)
If we want to test running a billboard campaign, we would need to continue business as usual and purchase a billboard. If we buy a billboard and a newspaper ad, it will be pretty tricky to know what strategy brought customers. Therefore, we buy a single billboard ad in a popular area.
At the end of the month, we average our daily totals and find we had 250 customers per day. We could estimate that 50 customers a day are our return on our investment. Alternatively, we could look at averages and determine changes in our revenue.
We would have to be careful with this estimation because outside variables could skew our data. An influencer could have tagged us in a post, or it could have been national pizza month. Just like the scientific method, we need to make sure we are accounting for any outside forces.
We could then test if one billboard equals 50 more customers a day or if this growth slows depending on how many billboards we put up around town.
However, if we are careful and stick our toes in the water before diving in headfirst, we can make the most of our marketing budget.
Another example of something marketers often have trouble quantifying is print advertising or posting on social media. It's challenging to know how many customers come from these marketing strategies because there are so many variables involved. A print ad in a magazine can run for one issue but sit on someone's coffee table for months. You're posting dozens of times a month on social media, but how do you know if you're getting calls from your efforts?
This is where Call Tracking comes into play. Call tracking is where you have a dedicated phone number for each platform you appear in. The phone number listed on your newspaper ad will differ from the one on your Instagram page. Your TV commercial's phone number will be different than the one you have on your Google Ad.
From there, you will be able to look at the data and determine how many calls you got from each medium. Call Tracking is excellent because you'll be able to use different strategies at once while still getting accurate data.
Using landing pages, forms, coupon codes, and other forms of data tracking can also help you quantify your results.
Discounts and ROI
A common marketing strategy is giving a discount to customers to get them to purchase more products or services. Deals can also be a strategy to get someone in the door for the first time or build loyalty.
To give a discount that benefits the customer and our company, we will need to make sure that we follow the same rules of our return on investment calculation.
For example, The Small Business Mentor Pizza Palace has spent our marketing budget putting postcards with a coupon under car windshields. We will consider customers that provide a postcard at checkout as a successful conversion.
We distribute 500 postcards with a coupon for 30 cents each at a total cost of $150, including the employee's time (We gave him an energy drink beforehand, so he was quick). One hundred people that received a postcard use it to purchase pizza. That is a 20% conversion rate - not too shabby.
To incentivize people to come to our pizza parlor, we gave them a 15% discount. In short, this discount means that we are giving them pizza for $17.50 instead of $20.
Therefore, our equation will look like this:
$20 (cost of the pizza) - ($1.50 ($150 postcards / 100 people)) + $2.50 (The discount applied) + $9.44 (Cost to make the pizza calculated earlier)/ $13.44 (Total Cost of Production)
We are making $6.56 on each pizza or an ROI of 48.8%.
We spent $150 on postcards and made $656!
But wait - there is another piece of the puzzle. We didn't offer discounts so that these customers wouldn't come back. We are going to provide great pizza and exceptional service. We offered a deal to introduce ourselves so these customers would come back again and again!
Customer Lifetime Value:
Customer Lifetime Value can be tricky to calculate without the proper systems in place. To make things easier on yourself, you may want to use a customer relationship management (CRM) tool. We have also seen companies do everything manually and use spreadsheets.
Small Business Mentor Pizza Palace is using a CRM. Whenever someone purchases pizza, we put them into our system and make a note of whether or not they provided a coupon.
Now, whenever that customer comes back in, our system keeps track of it. Of the 100 people that came in with a coupon initially, 70 of them came back at least once.
Let's Do the Math:
$20 (Price of Pizza)
- $1.50 Cost of PostCard
- $2.50 Discount on Pizza
- $9.44 cost to make the Pizza
+ $8.41 profit of customers returning and purchasing one pizza.
$14.97 Profit from 1 customer
x 70 customers
Add $196.8 from the 30 customers who only purchased once, and you get $1244.7
Our ROI just shot up and is now close to 830%.
Now let's say that 30 of those 70 customers returned an additional two times. Therefore, 30 customers showed up once, 40 showed up twice, and 30 showed up three times.
That means we made...
100 people purchasing a discounted pizza
70 customers purchasing a discounted pizza and purchasing a full-price pizza
30 customers purchased 2 more pizzas at full price
$6.56 x 100 =$656
$8.41 x 40 =$336.4
$8.41 + $8.41 x 30 = $504.6
= $1497 or nearly a 1000% return on our investment.
If you've ever wondered how businesses can afford "buy one get one free" deals or significant discounts on their offerings, this is how. A company may even lose money on the initial sale, but their data shows how they can get you back and make it up and more later on.
Businesses will also give discounts for phone numbers or membership sign-ups to be able to track your behavior. Not only do they know you'll come back, but they can also get more data on how their campaigns are working on you. In return for the ability to track you, they offer discounts knowing they will make a far greater profit than what they are giving up, and they get to track your purchases.
CVS and Walgreens are a great example of this. They will issue a discount card in return for discounted items in their store. Credit Card companies are also famous for introductory offers, paying people up to $500 to regularly use their cards.
The subscription model and ROI
The subscription model has become increasingly popular over the past decade. Software As A Service (SAAS for Short) and memberships allow companies to accurately increase their ROI and model their future revenue.
The Small Business Mentor Pizza Parlor could use a membership service to make it easier to track revenue and retain our customers.
To compete with other pizza shops, we are going to offer a discount. We know that the majority of our customers purchase two pizzas a month from us. For us to have a positive ROI and incentivize our customers to buy a membership, we will need to increase our profits while simultaneously decreasing the costs for customers.
This is what we know:
As we have mentioned, our pizzas cost the customer $20 each.
The pizza's cost us $9.44 to make. We average a profit of $10.56 per pizza.
Our Average Customer buys two pizzas per month or $ 21.12 per customer.
Knowing all of this, we could offer an incentive of a $50 monthly membership where the customer gets three pizzas.
The customer is getting cheaper pizza ($16.68 per pizza instead of $20) if they end up getting three pizzas a month.
It works out for us because we are now making an average profit of $26.40 per customer. We also will be able to estimate our revenue more accurately and spend less money getting customers to come back.
This simple example doesn't include the costs of marketing and managing subscriptions. However, it's still an excellent example of why so many businesses move towards the reoccurring revenue model.
Putting it all together:
This has been a LOT of information, but you got through it! Now let's put it all together.
$20 (Price of Pizza)
- Constant costs (rent/ maintenance/ etc./ salaried employees etc.)
- Employee costs (hourly workers)
- Marketing costs (marketing campaigns and discounts)
/costs = ROI
You can then use your CRM or spreadsheets to get really specific about your customer lifetime value, churn rates, and more.
Tips and tricks:
To protect yourself from errors that will leave you in the red, round-up expenses. If you can, try to identify the variables that significantly impact your margins and pay extra attention to these.
Use past credit card statements and payroll stubs to determine consistent costs.
Have 2 or 3 people double-check your math. You can easily miscalculate easy math when you have so many variables.
Use Excel or Google Sheets. It makes things much more manageable.
Don't forget the sales tax!
Don't forget to pay yourself.
Use CRM. There are many out there, and they can do most of the work in determining your ROI and Customer Lifetime Value.
Ask employees what would make their lives easier, what costs can be eliminated.
Don't forget about the time. Saving time means hiring fewer employees and paying more salaries.
Re-calculate often. If you're making 500 pizzas a week and the pepperoni price goes up by 10 cents, it'll make a dent in your profits.
Employees also have a lifetime value. Speaking strictly in dollars and cents, training employees is expensive. Training can be more costly than paying an employee enough for them not to want to leave. Do the math. Take care of your employees.
Put systems in place to protect you from losing money. If your power bill is too high, buy automatic lights. If you're often overstaffed, put protocols in place to send people home.
Be as detailed as possible. The more you know, the easier it is to grow your business. Do you get a higher return on investment for cheese pizza than pepperoni? Can your marketing campaigns give you a better ROI if focused on specific products than general sales?
Using ROI to Improve your Business
Finding scalable opportunities and having a high ROI is an essential part of a business' success. Whether it's fine-tuning your marketing or sales process or making sure your products are profitable, ROI will likely be your favorite equation.
Perhaps the most transparent insight you'll gain through measuring ROI is where you should be spending your money and time. For example, If you discover that one segment of your marketing strategy isn't yielding much of an ROI, you can allocate those funds more efficiently elsewhere.
Additionally, you can audit your costs and see where things can decrease. Negotiating prices by just a few percentage points can make huge impacts on your profits.
One of the most significant benefits of calculating your ROI is determining your product or service price. Often businesses realize that they are overcharging or undercharging for their services.
You can also make decisions on how to pivot a marketing strategy into new territory. Calculating marketing ROI can help you adjust your strategy according to customer behavior.
You don't necessarily have to focus on revenue, either. For example, if you're trying to boost your social media following, you can calculate ROI to determine your efforts' success. For example, spending X amount equals gaining one new follower. Using call and link tracking, you can even calculate the number of sales you get per follower.
Also, you can identify the tools to use to help your marketing succeed. If one particular marketing tool helps increase your business profitability, you'll feel confident in spending your marketing dollars (and time!) there. An extensive marketing budget doesn't seem scary when you can model the profits you will gain.
In summary, practically every business decision requires knowledge of ROI. If you're not sure whether your efforts are yielding results, how can you properly optimize profitability? Understanding the importance of ROI is crucial for any business to succeed.
If you're having trouble, don't be afraid to send us a message. We would be happy to help!