What is ROI

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SBRL ROI Time is MoneyWhat is ROI? ROI or return on investment is a means to evaluate the value of one type of investment relative to another. Will money invested in staff result in more profit than money invested in a robotic production welder?

Return On Investment Calculation

In its simplest form return on investment is the equation SELL – COST OF GOODS / COST OF GOODS expressed as a percentage.
Example: cost of goods; $1.25, sell; $1.50.
ROI is ($1.50-$1.25) / $1.25 = .2 or a 20% ROI.

This is a simple calculation of return on investment as implemented when you’re buying then selling goods. But return on investment evaluation is used in many other areas of your business as well.

Related Topics:
| Profit Margin Formula | How to Calculate ROI | Return on Investment Formula | What is Cash Flow | Cash Flow Management | What is Accounts Payable? | What is Accounts Receivable? | What is Bookkeeping? |

Return on Investment and TCO

Return on Investment calculations often involve the inclusion of TCO calculations; Total Cost of Ownership. Total cost of ownership is typically a calculation of the expenses involved in the acquisition, maintenance and disposal of a piece of capital equipment or property. It might also be applied in decisions around other sorts of strategies such as increasing your labour force or market development.

To explore this concept we’re going to examine a scaffold manufacturing company case study.


Case Study

You’re the owner of Soaring Profit Scaffold, a scaffold manufacturing company. You have 5 full time welders making 200 scaffolds a month. Your sales team just landed a purchase order to deliver 200 more scaffolds per month for five years. Congratulations! Now what do you do? How are you going to make the extra 200 scaffolds?

Solution 1: hire 5 more welders and put on a second shift (one of them will have to have supervisory responsibilities since the office closes at 5 pm)

You learn that a robotic welder can make 300 scaffolds a month with one operator.

Solution 2: buy a robotic welder, train one of your welders as an operator and lay off 1.5 of your full time welders.

Total Cost of Ownership: Solution 1

  • 4 welders + 1 welder/supervisor  x (wages, benefits, employer’s government contributions, cost of turnover)
  • 2x machine wear and tear (running 16 hours instead of 8)

Total Cost of Ownership: Solution 2

  • Price of welder (includes training operator)
  • Machine maintenance
  • less 1.5 welders x (wages, benefits, employer’s government contributions, cost of turnover) less separation packages
  • less machine resell value at close of contract

Let’s assume the robotic welder is the least expensive route. Is this our final step? It is in TCO but not in ROI.

Purchasing the robotic welder will cost cash reserve or require a capital equipment loan. What is the lost opportunity for those funds? What would you have gained by initiating a new sales or marketing program; or purchased your building; or invested in a new accounting / production / inventory control software package?

Until you know the TCO for every investment of your financial resources you can’t begin to calculate or maximize your ROI. Your TCO gives you your cost of goods, your cost of opportunity, to plug in to your SELL – COST OF GOODS / COST OF GOODS equation. But it’s only the first step in your relative ROI analysis.

Your second step is comparing each significant expenditure or strategy with your other business development options. This comparison will yield answers as to your best ROI at any point in the development of your business.

Conclusion

What is ROI? In its simplest form Return On Investment is SELL – COST OF GOODS / COST OF GOODS. Your return on investment is a mathematical calculation and evaluation of your total cost of ownership of each of your business strategies, relative to each other, on an ongoing basis.

  • John Fricker says:

    Solid advice for any business venture. ROI assessment together with TCO are the most critical and powerful tools to facilitate thoughtful decision making and strategic business planning.