Return on Investment is one of the crucial aspects that will help you determine whether you’re running your business efficiently or not.
The name is pretty self-explanatory; Return on Investment is a ratio that determines whether the expenditures of your business operations are generating a desired amount of income.
If you want your business to survive, you need to maximise your ROI.
Calculating Return on Investment
The formula above is pretty simple, but let me break it down for you.
EBIT is the amount of sales that a company generates before paying off costs such as interest or taxes.
In the Income Statement, you’ll find EBIT under the head of Operating Profit:
This is because we get EBIT from subtracting depreciation and amortization and other expenses from Net Sales.
What is considered a good Return on Investment?
You’re always hearing that ROI needs to be increased or maximised. But what is the benchmark that you need to reach?
The truth is, there is no set percentage of ROI that businesses need to achieve.
The benchmark or average ROI which is considered satisfactory varies from industry to industry.
The primary purpose of each industry ROI is to give investors an idea on the basis of which they can compare the performance of different firms.
Keeping all other variables constant, investors will spend money on firms with the highest ROI.
But how is an industry average set? The ROI of each firm is calculated using the formula above. It is multiplied with 100 to calculate the percentage.
To calculate the average, every firm’s ROI is added and the total is divided by the number of firms.
It’s simple math which you can carry out yourself if you are looking for the industry average of a specific industry that is not publicly available.
However, this information is available online for Public Limited Companies because their financial statements are uploaded on the company’s official website.
You can use those as well to compare the ROI’s and pick the one with the highest percentage, taking into account other factors as well.
Check out this guide on ROI by industry to find out different industry averages.
However, unlike ROE, you can break down ROI into different categories as well.
It is not just limited to the overall sales and capital of the company.
You can calculate the ROI of different departments within a firm, for example how much the marketing department is currently earning and how much capital is being invested into it.
Similarly, you can also calculate the ROI of a particular project or time period, for example, investing in SEO and social media marketing.
Calculate the amount of money invested over a period of time and the sales that it has generated:
How to Increase Return on Investment
Especially now due to COVID-19 when sales are declining sharply for most businesses out there, increasing ROI is crucial for survival.
Here are a few ways through which you can increase ROI instantly as well as in the long run:
- Review your costs
If you’re using a cost-plus pricing method, you’re already keeping a regular check on your costs.
However, it is important to do that in any case to ensure maximum profitability.
The first step is to review your overheads. Do you have extra employees for a job that can be done by fewer people? Or is there a new bot that can replace humans and is cost-effective in the long run?
This is because your overheads are variable and often, companies have extra labour or machinery that can be sold off or put to better use.
Then, move on to your fixed costs. These will not change too much in the short run but it is still beneficial to regularly monitor them.
You may be getting raw material supplies at a fixed rate from your long-term suppliers.
However, there are new entrants in the market in every industry that are willing to offer lower prices to penetrate the market and gain market share so keep a lookout for them.
- Analyse your competitors
Normally, I am always against following competitors and I still advise that.
Copying the strategy of another business will never bode well because even if two businesses are selling the same products, every business is unique and has its own secret to success.
That brings me to the bottomline – it is still important to analyse the strategies of your competitors.
There’s always that one business that is getting maximum customers or offers the lowest prices while remaining profitable.
This is why you need to find out what your competitors are doing and adjust your business accordingly.
You don’t need to offer low prices if you can’t afford it. If you’re losing customers to your competitors because of this, you can always offer premium products or customer service that attracts customers towards your business.
Make the overall experience better for your customers because a changing trend in consumer behaviour has been that millennials are much more willing to spend on businesses that make an effort to provide customers with everything that they need in addition to the core product, for example, free consultation before hair treatments.
- Maximise employee efficiency
This is also linked to the first point in which I talked about reviewing your costs, but it is not limited to that.
Just as customers require an fulfilling experience, so do your employees.
Minimum wage and doing grunt work from 9-5 does not cut it anymore for this generation of employees.
Employee motivation is a key driver of your company’s success so make sure you invest in Human Resource Management (HRM).
If your work process allows flexible hours, let your employees have them.
This will give them a sense of control over their work and motivate them to get it done quicker in exchange for fewer office hours.
Secondly, offer rewards and link them to work commitment.
In my experience, this is the biggest thing brands get wrong.
I’ve often seen firms give out end of the year bonuses to all the employees as well as tokens of appreciation.
However, if you don’t link these rewards to hard work, it will demotivate your core-performers who put in the most effort.
It’s tricky to offer bonuses to some employees as well because you run the risk of demotivating others but do your best to balance it because it goes a long way in boosting morale.
Remember, happy employees mean happy customers so your HRM efforts are part of your investment that will eventually generate results in sales.
- Focus on the long run
Everything that I mentioned above is something that most firms practice already.
However, in the case of both small and large-sized firms, it is important to focus on the bigger picture.
For example, if the management and shareholders of a company are separate, conflicts may arise.
In finance, this is what is called the Principal-Agent problem.
Managers and CEOs are focused on long-term profitability whereas shareholders want maximised returns on their stock in the short run.
There often arises a conflict because long-term profitability means reinvesting retained profit back into the business in order to expand operations and run operations smoothly.
However, since shareholders are owners of the corporation and upper management is employed, employees are bound to carry out the decision taken by shareholders.
The point is, its best to focus on what’s best for the company which is why it is important to take into account the long run.
There are only some exceptions where increasing dividend share is good for the company, for example, if you need to sell stock or your stock price has fell so you need to increase dividend payout in order to attract investors (another great way to attract investors is to lower the investing fee i.e. starting fee, ARR, additional contributions etc.)
- Balance your risk of investment
This is perhaps the trickiest part of increasing ROI and can go either way. And unfortunately, there is no right and wrong – it’s a risk you have to take.
I’ll tell you why overspending or underspending on your firm can both prove to be bad.
Playing it safe and not opting for riskier investments will get you satisfactory performance. You don’t run the risk of bankruptcy and you can slowly but steadily expand.
However, this strategy would have worked a decade ago when there wasn’t too much competition in the business industry.
In today’s world, if you’re too stringy with investing, competitors will see it as an opportunity to get ahead of you and before you know it, your market share will drop.
Take the example of a dermatology clinic that does not have automated equipment for laser surgery.
Older equipment is slower, less safe and requires more manual handling as compared to newer models.
While this would allow you to price your customers lower, most would still prefer going to a clinic that offers a seamless and risk free experience – thus, placing you behind your competitors.
Similarly, over-investing has been one of the biggest causes of bankruptcy throughout history.
Take the example of the Lehman Brothers.
If you don’t already know the story, here’s what happened.
As one of the largest investment banks in New York, the firm had over $690 billion in assets back in 2008.
It had the first mover advantage as one of the first banks to acquire mortgage originators.
However, the bank took on some of the riskiest investments with no borrower background checks, low credit ratings, poor FICO scores etc.
Unfortunately, within the same year, the firm filed for bankruptcy.
This remains one of the many examples of how some of the biggest firms went down due to investments that were too risky or spent over their capacity.
Financial analysts will always tell you that the riskier the investment, the higher the return. That’s true and had it worked out for the Lehman Brothers, they would have one of the most successful banks on Wall Street even today.
But it is also a lesson that excessively risky investments work out in rare cases so it’s best to balance the risk and return.
- Manage consistency
You need to achieve that balance between offering a great customer experience and handling customers who are not satisfied with your service.
One of the biggest mistakes businesses make is not realising that a perfect business does not mean 100% satisfied customers.
If you don’t plan for customers who may be problematic or find an issue with your offering, then your employees may not deal with them properly – leading to negative reviews and it’s no secret that negative word of mouth is much more damaging than the effect of positive word of mouth.
So what do you need to do?
The first thing is to accept that mistakes will inevitably happen.
If one of your employees is having a bad day, they could be rude to a customer.
Incidents like these are fine as long as you do damage control.
HRM studies are increasingly showing that employees are required to display workplace behaviour that often conflicts with their personal emotions.
Thus, instead of asking your employees to subdue that and lead to demotivation, allow them to come to you and express it.
However, if they make a mistake with customers due to this reason, make sure the employee apologises and if the customer still doesn’t seem satisfied, offer a discount.
While doing all this, make sure you show customers that you care.
That is the key driver for customer satisfaction.
Empathy and emotion will ensure customer loyalty even if you make mistakes.
Remember, mistakes are inevitable; it’s all about how you deal with them.
Apart from all these measures, you can also use tools for online marketing that will maximise ROI.
So that sums up everything you need to know about Return on Investment. The bottomline is always to maximise it and there are a number of ways you can do that.
However, they will only be effective if you choose the right path and execute it timely.