Written by Stephen Beard, Managing Director of Plyo Bookkeeping, a Vancouver-based bookkeeping firm.

Introduction

There are many financial metrics, but it seems they were not all created equal. There is one financial metric which has risen to rule all the others – and that’s Return on Investment (ROI). You won’t be able to have a business lunch and escape hearing about how something is justified by ROI, so today I’m going to unpack why it’s so popular, and so dangerous.

What is Return on Investment (ROI)?

Let’s start with the basics. Return on Investment is a way of measuring how profitable a particular investment or business decision was (when reviewing actual performance) or could be (when making business decisions). In general, I find that smaller businesses use ROI when they’re making decisions, which means that the numbers they’re using are estimates, including the potential ROI rate of return.

Like most financial metrics, the actual calculation is very easy. Defining the variables is the hard part.

ROI = (Net Profit/Cost of Investment) x 100

Return on Investment is the profit you made expressed as a % of the cost of the investment. This is very straight forward when talking about investing in something like a business. If you paid $100 for shares, and then one year later the shares were still worth $100 and they’d paid out a $10 dividend, your profit would be ($10/$100) x 100 = 10%.

When ROI gets Tricky

The above example was child’s play. But ROI get’s much harder to calculate when you’re trying to evaluate a business decision, like whether you should spend a significant amount of your marketing budget on Search Engine Optimization (SEO). SEO is a form of marketing that focuses on trying to get your website to rank higher on search engines like Google. The higher you rank, the more customers that will click on your website, and in theory the more sales you’ll make. It is the perfect example of something that’s very hard to quantify and measure.  

Uncertain Estimates

To calculate the Return on Investment of spending a few thousand dollars on SEO, you’ll need to do a lot of estimating on a topic that you’re likely not a subject matter expert on. If you produce an estimate for the ROI of spending money on SEO, it could be wildly inaccurate – leading to a bad decision.

For a lot of businesses, the key metric used when making decisions is ROI. But ROI can’t be used to justify every decision, and some decisions won’t be easily quantified. If you overly rely on ROI, the investment options which are hard to measure, but may be very good business decisions, often get ignored.

Short Term Focus

Return on investment doesn’t actually define a timeframe. A 50% ROI sounds amazing, but it sounds less amazing if that’s over a 25-year horizon. This isn’t a major problem, as you can easily decide to look at ROIs over a defined time frame.

I find that small businesses tend use ROI over surprisingly short time frames, with the most common being 12 months. In my own career, I’ve experienced how dangerous this can be. A very common problem is short-termism in advertising decisions. The Return on Investment incentive means that campaigns focused on last minute deals with a significant discount get the most sales, and therefore the highest ROI. Activities like long-term brand building (for larger businesses) or SEO (a longer-term advertising spend option that’s viable for small businesses) are constantly underfunded. Brand building and SEO have much longer time horizons for sales, and their true value is very hard to quantify in terms of ROI.

But the problem is more serious than simply not choosing the best mix of advertising channels. Short term deals and discounts may generate a quick buck, but if they’re done too frequently then it can damage your brand and image. If your product is constantly on sale, then that discounted price teaches customers that this is what your product is worth. In other words, a short-term ROI focus in marketing can damage your brand and your long-term business prospects

Forgets the Fluffy Stuff

Accountants don’t normally focus on the fluffy, non-financial business metrics, but they matter. As a metric, Return on Investment is just telling you about your net profit expressed as a percentage of the investment, nothing else.

Imagine a small law firm that’s deciding between hiring a contractor and an employee. The owner is concerned that there isn’t enough new business to justify a full time hire, but is also concerned that the current staff are overworked and stretched too thin. The contractor can have their hours flexed depending on the availability of work, whereas the employee will need to be paid for, regardless of how much work is available. Most small businesses hire the contractor, because the flexible hours mean that they can be paid less, and the ROI on hiring them is greater.

But this focus on ROI misses a lot of important fluffy stuff. A contractor on flexible hours lacks security and may end up finding other work, which means they’re much less reliable. It’s also doesn’t make sense to invest training into contractors, as they’re more likely to leave. For some jobs this isn’t a big issue, but for professional service industries it matters a lot. The ROI might be higher on a contractor, but if your staff base is full of poorly trained contractors who are likely to leave, well that’s not a great foundation to build a business on.

Full time employees cost more, but you can invest time and training into them, and also build up a sense of shared values and team moral – all stuff that will result in better work and happier customers. Hiring the contractor might still be the right call, but considering the fluffy stuff is important.  

Ignores Risk

The basic ROI metric doesn’t include risk. The ROI on not paying your insurance for the next year is a guaranteed 100% return (per the metric), but it’s still a terrible idea.

Consider two investment opportunities which both have an estimated ROI of 20%. These ROIs were created using estimates, some of which may be highly uncertain. One investment could be a guaranteed 20% return, while the other could be a 20% return with a significant chance of things going wrong and no return at all being made. The relative riskiness of the two investments is not captured by the basic ROI calculation.   

Conclusion – Modify ROI Formula to Suit Your Needs

It might seem like I’ve been arguing against the use of ROI as a key business metric, but that’s not the case. Rather, I’ve been arguing that ROI is just one metric, and that it should be used as part of a broader analysis when making business decisions.

The Return on Investment calculation can also be customized to your situation, allowing you to make it more relevant to your decision. For example, you can decide that you want to assign estimated values to things like customer satisfaction, staff morale and other non-financial considerations. You can then include these as costs or revenues associated with the investment. Just the process of trying to quantify the wider ramifications of an investment can be an excellent exercise in better understanding what matters in your business and your long-term strategy.