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As you begin to learn what it takes to run a small business, you’ll come across the phrase “return on investment,” also known as ROI. On the surface, the phrase itself seems relatively straightforward. When you really dig in, however, the concept of ROI can be a challenge to fully grasp.

Here are the most important things to know about ROI, including how to calculate it, why it’s useful and the best target ROI for your business.

Beginning with ROI basics

Simply put, ROI is the amount of money your business makes (return) compared to how much is spent (investment).

Keeping track of ROI, particularly for various forms of marketing, is vital for running a profitable business. It gives you a sense of the types of marketing that generate revenue, as well as those that don’t, so you can make smarter decisions going forward.

How do I calculate ROI?

When calculating ROI, there are two main ways to look at it: as a percentage or as a ratio.

Percentage

There are three steps to calculating your ROI percentage:

  1. Subtract the initial investment cost from the earnings that resulted.
  2. Divide the result by the investment cost.
  3. Multiply by 100 to calculate the percentage.

As a simple example, imagine you spent $100 on a Facebook advertising campaign, leading to $400 in total revenue from the campaign. Let’s go through the steps again:

  1. Subtract the initial investment cost ($100) from your earnings ($400): $400 – $100 = $300
  2. Divide the result ($300) by the investment cost ($100): $300 / $100 = 3
  3. Multiply that result (3) by 100 to calculate the percentage. 3 x 100 = 300

As you can see, the Facebook campaign led to an ROI of 300 percent.

Ratio

Staying with the same example, you can also look at your ROI as a ratio of the money you generated versus the amount you spent. In the Facebook example, your business made a profit of $300 for $100 spent, so your ROI ratio would be 3:1.

Figuring out the ratio is the same as calculating your ROI, minus the third step:

  1. Subtract the initial investment cost ($100) from your earnings ($400): $400 – $100 = $300
  2. Divide the result ($300) by the investment cost ($100): $300 / $100 = 3

The final answer here is 3, meaning you made $3 for every $1 you spent, or a ratio of 3:1.

Setting ROI goals

The ideal marketing ROI for your business depends on a variety of factors. It’s affected by the type of business you run, as well as the type of investments you make. No matter the number, however, you always want your ROI to show that your investment resulted in profit.

For example, an ROI of 200 percent or 2:1 would not be ideal for a clothing boutique, because the business must factor in the initial cost of the clothes they are selling. In this example, assume the cost of the clothing was 50 percent of the final sale price.

If this business spent $100 on marketing for $300 in revenue, the ROI would be 2:1 ($200 profit for $100 spent). However, because the store had to pay 50 percent of the sale price of the clothing before it could sell it, $300 in revenue also means the store paid $150 for the clothing up front. Essentially, the business owner made a profit of just $50 – probably not worth the investment.

That’s not to say a 200 percent ROI is always unacceptable. For example, if your business spent $200 on eChecks but saved $400 on mailing costs by emailing checks to vendors, that 2:1 ratio would be welcome because it’s all saved money.

As your business grows, you’ll begin to calculate ROI for many different types of spending. Over time, this will teach you the types of investments that work and the types that don’t. And in the end, this will help you make smarter decisions that keep your business profitable for the long haul.

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