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Whether or not you are specifically familiar with the subject of Return On Investment (ROI) and can answer the question, what is ROI?, most everyone understands the concepts behind efficiency. Asking what is ROI is like asking "what is efficiency", but only when it is applied to your money. Understanding that most basic idea, let's take a further look at what people mean when they talk about ROI and also why so many people seem to care so much about it.
While the concept of ROI usually only refers to business, it can actually be used anywhere in society when you think about it from a broader sense. Most all individuals have some sort of wealth whether in billions or merely in dollars. We make decisions to spend the wealth because having money in itself is nothing. Money only has value because it allows us to obtain something else. Therefore, the concept of what is ROI? is pretty important to calculate because we need to be able to evaluate what our return is for a given investment.
While the concept of ROI usually only refers to business, it can actually be used anywhere in society when you think about it from a broader sense. Most all individuals have some sort of wealth whether in billions or merely in dollars. We make decisions to spend the wealth because having money in itself is nothing. Money only has value because it allows us to obtain something else. Therefore, the concept of "what is ROI" is pretty important to calculate because we need to be able to evaluate what our return is for a given investment.
Investopedia defines return on investment as "A performance measure used to evaluate the efficiency of an investment…" Then, what is ROI? It's equal to the (Ending Value of an Investment - Cost of the Investment) / Cost of the Investment.
A more direct definition of return of investment might be: what you earned, expressed as a percentage of what you paid for it.
Now to further answer what ROI is. If a young child purchases a bicycle which he or she uses for a while and then sells it to another child at some point down the line, we can calculate the ROI. There was an initial investment (the purchase of the bicycle), and also an ending value within the assessment to the investment (the ending purchases price).
If the child purchased the bike for $100.00 up front and then sold it for $100.00 we can use that information to calculate efficiency. What is the ROI? In this case the ROI would be 0%. This is not a good thing in the real world because of items such as inflation and opportunity cost, but to say that an individual didn't receive any return on investment basically means they could have taken the money and shoved it in a safe for a while; it would probably have been safer. We are of course ignoring the value of the child using the bike.
If the child polishes the bike up and sells it for $110.00, what is the ROI in this case? He or she would have had a ROI of 10%. Likewise, the investment could have lost money as well. But in both cases there is a return on investment and it can be positive, negative, or zero.
Now that you understand the very basic idea of what ROI is, you can truly take it to the most common level where it is used. Businesses (especially financial companies) evaluate ROI because it shows whether or not a company is making intelligent decisions with their money. It also shows whether a particular investment is worth investing in.
ROI is used many times because it gives a very good indication on what a business truly brings to the table while also allowing for the valuation in a minimal amount of steps. When faced with the dilemma of limited funds (as everyone is), an individual can choose based upon what the expected ROI will be of a given decision.
For example, why would a purchasing manager want to bring in a brand new machine if there was an older machine for sale that could provide a higher ROI? The first question to ask about the machine is "What is the ROI?" Basically, is the older machine more efficient and it will it give us a higher return on our money than a newer one could?
Plus, it is a great way of making a decision when there is so much information to filter through; especially when a sales person tries to sell you all of the bells and whistles of the new machine as well. That answers the question of: "what is the ROI," in a number of ways.
Overall the point of what ROI means can be summed up by efficiency. Comparing multiple decisions or opportunities can be difficult and can also take up a lot of valuable time. However, by having the ability to look at two numbers quickly and just compare them, we can already put the expected value or profitability of each decision into context. Of course, if there are annual cash flows and and interest rates to consider one might want to make time value of money calculations using net present value or interal rate of return to make the decision. However, ROI can be a quick and dirty method of evaluating investments.
This is tremendous as it allows us to save time and still make a better informed decision. And, whether you are trying to calculate ROI on a million dollar machine for your company, trying to calculate a stock investment, or just trying to calculate if a new bike is a profitable investment for your children, the conceptual ideas of return on investment can definitely help to put things in perspective.
