The Short Answer

How Do You Calculate ROI?

Textbook Definition

Return on investment (ROI) is a performance measure that compares the gain from an investment to its cost, calculated as net return divided by the cost of the investment, usually expressed as a percentage.

In Plain English

ROI tells you how much a spending decision brings back compared to what it cost. Take what it earns, subtract what it cost, and divide by what it cost. Then compare that to doing nothing, because doing nothing has a cost too.

Why It Matters

Why Does Saving Every Dollar Sometimes Cost More?

Saving is a strength. Spending carelessly sinks businesses. But money that sits still earns nothing, and a business that will not invest in itself slowly shrinks. The cost of not spending is real. It just never shows up on any statement, because it is made of sales that never happened.

That invisible cost is opportunity cost: what you give up by choosing one option over another, including the money you never made by not acting. ROI puts spending and not spending on the same yardstick, so you can compare them honestly.

Signs you have this problem:

  • You are putting up with broken or slow equipment to avoid spending.
  • You turn away orders because you cannot produce enough.
  • You have savings well beyond a reasonable reserve sitting idle.
  • You think of every dollar spent as a dollar lost.
  • You have never worked out what a repair or upgrade would bring back.
  • A competitor with newer tools is taking work you used to win.
Keep a reserve. But the dollars beyond the reserve should be working. Measure what the fix brings back, and what waiting has already cost.

What It Looks Like

What It Looks Like When the Savings Sit Still

From the Fabled Forest · Chapter 18

Thelma the Tortoise makes the best pots in the desert. She lived through seven drought years and came out with one rule: never spend a coin you do not have to. She has four hundred coins in a sealed jar. Her mother's kiln has a crack down the side, and two pots in three now break in it.

Cal the Camel has a good used kiln for 124 coins with delivery. Thelma asked Doctor Owl why she should spend coins she had already saved. He worked it out: twenty cracked pots a month, at three coins each, for eight months. The cracked kiln had already cost her 480 coins in sales she never made. More than the whole jar.

The new kiln would bring back sixty coins a month and pay for itself in about two months. Mrs. Owl-Willow asked whether the drought jar was still the right jar for the rain. Thelma kept 276 coins in reserve and bought the kiln. Twenty-nine of the first thirty pots came out whole.

Thelma's story is Chapter 18 of Accounting and Finance for Small Businesses, Book 2 of Dr. Paul's Fabled Forest Business School Series.

The Fix

How to Calculate ROI for a Small Business Investment in 5 Steps

Use this for equipment, a hire, a repair, a software tool, anything you are deciding whether to buy.

  1. Write down the total cost.

    Purchase price, delivery, installation, training. Everything it takes to get the thing working.

  2. Write down what it brings back each month, and how you know.

    More sales, fewer defects, hours freed for paid work, lower costs. Use real numbers: orders you are turning away, time you are losing, waste you can count.

  3. Work out the payback period and the first-year return.

    Months to pay back is cost divided by monthly return. A year of return is monthly return times twelve.

  4. Calculate ROI.

    First-year return minus cost, divided by cost. A result of 1.0 means it earned back its cost plus 100 percent more. Use the same formula on every option so you can compare them fairly.

  5. Compare it to doing nothing.

    Add up what the broken or missing thing has already cost you. Then keep enough in reserve for bad months, and let the rest work. That is reinvestment.

Dr. Paul's Insight

ROI is a decision tool, not a guarantee. The number is only as good as the estimate of what the purchase brings back. Base that estimate on something you can see, like orders you are already turning away or defects you are already counting, not on hoped-for new customers. And never spend the reserve to chase a return. The reserve is already doing a job: protecting you.

Worked Example: One Kiln, Measured A used kiln costs $1,240, delivered. The cracked kiln ruins 20 sellable pots a month at $30 each: $600 a month in lost sales. Payback: $1,240 ÷ $600 = about 2 months. First year: $600 × 12 = $7,200 back. ROI: ($7,200 − $1,240) ÷ $1,240 = about 4.8, or 480%. Waiting eight months had already cost $4,800. Figures are an illustration to show the math, not a projection for your business.

Sample: A Payback Sheet

One purchase, every line. Fill in the "cost of waiting" line honestly.

Purchase: Replacement kilnReserve kept: Yes
LineAmount
Total cost (equipment and delivery)$1,240
Monthly return (20 pots no longer lost, at $30)$600
Months to pay backAbout 2
Return in the first year$7,200
Gain in the first year, after cost$5,960
First-year ROIAbout 480%
What waiting has already cost (8 months)$4,800

Sample for illustration. Base the monthly return on sales or savings you can already see.

Watch

Video: How to Calculate ROI on Equipment and Upgrades

Video Coming Soon

How to Calculate ROI for a Small Business Investment

Dr. Paul fills in a payback sheet and calculates ROI and opportunity cost on screen.

From the Book

Why Spend Coins Already Saved?

Chapter 18 · Return on Investment

Sitting on Coins: A Tortoise's Treasure

"Four hundred," she said. "Every coin I did not have to spend, for twenty years." She put one foot on the lid. "That is what I asked you in my letter. Why should I spend coins I have already saved?" She looked at Doctor Owl with ancient, patient eyes. "I want you to tell me. Because I do not see a reason."

What had the cracked kiln already cost Thelma, and what did she decide? Find out in Chapter 18. Book 2 of Dr. Paul's Fabled Forest Business School Series.

Get the Book on Amazon →

FAQ

Return on Investment Questions

What is the ROI formula?
ROI equals the return from an investment minus its cost, divided by its cost. If equipment costs $1,240 and brings back $7,200 in its first year, the ROI is ($7,200 minus $1,240) divided by $1,240, or about 4.8, which is 480 percent. Use the same time period for every option you compare.
What is a good ROI for a small business?
It depends on the risk and the time it takes. A short payback period on a well-understood purchase, like replacing broken equipment that is losing sales, can justify almost any positive ROI. Riskier or longer-term investments should promise a higher return. Always compare against the cost of doing nothing.
What is opportunity cost?
Opportunity cost is what you give up by choosing one option instead of another. If you keep money idle instead of fixing a machine that is losing sales, the opportunity cost is the profit from those lost sales. It never appears on a financial statement, which is why owners often ignore it.
Should I reinvest profits or save them?
Both, in order. First build a cash reserve of a few months of operating costs. Beyond that, money sitting idle earns little, so reinvest in things that measurably bring back more than they cost, like equipment that removes a bottleneck or replaces something losing you sales.

Keep Going

Related Foundations

ROI connects four foundations, from how you pay for an investment to how you plan for it. New to a term on this page? Every one is in the accounting and finance glossary.

Foundation 17 · Debt and Leverage

If you borrow for the purchase, the debt has to earn more than it costs.

Foundation 19 · Break-Even Analysis

Break-even shows how much new work a purchase needs to pay for itself.

Foundation 16 · Cost of Financing

Add the cost of financing to the cost side if you are not paying cash.

Foundation 20 · Budgeting and Forecasting

Put planned investments into next year's budget, after the reserve.
← Back to the GuideAll 20 Accounting and Finance Foundations

Written by Dr. Paul Borosky, DBA, MBA, business consultant, author, and educator with an MBA focused in finance. Weighing a big purchase and want the numbers checked? See fractional CFO services.

This page is for general educational purposes only. It is not legal, financial, tax, accounting, or lending advice. Tax rules change by place and by year. Dollar figures are illustrations. The Fabled Forest and its characters are fictional. For decisions about your own business, consult a qualified professional.