| NewsletterCalculating Return on Investment
Businesses of every size are concerned about their return on investment. All investments, whether time or money, must generate a positive return on the investment in order to remain in business. The return on investment for advertising is often the hardest to calculate due to intangible evidence used in the equation. Pay-per-click (PPC) advertising offers a unique opportunity to more accurately calculate the return on investment. To understand how PPC advertising returns can more accurately be determined one must understand how ROI is calculated, where the equation is wrong and how the equation should be adjusted for greater accuracy.
Traditional ROI Calculation
Business statistics courses teach two methods for calculating the return on investment.
The first method of determining ROI is …
ROI = (Revenue – Investment) / Investment * 100
This method is simpler and more straightforward. Simply determine the revenue for the investment period and the investment cost. Once these two numbers are determined the ROI is easy to determine.
The second method of determining ROI is …
ROI = (Δ Revenue – Investment) / Investment * 100
In order to determine the Δ Revenue, one must first determine the baseline revenue. The baseline revenue is an educated guess based upon previously observed revenue behaviors and identified as Rev1. The revenue generated during the investment period is then determined based upon the new observed revenue behavior and identified as Rev2. Once these two revenue numbers are determined we determine the Δ Revenue with the following equation.
Δ Revenue = Rev2 – Rev1
The investment period should represent the period during which the investment is being used. In the case of advertising, the period could be determined starting with the first day the advertisement runs and ending with the last day advertisement runs.
Inaccurate ROI Calculation
In general terms, the two methods provide an insight into the business and how an advertising campaign affected the business.
Using the first method and using the following numbers one can assert that a ROI of 567% was generated.
ROI = (Revenue – Investment) / Investment * 100
ROI = (100,000 – 15,000) / 15,000 * 100
ROI = 85,000 / 15,000 * 100
ROI = 5.67 * 100
ROI = 567%
The second method allows us to see a totally different picture based upon how the revenue changed from the baseline comparison. It is every business owner’s hope that the revenue change will be positive. A negative change can be easily seen, but a minor increase may not always be noticeable using the first model. The first model assumes the entire revenue is generated from the advertising campaign.
Using the second method with the following numbers one can assert that the ROI of the advertising campaign is …
Rev1 = $80,000
Rev2 = $100,000
ROI = (Δ Revenue – Investment) / Investment * 100
ROI = ((100,000 – 80,000) – 15,000) / 15,000 * 100
ROI = (20,000 – 15,000) / 15,000 * 100
ROI = 5,000 / 15,000 * 100
ROI = .333 * 100
ROI = 33.3%
Each of these methods is accurate for its general purposes. However, they do not properly represent an accurate picture of return on investment.
Calculating True ROI
What is true ROI? The return on investment after accounting for the cost of goods sold and SG&A (selling. general costs, and administration). Essentially, it comes down to income before interest and taxes (EBIT). However, only the accounting department or comptroller will know how the true ROI shakes out.
There is a method of getting closer to the true ROI that can be used for any product, category of products or the entire catalog of products or services. This method uses the following equation where COD is cost of delivery.
ROIt = ((Revenue – COD) – Investment) / Investment * 100
Cost of delivery is calculated using the following equation.
COD = COGS + Shipping + Labor + Overhead
Notice this equation is now giving us a better picture of how the cost to make or purchase the product, shipping costs (if any), labor, and overhead are now subtracted from the revenue to get an idea of how much profit was truly generated.
Using the ROIt example below one can now see how important it is to include COD in the equation.
ROIt = ((Revenue – COD) – Investment) / Investment * 100
ROIt = ((18,936 – 13,255) – 9,172) / 9,172 * 100
ROIt = (5,681 – 9,172) / 9,172 * 100
ROIt = -3,491 / 9,172 * 100
ROIt = -.38 * 100
ROIt = -38%
While the traditional ROI equation would represent a positive profit, the reality is the entire advertising campaign was a loss. While it is sometimes hard to come up with the real COD value, one can estimate it based upon the business’ desired net margin profit. For example, a desired net margin profit of 30% would be subtracted from the revenue to get the desired or expected COD. Of course, the COD value would be an estimation.
The Δ Revenue ROIt equation, as represented below, can be used to evaluate the increase or decrease in revenue compared to the investment.
ROIt = ((Δ Revenue – COD) – Investment) / Investment * 100
In this equation the COD should be estimated using the Δ Revenue versus the revenue as in the first method.
In Conclusion
Accurately calculating and evaluating a business’ return on investment is essential to the success of the business. The traditional ROI equations fail to identify short-comings or false beliefs unless the revenue for the period is less than a comparable baseline. Both the traditional and true ROI methods inaccurately assume that all revenue is generated from the advertising campaign. However, the true ROI method helps gain a better understanding of the business’ profitability.
