Article Discussion: Will the Real ROI Please Stand Up?

For a long time now, I’ve noticed a disturbing trend in the use of
the term “Return on Investment” (ROI). Since the ROI equation is really just
about division, I’m going to take a minute or two to go over the details of what
the real ROI is about and how you can use it in the optimization of your SEM and
other interactive advertising activities. Be forewarned here, kids, we’re going
to be talking about mathematical equations here today. But don’t panic, it’s
nothing close to John Nash level equations, just simple division and
multiplication.


Read the full article here: Will the Real ROI Please Stand Up?

The equation states "(profits/invested capital) x 100"
The author goes on to state that if your profits are $100 and your capital is $100, than you have made a ROI of 100%, doubling your money.

But actually, you have made an ROI of 0%.

So either the equation, or the example description is incorrect.

OK, you are kinda right and kinda wrong wrong, but so is the author (to a degree), and perhaps this wasn't spelt out very clearly.

I think the author, in this ROI equation, counts ad spend as a variable expense, that is it is already accounted for in what he calls the "profit".

e.g. if you sell $1,000 worth of "stuff", with a 20% margin, and it cost you $100 of ad spend top get it, then your ROI is:
ROI = ($1000 (revenue) * .2 (margin) - $100 (Advertising spend)) / $100 (advertising spend)



Personally, I don't like the word "profit" in this context. Profit relates to revenue * margin - ALL expenses, including wages, electricity etc, i.e. both fixed and variable Expenses.

Put another way, ROI is a measure of spend to margin, but whether you make actual, tangible profit is not a measure of an isolated ROI, but revenue - variable expenses - fixed expenses.

To illustrate a positive ROI unprofitable business, if one spent $75 on ads, made $300 in margin over a month (including ad spend), yet one's rent was $1000 for the month, electricity $100, telephone $100, and other expenses $200, the ROI would be quite healthy (300/75 = 400%), but actual net income / profit would be aweful (-$1100).

Don't get me wrong, ROI is extremely important, but in teh end, it is just another business metric, not the sole business metric. It is only by looking at the final bootom line that one can see the true state of a business. I know that a lot of this is beyond the scope of the article, but it kinda needed saying methinks, especially in light of the erroneous use of the word "profit", and how this could be misconstrued.

Let's take an example

I pay: $1/click
I get 10 clicks => my cost is $10 (let's forget about resources, etc ...)
I sell 1 product (margin=$5) => I make only 5$

According to this article : ROI = 5/10= 50%. Not worth it then?

Well, the 9 other visitors clicked on the ads I display on my site, and I made $10 out of that.

Now my ROI=15/10=150%.

Conclusion : It's easy to become too pessimistic regarding your ROI too,and to miss good sources of profit !

Hi Rick,

the equation is correct. ROI is not the same as profit.
If you spend 100 $ in ads and make 100 $ from it,
then your ROI is 100%, because ROI means return
on investment and in the above case 100% of the
money you´ve invested came back (returned).

Of course your net profit in this scenario is 0.

Hope this helps.

Guido
TheJungleMarketer.com

ROI = income / investment, not revenue / investment.

ROI can be calculated different ways. From my glossary:

RETURN ON INVESTMENT (ROI) is a profitability measure that evaluates the performance of a business. ROI can be calculated in various ways. The most common method is Net Income as a percentage of Net Book Value (total assets minus intangible assets and liabilities).

ROI is an indicator that is not to be taken as a stand alone. In many cases Cash Flow and/or Net Profit Margin are better indicators. ROI is usually used to indicate if an investment yielded or will yield the results planned upon.

You know what's funny? In my MBA classes, each class seems to have a slightly different measure of ROI. Boiled down, Cygnus version:

[How much per dollar profit yielded from per dollar investment exists from an activity costing viewpoint] -- each discipline skews this to meet their needs "marketing dollars", "operational efficiency ROI", etc. Blah. If you don't need the MBA for the rubber stamp that it is, don't bother getting one.

Cygnus

Cygnus... got my rubber stamp quite a while back. Also carry a stamp for my students.

ROI is NOT a measure of profit. IT CAN NOT BE be definition. ROI is a measure of teh margin returned from spend. In fact, a business can make a paper profit, and go belly up (bad debts etc).


That is Nutz. ROI is measured based on users. If you make $1000 in sales, teh source of that traffic needs to be known, i.e. where did people who bought stuff find out about your site? The ROI example carote used is simply wrong. if 10 peopel see an ad and click through and buy stuff, even if they click 30 more times in between, that still needs to be attributable to some source. If a source of traffic generates NO revenue, or the margin doesn't cover teh cost, then that is a negative ROI.

Conclusion: ROI confuses many people. Keep it simple: ROI = Total of sales - cost of goods - cost of ad / ad spend. Easy.

Yet another definition. Just FYI, ROI in all the B-schools is taught as a profitability ratio/measure, but it is not the only measure AND it can be calculated many different ways.

SEO_AM -

Have you ever brought up the subject of SEO and search engine marketing in a MBA marketing class? I received nothing but blank stares when I forcefully said that this method would yield the highest ROI, in terms of interactive / web advertising, for at least the next 5 years.

Naturally, the comments were lost in obscurity. The business world (and most large ad firms I've dealt with) still don't get it: this is a pull marketing method; people search, you provide the accurate response. Anyhow, I'm getting off-topic.

Cygnus

Cygnus, you are absolutely correct. This will become truer and truer through the next several years. In fact there are major discussions and Harvard level studies looking at SE branding. My own site is a test of sorts re: SE branding. The thesis being that if you place consistenly in the top 5 for many industry keywords/phrases, the searching public of that subject matter will begin to recognize and trust the non-advertized brands more than the those that are adivertised. This without a dollar of advertising being expended. My site generates good revenue, but we have yet to spend $1 in advertising of any kind. For the proof of our thesis, this will require that the SE's maintain some form of relevance criteria in their rankings for some time into the future. We are both off-subject now. But it is fascinating.

Actually, $100 devided by $100 is 1, times 100 is 100, which in this case represents 100%, or an even ROI - you made back enough to cover your expenses and some profit.

Yes, that's what the article is making a point of correcting... so often, people simply use revenue above the line and that's just incorrect. Not putting profit (or income) in that top spot is just asking for trouble.