Suppose you have a printing business and you spend $1000 on advertising in January, and you make a gross profit of $1010. Per wikipedia’s ROI article, ROI is:
Return on investment (%) = Net profit ($) / Investment ($) × 100
or: ROI = (1010 – 1000) / 1000
That’s 1% for the month, or annualized about 12%. Not bad — it means that you’re doing better by buying the advertizing than putting the money in the bank.
So far, so good, but what if you’re not profitable yet? Worse, suppose you are incredibly un-profitable. Suppose you spend $1000 on advertising and make only $10 back. By the same formula you get:
ROI = (10 – 1000) / 1000 = -99%
That’s -99%. If you understand ROIs that’s fairly straightforward, but here’s the rub: suppose that in February, undeterred by your lack of success in January, you spend another $1000 on advertising. You’re still not very successful, but you do manage to make two sales and a gross profit of $20. Back to the formula:
ROI = (20 – 1000) / 1000 = -98%
Take a moment to consider: your sales doubled. That’s huge. But the ROI went from -99% to -98%. That’s disappointing. The difference appears small becuase ROI isn’t measuring what intuiitively we think we measuring. ROI isn’t measuring the distance from 0; it’s measuring the distance from complete failure — from -100%.
Looking at it that way brings the example into line: you doubled your sales, and (-98 – -100) = 2 is twice as great as (-99 – -100) = 1.
The situation is just as strange around breakeven. How is ROI useful when comparing a month where you made a gross profit of $900, for an ROI of -10%, and a month where you had $1000 in sales, and hence an ROI of 0%. How does 0% compare to -10%. It’s better, obviously, but how much?
ROI is useful when you get a reasonable return and want to compare it to other ways to invest your money. If they ROI is better than 10% annually (roughly) then you should definitely invest.
A better alternative is to simply compare the net profit to the investment. It’s a small distinction, and perhaps it has flaws of its own, but it would show much better in cases like these examlpes what’s going on.
I’m curious what others would use in this situation