What is ROI Return on Investment explained

What is ROI?

Many of the business decisions made every day take ROI into account. Most good managers, or business owners, will not make a decision unless there is some sort of ROI to the company involved in making that decision. The concept of ROI dictates sales decisions, and it can also dictate other important decisions such as personnel decisions and business plans. In order to be able to efficiently and effectively run any kind of business, you must have a complete command of the concept of creating a positive ROI for your company or else you will not be in business for very long. So what in the world is ROI?

In the world of business ROI is king and ROI stands for Return On Investment. In order to justify the purchase of a piece of equipment, a business person must first show that there is an ROI on purchasing that equipment. Very few managers or business owners will approve a purchase made without there being sufficient ROI shown for the purchase. It may sound pretty easy to understand ROI, but there is a lot that goes into determining ROI and in many cases using ROI to justify a purchase can constitute a huge risk being taken by that business.

One of the ways to determine ROI that is used by many businesses when determining whether or not to purchase a large amount of equipment is something referred to as lifecycle ROI. Every product purchased by anyone has a lifecycle, and the value of that lifecycle is not always determined solely by the cost of the product itself. There are many examples to illustrate this point, but probably the best example is by using the lifecycle ROI of purchasing a single computer for a business.

Determining actual ROI varies from business to business, but the process most businesses use is usually the same. When a company decides it may be time to purchase a new computer, they first must determine if the cost of the computer is worth it to them. If a computer costs $1,000.00, then there needs to be at least $1,000.00 worth of production being lost by using the current computer. Recovering that lost production may not pay for the computer immediately, but as long as it can be shown that it can be repaid in a reasonable amount of time then the purchase can be justified. In most cases, the company purchasing the computer will use the term of the warranty as the time they will need to recover their cost. Once the warranty is up, the computer then becomes a potential source for revenue loss because fixing it will cost money. But the original lost production is used to determine that a computer purchase needs to be made, and that determines the initial ROI on the computer.

When a company purchases a piece of equipment, they do not log that cost all at once in their accounting. The value of the equipment is stretched out over time, and the value of the equipment is depreciated over time. That is why a $1,000.00 computer can show ROI over time. The cost of the computer is not absorbed all at once by the company's accounting records. Once the computer has been accounted for in the records, it is no longer a tax benefit for the company. The tax write off for the company in purchasing the computer also goes into figuring the ROI of the computer. Once the computer is out of warranty, and is no longer a tax benefit, the ROI of the computer is determined by its continued ability to perform without requiring costs associated with repair and the ability to allow sufficient production by the person using it. If the computer becomes too costly to keep due to repair costs or lack of production, then it has outlived its ROI and is usually discarded. Even storing old computers is a negative ROI because that space is not producing any revenue; it is just being used to store old machines that do not help the company's bottom line at all. That is why companies prefer to discard old equipment rather than hang on to it.

This is a simple explanation of ROI, and it hopefully gives an understanding of how a company assigns value to the purchases they make. Just remember that a company will not make a purchase unless there is some sort of ROI associated with that purchase. When the ROI begins to become negative to the company, they would rather discard the equipment than continue to allow a negative ROI on their books.