ROI Explained: The Formula, a Worked Example and Its Limits

The ROI formula

ROI = (gain from investment − cost of investment) ÷ cost of investment × 100Equivalent to net profit divided by the amount invested.

Worked example: you spend 12,000 on a piece of equipment, and over the following year it brings in 15,000 of extra income. The net gain is 15,000 − 12,000 = 3,000, so ROI is 3,000 ÷ 12,000 = 25%. Put another way, the return multiple is 15,000 ÷ 12,000 = 1.25: each 1.00 invested came back as 1.25.

An ROI of zero means you only got your money back. A positive figure is a profit. A negative figure is a loss, and it can never be worse than −100%, which is losing everything you put in.

Count every cost

The cost side needs the same care as the gain side. Go back to the 12,000 piece of equipment and suppose it also needs 900 of maintenance and 600 of staff training during the year. The true cost is 12,000 + 900 + 600 = 13,500, and the net gain is 15,000 − 13,500 = 1,500.

ROI is now 1,500 ÷ 13,500 = 11.1%, less than half the 25% from the purchase price alone. Fees, installation, financing charges and the value of your own time all belong in the cost if they were needed to get the result.

Revenue is not the same as gain

The most common error is putting revenue into the "gain" slot. Sales that cost money to deliver are not all profit.

Worked example: a business spends 2,000 on advertising and attributes 5,000 of sales to it. Revenue is 2.5 times the ad spend, which sounds excellent. But if the products carry a 40% gross margin, those sales leave 5,000 × 0.40 = 2,000 of gross profit. The gain equals the cost, so the ROI is (2,000 − 2,000) ÷ 2,000 = 0%. The campaign merely paid for itself.

Revenue divided by ad spend is often reported separately as return on ad spend, and it is a different measure. Use profit in the numerator when you want ROI.

Why time matters: annualized ROI

A plain ROI figure says nothing about how long the money was tied up. Compare two projects:

Project B has the higher ROI, but it took three times as long. To compare fairly, convert each to an annual rate using the compounding formula:

annualized ROI = (1 + ROI)^(1 ÷ years) − 1Use ROI as a decimal: 35% is 0.35.

For Project B that is 1.35^(1/3) − 1 = 10.52% a year, while Project A stays at 25% a year. Once time is taken into account, A is clearly the stronger result. The same calculation is what a CAGR calculator performs.

What ROI leaves out

• Risk. Two investments with the same ROI are not equal if one is far less certain than the other.
• Hidden costs. Count fees, maintenance, training, financing and your own time, not only the purchase price. Leaving them out inflates the result.
• Scale. A 50% return on 200 is less useful than a 10% return on 20,000, depending on what you need.
• Timing of cash flows. Money arriving in year three is worth less than the same money now. Measures such as net present value and IRR handle this, and plain ROI does not.
• Definitions. Teams define the gain and the cost differently, so always ask what went into each number before comparing two ROI claims.

Use ROI as a first filter, then look deeper at the figures behind it. To run your own numbers, try the ROI calculator.

This article is general education, not investment or financial advice. Past results do not guarantee future returns, so consider your own situation and seek qualified advice for significant decisions.