Internet Marketing – Return on Investment
I recently read an article entitled, Accounting 101, about determining and using ROI or Return On Investment in the internet marketing business. The author began by stating that ROI is the basis for determining profit for virtually any business. He goes on to say that ROI is also the kind of topic marketing consultants like to over complicate and make a big dramatic deal out of. But, he says that the whole concept is incredibly straight forward and easy to apply. Your ROI, he says, is simply what you can expect to gain from a potential endeavor expressed as a percentage, and you make this determination by comparing your costs against your profits.
He goes on to say that it’s easy to assume that ROI is only for large companies. However, even a one-man show can use the ROI calculation to decide which projects are worth pursuing. You have finite time and resources so using ROI provides a means to prioritize projects and using what companies call a hurdle rate, you can quickly decide whether to go forward with a project or not. In essence using ROI can insure that you’ll put your resources where you forecast that the return is the highest and therefor help you to increase the chance to maximize your income.
These are all valid points. RIO used properly can be very helpful to you to achieve the greatest return from your resources. But I would like to discuss ROI in two parts. The first is the calculation of ROI. Second are some aspects of it that I think you need to keep in mind when you are using it.
In regard to the calculation the author of the article shows several examples, which are very similar. One is the following:
You price an eBook you want to market at $30.
After one week you sell 10 ebooks for a total revenue of $300.
Your costs are as follows:
Your web hosting per week is $2.
You paid a graphic designer to create the eBook cover $50.
Your merchant fees are $.80 per eBook or for the week $8.
Total costs equal $60.
Total profit is $240.
He determines ROI by dividing the profit of $240 by the costs of $60 times 100 to arrive at 400%. His ROI is 400%.
Our author would be the first to admit that he has made over simplifications to illustrate how to calculate ROI so we’ll use his numbers to make a couple of points. First of all, it is important to understand what ROI calculates and how to determine it correctly. The numbers our author used in his calculation are small so different treatment doesn’t change the final ROI by much. However, in other cases they can make a significant difference so you should understand how to make the correct calculation. First of all ROI is basically a calculation based on your net cash inflows against your cash outflows compared to your cash investment. In this case your net cash inflows are your sales less costs directly related to those sales. In the above example the author does not present all the facts so we need to make some assumptions. First of all it is fairly obvious that you already own the ebook. Secondly, I assume you already have web hosting so that web hosting costs are not related specifically to this eBook and if this is the case, should not enter into the calculation. Thirdly, paying a graphic designer for a cover is something you feel you must do if you decide to market the ebook. Finally, you didn’t have any investment since you already owned the ebook. You may have bought the eBook previously, or created it previously, or someone gave it to you. No matter! Your investment has been already made. Your only costs are those which are directly related to selling your ebook, which in this case would be the graphic designer and the merchant fees. You aren’t going to incur these costs unless you market the product. So your profit selling the eBook is $300 less cash costs directly related to the sale of $58 for a profit of $242. You have an infinite ROI on your ebook.
Just to demonstrate the calculation of ROI, we can add a hypothetical investment cost to purchase this eBook of $150, which in this case would have given us an ROI of 61%. ($242 less investment of $150 = $92 divided by $150 x 100)
Let’s go back to why you are calculating ROI. You calculate ROI first of all to determine if it meets your ROI hurdle rate. Your hurdle rate being the minimum ROI you need in order to make any investment. Secondly, if you have a number of possible projects to invest in, you want to rank them in order of profitability. ROI is a good measure to start with in ranking projects.
Calculating ROI or Return On Investment is certainly not a new idea to evaluate how profitable you estimate a project will be. Most companies use ROI as a way to rank their profitable investment projects in order to decide which ones meet their hurdle rate and rank those that do. It makes sense to make this calculation when you are talking about significant investment decisions. Clearly, in calculating ROI making a good forecast of your sales revenue for the product is fairly difficult and requires the most care . You can decide on the sale price based on your assessment of market conditions, but how many ebooks are you going to sell at that price? You would base it on past experience and past sales of similar products. You probably would consider a range of possibilities to see if the worst case would still give you a reasonable ROI.
This is how you should use ROI. It is a tool for forecasting or estimating your profit on a new project. It can help you decide whether to buy an eBook or start working on a new system. It can help you decide whether to market a product or not. And after your product is on the market it can help you evaluate whether your product has been profitable or not.
But ROI should be calculated correctly. It is not simply your profit from a product divided by the cost to sell it. This is a calculation of gross margin not ROI. ROI stands for Return On Investment and as I stated earlier is really a measure of your net cash inflows against your cash investment outflows . Expenditures not specifically related to a project should not be considered. For example many accountants like to allocate a portion of general or overhead cost to a project to determine its profitability. Whether this is useful or not is a separate discussion, but it has no place in the calculation of a project’s ROI. You take your cash nvestment in the project and you measure it against your net cash inflows to produce and sell it.
One last point is that ROI is a percentage. To state the obvious you can have a number of projects with wonderful ROI’s, but if the total profits don’t add up to acceptable total net income, you can’t live on it. You might want to accept a much lower ROI on a project if it generated enough profit to live on.
So you need to understand that ROI is a tool for decision making. Useful for evaluating profitability later, but really a decision making tool. Secondly, it should be calculated correctly. I hope I have been helpful in showing you how to do that. So use ROI to help you decide your investment decisions. And like the man said don’t make a big deal out of it.