Calculate your potential Return on Investment on a Product before investing
If you are in business then the likelihood that you will be approached with investment opportunities is great. Some ideas appear to be very lucrative and others less so. However, there must be a way in which businesses can calculate whether or not a product is worth investing in. There is. Return on Investment analysis or ROI is commonly used by financial investors to advise companies where money should be allocated. The procedure is rather simple.
First determine how much the products initial investment will cost
The first part of the ROI calculation is to determine the initial investment cost. This is NOT the price of the product but the accumulative finances which will be necessary to get the product up and going. For example: If you purchase a product for £5000 and it costs you another 1k to get the product installed and then 40 work hours (at an averaged £9.25 per hour) then your initial investment part of the formula would look like this.
Initial investment = 5000 + 1000 + (40*9.25)
Initial Investment = 6000 + 370
Initial Investment =£6370
It is critical that you calculate the total investment cost and not the product cost. Many times businesses miscalculate their ROI because they forget that a product will take other costs to get it up and operational. For example: if you are purchasing a product for a low £25 a piece, you need to calculate how much the bulk rate is, promotional costs, training and setup.
If payouts are spanned out of several years you need to adjust your investment per year. For example: If you still require the 40 hours of training and it costs 1000 to upkeep and maintain the product your investment after the first year would be £1370.
How much do you want to make from the product?
The next step in determining the ROI is to ask yourself “What do I expect to get back on this investment?”. If the person selling you the product promises that you can double your investment then you would set your payback at £12,740. Now, here is where a wrench is thrown into this part of the formula. If you are expecting to double your money in a year, then leave the payback as it is. However, if your investment will return your money in say 5 years, then you would divide your payback by that amount of time to get your yearly payback.
Payback over a 5 year period to double your investment = 12740/5
Payback = £2548 per year
Determine your ROI per year percentage
The whole purpose of the ROI is to determine if you are making a smart investment. If the percentage is under 50% then the product is not giving you an adequate ROI. Percentages which are over 50% are desirable. However, most companies want their ROI to be in the 70%-80% investment area (though this may be a bit idealistic).
Here is the formula:
Return on Investment = [(Payback-investment)/Investment)]*100
If we use the Investment and Payback from earlier the formula will look like this:
ROI = [(2548-6370)/6370]*100
RIO = -.6*100
ROI= -60% for the first year
For the second year through the fifth year your initial £5000 would not be part of the formula but just the investment to train and maintain. Your ROI will drastically change.
RIO=86% for year 2 to 5
Analyse your ROI
As you can see from the formula, the return of investment will change from the initial startup cost to the next few years. Where the first year the company would see a -60% return, the following years have a 85% gain. If the company for which you are buying the product is well established (meaning that you are confident that they will be around after a year) then this would be an investment worth seeking. Keep in mind that your business must be able to take the loss of finances the first year as well. Do not bank upon the next year’s payout. Keep in mind that in this example you are only going to get £2,548 a year. Where your investment does double over time, you must calculate whether or not that first hurtle will be a financial risk that your business can handle.
ROIs are not definitive financial predictions
One thing that should be noted is that ROIs are not definitive financial predictions. No one (no matter how good an analysis they preform) can predict the future. Factors such as product repair, product recall, and other unforeseen issues will affect your ROI. While your ROI will give you a pretty definitive gauge in which to measure whether or not the product is worth investing in or not, it is ultimately the decision of the business overall and something as simple as ‘gut feeling’ may come in to play.