ROI is NOT Profit

ROI is NOT Profit

02, Oct David Deppner

Would you rather have a 10% return on $100 or a 5% return on $1000?

\[ \begin{align} $100 \times 10\%_{ROI} &= $10 \\ $1000 \times 5\%_{ROI} &= $50 \end{align}\]

If you have to pick one or the other, you’d pick the $1000 investment at the lower ROI. In the real world, though, we can usually pick both. The issue is in focusing too much on the ROI of each, rather than the total profit we’re generating.

Clearly, what matters is profit at the end of the day. Assuming you’re actually talking about real ROI and not Return on Ad Spend (see my blog post on that topic: How Digital Marketers Misunderstand ROI), you still shouldn’t care what the ROI is most of the time. What matters at the end of the day is driving profit to the business.

ROI is useful for helping you find which investment opportunities will tend to generate the most returns. But that assumes that the investment opportunities available to you all scale the same. If you have a way to get a 10% return on $100, then take it! But if that opportunity only allows you to invest $100, and you have more to invest, then you’re going to improve your total profit by investing everything else in lower ROI opportunities. This will drop your ROI as a percentage at the same time your total profit increases.

Put another way… In marketing we have many investment opportunities across many channels. Some could be high ROI, but small scale. Take all of those. But as we try to scale up, the returns tend to decline. It still makes sense to take the next highest ROI investments next, until they’re exhausted, and then the next, and the next. But then if we create a report that expresses returns of various investments compared to each other, some will end up with a higher ROI and some will end up lower. What matters isn’t that some are lower, but that those were the best opportunities to take.

Of course resources should be shifted from low-ROI opportunities to high-ROI opportunities if that is possible. But more frequently, the high-ROI opportunities have been exhausted and the low-ROI opportunities are the next best. So judging them less beneficial is a complete fallacy.

What matters here is that you’re producing the most profit possible with a given allocation of resources. That has to do with the portfolio of investments.

High ROI investments tend to be high-risk investments. If you haven’t encountered the Capital Asset Pricing Model (CAPM), you have some reading to do. What matters for this discussion is that asset pricing is affected by risk. Assets with highly variable returns tend to have discounted prices relative to assets with stable returns. A government bond may have an annual ROI of 1%, while a volatile stock may have an average annual ROI of 8%, but with fluctuations where some years it gains 30% but other years it loses 20%. Ignoring risk and volatility to just focus on the average ROI is fairly misguided.

Ultimately, you’re not making a single investment decision. You’re not investing in a single marketing or advertising channel (if it’s even valid to speak of that in terms of “investment”). You’re tackling a portfolio of investments, with different risks and different returns. And simply comparing them on an ROI to ROI basis is extremely short sighted. Anyone trying to sell you “ROI" rather than “profit” is immediately suspect, in my view.

Psyberware specializes in managing online advertising for ecommerce businesses, and nothing else. If you want to build a great relationship with a group of dedicated people who really understand ecommerce, get in touch with us.

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