In some MBA programs they clearly define the ultimate return on investment (ROI.) At the Booth School of Business at the University of Chicago, I was taught:
ROI: Income (before distributions to suppliers of capital) for a period. As a rate, this amount divided by average total assets. Interest, net of tax effects, should be added back to net income for the numerator. (source-Managerial Accounting, Maher, Stickney, Weil 1994) Usually this is applied, in a larger organization to a division or a project.
In Wikipedia the definition is as follows:
“In finance, rate of return (ROR), also known as return on investment (ROI), rate of profit or sometimes just return, is the ratio of money gained or lost (whether realized or unrealized) on an investment relative to the amount of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or net income/loss. The money invested may be referred to as the asset, capital, principal, or the cost basis of the investment. ROI is usually expressed as a percentage rather than a fraction.” And, following, there are many examples.
There are any number of ways of determining ROI but from a most simple standpoint a business buyer can look at the ROI from two vantages: One accounts for personal time spent running the business at a fair market rate. The other does not.
These examples demonstrate the difference.
Initial Investment: $200,000
Net to owner at the end of the year, not including owner wage salary: $100,000
ROI: $100,000/$200,000 = 50 percent
Net to owner at the end of the year, including an owner’s wage of $75,000:
ROI: $25,000/$200,000 = 8 percent
I personally like the methodology of example 2 because it allows that if I take a job with some company and invest the $200,000 in the stock market, I would likely earn 8% on the investment PLUS my wage of $75,000. If I am not able to make in my own business a fair wage AND at least 8 percent, then, the happiness factor of being my own boss must be very, very high. Otherwise, I should take the job for the company.
Certainly recent economic conditions have taught us that there is no assurance in having a job or owning our own business.
Note: In this brief explanation, wage and benefits are assumed as one. In the declaration of investment, it is assuming a cash purchase of the business.