How to Calculate the ROI of Online Communities

By Richard Millington

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ROI People

Two trends have emerged in recent years. One is the belief that the ROI of a community cannot be calculated to a specific metric. This supposes that many of the benefits are intangible and hard to define. If two members meet in the community and become best friends, what is the value of that? What is the value of building a sense of community among members?

If two members meet in an online community and become best friends, what is the value of that?

 

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The second trend is a broader confusion between return, profit, and return on investment (ROI). The return is the value created as a result of community activities. This usually means revenue generated or revenue saved. For example, the community may be shown to generate an additional $2m in product sales via increased retention rates.

The benefit of calculating the return is to show the business value created by the community. The drawback is that it neglects the investment required to ascertain this benefit. If a community generated an additional $2m in sales but cost $4m to set up and manage, this wouldn’t look so good.

Profit is easier to understand. It is simply the return less costs. If a community generated $2m in additional revenue and incurred $1m in costs, the profit generated is $1m. Most of the measurements of value we uncovered highlighted either the return or the profit generated.

Return on investment is a different metric altogether.

Return on Investment

Return on investment is a method of determining the efficiency of an investment. Typically, it is a way for investors to determine whether they are receiving enough gain to continue investing.

ROI is ambivalent about total profit. ROI does not measure whether the community generated $100k or $100m in profit. ROI determines which metric generated the best possible return.

The ROI is used to determine where best to invest an organization’s limited resources to achieve their biggest impact. Organizations should (in theory) allocate their resources in the fields which generate the highest long-term ROI. ROI can be expressed in the following formula:

ROI = Net Profit / Cost of Investment

The sole purpose of calculating ROI is to determine whether to allocate greater or fewer resources to the community.

The ROI brings cold rationality to financial decisions. If every dollar invested in sales generated $1.4 (40% return) and every dollar invested in community generated ($1.2) back (20% return), it is logically best for the company to reallocate resources in favor of sales regardless of the total profits of each channel.

The ROI therefore is not a financial metric, but a percentage (or ratio).

The Limits of ROI

ROI is not an all-conquering metric for any business. It has its own limits. Most business investments face a law of diminishing returns. This means that each investment has an optimum level. Further investment beyond that optimum level generates less value for every dollar invested.

Imagine you have a sales team which generated a 200% return ($2 for every $1 invested) in the first year. Over time, they will exhaust the best leads, find rising levels of competition, and reach the maximum number of people who could theoretically be interested in the product. Beyond this point, each additional dollar invested will generate less returns. This is why financial absolutism (allocating all resources to those that deliver the best return) is thankfully rare.

However, when budget cuts are applied, it is usually the areas with the lowest or least understood level of return that bear the brunt of the burden.

What is a Good ROI?

A good ROI must surpass the cost of investment and the hurdle rate. The hurdle rate is the minimum return the organization expects from investing in a project. The hurdle rate will at minimum be the benefit of keeping the money safely in the bank (e.g. buying government-backed bonds) and, at maximum, be investing the money elsewhere.

Many organizations use a 12% hurdle rate which is based upon annualized historical growth of the S&P 500 index (e.g. below a 12% annual return, your organization can invest the same amount in the stock market and is likely to yield better outcomes without the risk).

Many organizations use a 12% hurdle rate which is based upon annualized historical growth of the S&P 500 index

 

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It’s important to understand this opportunity cost to any investment decision. Very often the competition is not the S&P500 index but other departments. For example, $200k invested in the community this year cannot be invested in sales or marketing. A typically acceptable IRR (internal rate of return) might vary between 12% and 30%.

This is sometimes made more complicated by including what’s known as Net Present Value (NPV). This is a formula by which money predicted in the future is discounted for inflation to its current value today. The discount rate is usually the annual interest rate set by the major national banks. This is the ‘cost of lending’.

For example, if the interest rate is 2%, $102 next year will be worth $100 today. Or, imagine your community generates $2m per year in value and the interest rate is 2%. If everything remained the same, the net present value of those returns over five years would be the sum of the below.

Year 1 Year 2 Year 3 Year 4 Year 5
$1.96m $1.92m $1.88m $1.84m $1.80m

In practice, only the very largest organizations making the most critical investment decisions use NPV of returns. However, it is important to understand what NPV is and why it matters. Soon, we will discuss customer lifetime value (CLV) where Net Present Value should theoretically be applied.

Summary

  1. Return is value created from community activities (usually revenue generated or costs saved)
  2. Profit is the return less the cost of investment.
  3. ROI is an efficiency ratio used to determine where to allocate money.
  4. ROI does not measure profit generated.
  5. ROI faces a law of diminishing returns.
  6. A good ROI must surpass an internal hurdle rate (12%+).
  7. Net Present Value (NPV) is how much money in the future is worth today (after inflation)

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