Return on investment
ROI equals the gain from the purchase minus its cost, divided by its cost. If a $10,000 machine adds $4,000 a year in profit for three years, the total gain is $12,000. Subtract the $10,000 cost to get $2,000, and divide by $10,000, for an ROI of 20% over three years.
Be careful to use profit, not revenue, in the gain. Extra sales that cost money to make are not all gain.
Payback period
Payback tells you how long it takes to earn back the cost. Divide the cost by the yearly benefit. For the machine above, $10,000 divided by $4,000 is 2.5 years.
A shorter payback means less time at risk. It ignores what happens after payback, so a purchase with a long payback may still be worth it if it keeps producing for many years.
Include all the costs
Count the purchase price, delivery, setup, training, maintenance, insurance, financing interest and any fee for the first year. For software, include the subscription for the whole period you will use it.
Also count your own time. A tool that saves ten hours a month is only worth the hours you would really use for something else.
Estimate the benefit honestly
Base the benefit on something you can measure: hours saved, extra jobs completed or lower spoilage. Use a conservative number, and test what happens if the benefit is half as large.
If the purchase only works under the best case, it is risky. If it still pays back under a cautious case, it is easier to justify.
Record it correctly
A purchase of equipment is usually recorded as an asset and written off over its life, not as an expense all at once, though tax rules differ from book rules. Ask your tax preparer how a particular purchase is treated.
After you buy, compare the results to your estimate a few months later. That shows whether your assumptions were realistic and improves the next decision.
A comparison of two options
Say you can buy a $10,000 machine that returns $4,000 of profit a year, or spend $6,000 on software that saves $2,400 a year. The machine pays back in 2.5 years and the software in 2.5 years too, but the software ties up less cash and carries less risk.
Add the lifespan. If the machine lasts ten years and the software needs replacing in three, the lifetime return changes. Put each option on the same footing before you choose, and keep the cash you need for operating the business.
Common questions
What is a good ROI?
It depends on the risk and alternatives. Compare it to what else you could do with the money, including paying down debt.
Should I use payback or ROI?
Use both. Payback shows how fast you recover cash, and ROI shows the overall return.
Can I lease instead of buying?
Often, yes. Compare the full cost of each, including interest and what you own at the end.
This guide is general information, not tax, legal or accounting advice. Rules, fees and due dates change; check with the IRS, the NJ Division of Taxation or a licensed professional for your situation.