Payback Explained

What is Payback?

In short, Payback tells us when we get our money back from our original spend. It is part of the family of Return On Investment (ROI) measures which also includes Net Present Value (the profit in today’s terms) and Internal Rate of Return (the annual % rate of profitability of an investment decision). It is a comparison of the initial outlay of monies, to buy equipment or services, against the time taken for the savings to cover that initial outlay. The payback period is a time measure and is usually quoted in months or years.

Explained: Payback indicated when an investor will...

...get their money back and they often focus on Payback because it is easy to understand. After all, getting your money back is an important consideration! However, it can be a problem if Payback is too long; long Paybacks raise doubts in the customer’s mind that investment in the solution is a good idea.

Complex solutions or projects often have benefits which cannot be counted for some time and any pre-conceived expectations of achieving a quick Payback period may be unrealistic. Consequently, it is unwise to rely only on Payback when creating a business case; the NPV and IRR values should be used to emphasise the value and rate of return, both of which may still exceed expectations.

EXAMPLE 1

To demonstrate how payback is easy to understand, take the following example:

Spend $100 today, receive $10 per month, every month for 36 months.

Payback = 10 months

Fig. 1 Simple Payback Example

To demonstrate how Payback is dependent on the timing of the benefits, imagine an example similar to the one above where the investment is still $100 but the total benefits are received in a single lump sum instead of $10 per month:

EXAMPLE 2

Spend $100 today, receive $120 lump sum after 12 months.

Payback is now 12 months not 10 months

Fig. 2 Simple Payback Example 

Notice that the Payback period calculation does not include any complicated mathematical operations. It is based on the cash values of the costs and benefits and does not take into account the time value of money, unlike NPV and IRR which, without Shark, are almost impossible to arrive at a correct answer with simple mathematics.

Multiple Payback Results

It is also possible to get multiple Payback values, see Fig.3. Here the cashflow crosses the zero line multiple times. This can happen when periodic recurring costs take the net cash position negative again.

Fig. 3 Multiple Payback Results

In practical terms this means that you must always take into account the timing of the costs and benefits and, when interpreting the result, always take the worst-case result so that there is minimal danger of embarrassment!

Pitfall 1: The strengths and weaknesses of Payback

On the surface Payback is easy to understand and non-threatening, which is its great strength but, as we have seen, the uninitiated will have pre-conceived Payback ideas which can cause problems when evaluating a complex business project.

In addition, the Payback result gives no clue as to what will happen after that point in time. Investments often have more value stretching into the future so by quoting the Payback we might be missing the opportunity to express that to a potential investor. When in doubt, always use NPV and/or IRR to support any Payback number and choose your appraisal period wisely!

The Solution: Using QorusDocs ValueHub to calculate correct Payback

In QorusDocs ValueHub every single benefit calculator (same for the costs) creates its own individual monthly cashflow. As we have highlighted above, this timing information is important when gaining customer sponsorship because a delayed benefit is easier to support than one which is claimed to start immediately.

You can see an individual benefit calculator cashflow by clicking on the icon highlighted.

Note that the average monthly savings are 685 x 30/36 = $571

Conclusion

Correct Payback calculation depends on the accurate management of the timing of the costs and benefits. The only way to ensure client sponsorship for the business case is to value costs and benefits in the months they occur – this is handled transparently and seamlessly in QorusDocs ValueHub.