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The Payback Period is a Return on Investment analysis that determines the amount of time needed to accumulate enough benefit to pay for the cost of the project.

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Quick reference

Payback Period

The Payback Period is a Return on Investment analysis that determines the amount of time needed to accumulate enough benefit to pay for the cost of the project.

When to Use Payback Period

Like all project ROI techniques, this analysis is done as part of the preparation of the business case used to justify a project.  Payback Period ROI analysis is the easiest to calculate mathematically. I use this technique with small projects that have a short duration.  This technique is especially well suited for productivity projects rather than new sales projects because it is normally easier to estimate the amount and timing of the productivity benefit than it is to estimate the amount and timing of the new sales volumes. 

Instructions

This analysis is very easy to do using the ROI spreadsheet that we illustrated in the module on ROI.  All of the project costs and project benefits are entered on the spreadsheet and then are spread across the time periods in which they will occur.  Cost should be entered as negative numbers and benefits should be entered as positive numbers.  When entering costs, ensure you include any additional sustaining costs that are now required because of the project.  And of course, any current sustaining costs that are no longer needed should be shown as a benefit.  Also, if the project will result in any increased or decreased Gross Profit; that should be entered appropriately.  The Gross Profit effect should only be the incremental impact due to the project – such as incremental sales or incremental reduction in product costs.

All of the costs and benefits are added for each time period to get the Period total.  A cumulative number is then generated to create a cumulative total.  The point in time at which the cumulative total shift from a negative number to a positive number is the time of the payback period.

There are two ways of calculating the payback period.  These two methods are based upon a decision when to start counting the time in the period.  The ending point is the same in both methods.  The Type 0 method starts counting the day the project ends and the benefits start.  The Type 1 method starts counting the day the project starts.  Both methods are used in industry and the various experts and gurus will passionately defend their approach.  In my opinion they are equally valid and useful.  Use the method preferred in your company.  If there is no preferred method, at least be consistent with what is used in other projects.

Type 1 Method Calculations.

Recall that Type 1 starts the timing of the payback period when the project starts.  In this case, the first column represents the first day of the project and is labelled column 1.  If the columns are one year columns, then the second column starts on the anniversary of the start of the project and each column continues with that as the start day (note that it is unlikely that this is aligned with the start of the calendar).  All of the project costs that occur within one year of the start of the project are placed in the first column.  If the project is a multi-year project, the remaining project costs are spread appropriately through the remaining years.  The project benefits start based upon when the project ends.  Since the project normally ends in the middle of a year, the first column with benefits is often a partial year of benefits.  If the project lasts less than one year, the first column (column 1) will have some benefits in it.

When it comes time to do the calculation, the cumulative value of the first column must be a negative number (costs exceed benefits) for the math to work correctly.  Sometimes on small quick projects, the cumulative value is already positive by the end of the year.  When that is the case, change your column time period to months, and respread the costs and benefits across the months of the first year.  There is no need to spread benefits past the first year since the payback will occur within the first year.

Once the spreadsheet is setup, the math is very simple.  The payback period will be the time represented by all of the columns with a negative cumulative value and a fraction of the first column with a positive cumulative value.  The fraction of that column is determined by dividing the absolute value of the cumulative project value in the last time period that had a negative cumulative total by the period value of the first column that had a positive cumulative total.  See the example below. 

In this case year 2 is the last year with a negative cumulative value.  That value is ($100,000).  This means that payback will occur sometime in the following year.  To determine how much of the following year; we divide the absolute value of the year 2 cumulative value – which is #100,000 – by the annual value of year 3 which is $400,000.  That gives an answer of .25 portion of year 3 and the payback period is 2.25 years from the start of the project.

 

Type 0 Method Calculations

Type 0 method calculations are similar, but since we are starting our payback period from the project end date, we don’t care how long it takes to do the project.  Therefore we put all project costs in the first column and label that column “0” (which is why we call it Type 0).  The second column, which is label column 1, starts on the first day of project benefits.  Like with Type 1, each succeeding column starts on the anniversary of the start of the first column.  This means that the “0” column will be of an arbitrary time length depending upon the length of the project, but all succeeding columns will be of an equal time length – normally one year.

The math is now the same.  The payback period will start at the beginning of column 1 and will include all of the columns with a negative cumulative value and a fraction of the first column with a positive cumulative value.  Let’s look at the same project as before but now using the Type 0 approach.    

In this case, year 1 is the last year with negative cumulative value so payback will occur sometime in year 2.  The negative value at the end of year 1 is ($40,000).  We will take the absolute value of that number - $40,000 – and divide it by the annual total for year 2, which is $400,000.  The result is .1 year and the total payback period then is 1.1 years from the end of the project.

 

Hints and Tips

  • The calculations are all conducted using period and cumulative totals.  Don’t get hung up trying to put everything in the right category.  As long as the costs and benefits are in the correct year and with the correct sign (costs – negative, benefits – positive) the totals will be accurate.
  • This technique will tell you how fast you get your money back, but it provides no insight as to what happens after that point.  The project could provide exponentially growing benefits or the benefits could quickly dry up.  The payback period could be the same.
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  • 00:03 Hi, this is Ray Sheen.
  • 00:05 Let's look at the ROI technique known as payback period.
  • 00:09 Payback period is the ROI technique that focuses on time.
  • 00:13 The payback period is the time required to accumulate benefit to the business that is
  • 00:17 equal to the cost to the business for the project.
  • 00:20 Payback is usually expressed either in months or in years.
  • 00:23 You can think of this as a big scale.
  • 00:25 When the project starts, project costs are added to one side of the scale.
  • 00:29 These are, of course, the costs of doing the project, but
  • 00:31 it can also include an increase in overhead or operating costs, or
  • 00:35 a decrease in gross profit from sales.
  • 00:37 As a project finishes, benefits start to add up on the other side of the scale.
  • 00:42 These are either the reduction of overhead and operating expenses, or
  • 00:45 the increase in gross profit from sales.
  • 00:48 The end of the payback period is marked by the point in time
  • 00:51 when the cost equals the benefit.
  • 00:53 Let's go over how the calculations are done.
  • 00:56 Start by getting all the cash flows into the ROI spreadsheet that we discussed in
  • 01:00 the ROI module.
  • 01:01 This needs to include all of the costs and benefits.
  • 01:04 Remember, costs are entered as negative numbers, and benefits as positive numbers.
  • 01:08 Once the values are entered, they are spread across the time columns.
  • 01:12 To do the payback calculation, we will need both the period total and
  • 01:16 the cumulative totals.
  • 01:17 Period totals are determined by adding all the costs and
  • 01:20 benefits in one of the time columns of the spreadsheet.
  • 01:23 Cumulative totals are calculated by adding all of the period totals up
  • 01:26 through a particular column.
  • 01:28 The payback period will include all of the columns with a negative cumulative total
  • 01:33 and a fraction of the first column that has a positive cumulative total.
  • 01:37 This means that until the benefit has equaled the cost,
  • 01:40 we're still within the payback period.
  • 01:42 Now, you may have noticed something.
  • 01:44 I keep talking about when the payback period ends.
  • 01:47 What about when it starts?
  • 01:49 What is the beginning point for the payback period?
  • 01:52 Well, there are two approaches to use for setting that point.
  • 01:55 I can make a strong argument for either one, so
  • 01:57 find out which approach your company uses, and stick with that definition.
  • 02:01 The first approach I want to discuss is what I call type 1 payback.
  • 02:05 In this case, the payback period starts when the project starts.
  • 02:09 That means that all of the project time is part of the payback time.
  • 02:12 The first time column on the spreadsheet starts with the day the project starts,
  • 02:16 and the column represents year 1 of payback time.
  • 02:20 The next column starts on the anniversary of the project start
  • 02:23 exactly one year later, and so on with each succeeding column.
  • 02:27 The payback period calculation shows the full amount of time the project
  • 02:30 Money is tied up before it is recovered.
  • 02:33 However, if the project is delayed, the payback period is extended.
  • 02:38 I call the other approach type 0 payback.
  • 02:40 In this case, the payback period starts when the benefit starts,
  • 02:44 which is normally at the time of project finish.
  • 02:47 The project time is not part of the payback period, so
  • 02:49 this calculation will not be impacted by project delays.
  • 02:53 When using this approach, all project costs up to the point of
  • 02:56 the start of benefits go in the first column, which is labeled column 0.
  • 03:01 That first column is whatever length of time is needed for the project work.
  • 03:06 The second column starts on the first day of project benefits, and
  • 03:09 is labeled column 1.
  • 03:11 The second column lasts one year, and
  • 03:13 the third column starts on the anniversary of the beginning of project benefits.
  • 03:17 The remaining columns follow the same pattern.
  • 03:20 Let's look at some examples.
  • 03:22 First let's consider the type 1 payback period.
  • 03:25 This table shows the summary of the three sections of the ROI spreadsheet.
  • 03:29 Column 1 starts on the first day of the project and lasts one year.
  • 03:33 The project was planned to take a little over 13 months, so
  • 03:36 some of the project cost ends up in column 2.
  • 03:39 The benefits of the project start in column 2,
  • 03:42 although they are only a partial year of benefits.
  • 03:44 The first full year of benefits is in column 3.
  • 03:47 You can also see that the annual and
  • 03:49 cumulative totals are calculated at the bottom of the chart.
  • 03:52 The payback period will include all of the columns with a negative cumulative total,
  • 03:56 which is year 1 and year 2.
  • 03:58 The payback period also includes a portion of year 3,
  • 04:01 which is the first year with a positive cumulative total.
  • 04:04 The way we calculate the portion of year 3 is to take the absolute value of
  • 04:08 the cumulative total from the last negative year and
  • 04:10 divide it by the annual period total of the first positive year.
  • 04:14 In this case, that means we take the 100,000 of year 2 and
  • 04:17 divide it by 400,000 from year 3.
  • 04:20 This means that 25% of year 3 is within the payback period.
  • 04:24 The total payback period then is 2.25 years, or 27 months.
  • 04:27 Now let's look at a type 0 payback period.
  • 04:32 Note that now all the project costs are in the first column, column 0.
  • 04:36 In this case, the column is 13 months long.
  • 04:39 The second column is labeled year 1,
  • 04:41 and will be the first column in our payback period.
  • 04:44 It has a full year of benefits, and this continues on for the succeeding years.
  • 04:49 Again, we have the period and cumulative totals.
  • 04:52 The last column with a negative cumulative total is year 1, so
  • 04:55 the payback period will be one year, with a fraction of the next year.
  • 04:59 The fraction is calculated the same way as before.
  • 05:02 The absolute value of the cumulative total for
  • 05:04 the last negative year is divided by the period total for the first positive year.
  • 05:08 In this case, that is 40,000 divided by 400,000, or 10% of year 2.
  • 05:14 The payback period using type 0 method is 1.1 years,
  • 05:19 or slightly over 13 months.
  • 05:22 With the ROI spreadsheet filled out, the payback period calculation is very easy.
  • 05:27 This technique helps us understand how fast we'll
  • 05:30 achieve the return on investment.

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