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## About this lesson

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.

## Exercise files

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Payback Period.xlsx15.6 KB Payback Period - Solution.xlsx

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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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