Wednesday, December 1, 2010

Payback Period

The benefit measurement methods involve a variety of cash flow analysis techniques. One famous technique in the cash flow analysis is payback period.

The payback period is the length of time it takes the company to recoup the initial costs of producing the product, service, or result of the project. This method compares the initial investment to the cash inflows expected over the life of the product, service, or result.

For example, say the initial investment on a project is $200,000, with expected cash inflows of $25,000 per quarter every quarter for the first two years and $50,000 per quarter from then on. The payback period is two years and can be calculated as follows:
  • Initial investment = $200,000
  • Cash inflows = $25,000 * 4 (quarters in a year) = $100,000 per year total inflow
  • Initial investment ($200,000) – year 1 inflows ($100,000) = $100,000 remaining balance
  • Year 1 inflows remaining balance – year 2 inflows = $0
  • Total cash flow year 1 and year 2 = $200,000
  • The payback is reached in two years.

The fact that inflows are $50,000 per quarter starting in year 3 makes no difference because payback is reached in two years.

The payback period is the least precise of all the cash flow calculations. That’s because the payback period does not consider the value of the cash inflows made in later years, commonly called the time value of money. For example, if you have a project with a five-year payback period, the cash inflows in year 5 are worth less than they are if you received them today.

Several limitations of the payback period are as follows:
  • It assumes enough earnings to pay back the cost. If your company stops selling the product that the warranty repair project supports, the monthly savings may not continue for the calculated payback period, which ends up costing money.
  • It ignores cash flows after the payback period ends. Projects that generate money early beat out projects that generate more money over a longer period. Consider two projects, each costing $100,000. Project #1 saves $20,000 each month for only 5 months. Project #2 saves $10,000 each month for 24 months. Project #1’s payback period is 5 months compared to Project #2’s 10 months. However, Project #2 saves $240,000, whereas Project #1 saves only $100,000.
  • It ignores the time value of money. There’s a price to pay for using money over a period of time, just like the interest you pay on the mortgage on your house. Payback period doesn’t account for the time value of money, because it uses the project cost as a lump sum, regardless how long the project takes and when you spend the money. The measures explained in the next sections are more accurate when a project spends and receives money over time.

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