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.

What factors that trigger a project

A project is started with key business objectives that are considered during the project selection process. The project with the best benefits will be selected. You can read more detail in the the project selection methods.

The following are the most factors that trigger a project:

• Satisfy regulations or compliance.
• Increase productivity.
• Increase revenue
• Improve profitability
• Increase market share
• Increase customer satisfaction
• Increase product quality or safety
• Reduce price to stay competitive
• Reduce time to market
• Reduce costs
• Reduce risk
• Reduce waste

Needs and Demands that drive Projects

Projects are usually come as result from business requirements, opportunities, or problems. Most of the projects will fit one of the following needs and demands:

• Market demand. The demands of the marketplace can drive the need for a project. For example, a bank initiates a project to offer customers the ability to apply for mortgage loans over the Internet because of a drop in interest rates and an increase in demand for refinancing and new home loans.
• Strategic opportunity/business need. The new phone system that was announced at the quarterly meeting came about as a result of a business need. The CEO, on advice from his staff, was advised that call volumes were maxed on the existing system. Without a new system, customer service response times would suffer, and that would eventually affect the bottom line.
• Customer request. Most companies have customers, and their requests can drive new projects. Customers can be internal or external to the organization. Government agencies don’t have external customers, but there are internal customers within departments and across agencies. Perhaps you work for a company that sells remittance-processing equipment and you’ve just landed a contract with a local utility company. This project is driven by the need of the utility company to automate its process or upgrade its existing process. The utility company’s request to purchase your equipment and consulting services is the project driver.
• Technological advance. Many of us own a multifunction cell phone that keeps names and addresses handy along with a calendar and a to-do list of some kind. I couldn’t live without mine. However, a newer, better version is always coming to market. Satellite communications now allows these devices to also act as GPS units. The introduction of satellite communications is an example of a technological advance. Because of this introduction, electronics manufacturers revamped their products to take advantage of this new technology.
• Legal requirement. Private industry and government agencies both generate new projects as a result of laws passed during every legislative season. For example, new sales tax laws might require new programming to the existing sales tax system. The requirement that food labels appear on every package describing the ingredients and the recommended daily allowances is another example of legal requirements that drive a project.
• Ecological impacts. Many organizations today are undergoing a “greening” effort to reduce energy consumption, save fuel, reduce their carbon footprint, and so on. These are examples of ecological impacts that result in projects.
• Social need. The last need is a result of social demands. For example, perhaps a developing country is experiencing a fast-spreading disease that’s infecting large portions of the population. Medical supplies and facilities are needed to vaccinate and treat those infected with the disease. Another example might include manufacturing or processing plants that voluntarily remove their waste products from water prior to putting the water back into a local river or stream to prevent contamination.

All of these needs and demands represent opportunities, business requirements, or problems that need to be solved. Management must decide how to respond to these needs and demands, which will more often than not initiate new projects.