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How to Calculate Payback for Purchases

A valuable help in deciding whether a particular purchase makes economic sense is knowledge of how long the expenditure will take to pay itself back in reduced costs or increased revenue. This information can be developed via simple payback analysis, the determination of how long it will take to recover the money spent for any particular purchase or investment. If you ever think, "Should I buy this new technology or fund this proposed undertaking?" look to payback period to help with the decision.

One important measure of a good deal is the length of time it takes to pay for itself in either increased income or decreased expense, and whether the result is increase in revenue or reduction of expense, the net result drops directly to the bottom line. However, what makes any potential investment a good deal is not just its impact on the bottom line but also how quickly that impact accrues compared with the payback for other possible uses of the same money.

Simple payback period is determined by dividing the cost of a project or investment by the average annual improvement in cash flow. For example, an undertaking that costs $4,000 and generates $1,000 per year added to the bottom line will pay itself back in four years.

To address payback period, it is first necessary to gather information about the project's cost, likely benefits and expected life. Costs are the easy part; it's simple enough to learn the exact cost of a new piece of equipment, for example, and it's not difficult to determine the costs of installation and operation. However, benefits and expected life can be another matter.

In considering payback:

  • The estimated life of the potential bottom-line improvement must be longer than the payback period so as to recover the investment and generate additional income or savings.
  • Ask: How much will the investment increase revenue, or how much will it reduce costs? These amounts must be estimated; their actuality lies in the future; however, you usually have knowledge and experience from which to develop reasonable estimates.

Further, you will need to:

  • Make a reasonable estimate of the economic life of the expenditure so that this can be compared with the calculated payback period. 
  • Consider whether the cash-flow pattern is likely to be even or uneven. For example, if it looks like cash flow will be greatest near the beginning of the undertaking, this may give additional weight to the investment's value as a short-term opportunity.

Simple payback is the easiest means available for assessing the potential value of various expenditures. Its major shortcomings are, first, it doesn't account for improvement beyond recovery of the investment, and, second, it doesn't address the time value of money (the use of interest rates).

Nevertheless, payback period can be a valuable help in determining where limited funds can be applied to best advantage. The tighter money becomes, the more potential uses will be competing for it. And more often than not, the alternative generating the quickest payback is the one that will contribute most to the financial health of the business. To express the idea behind payback period as simply as possible: the quicker an expenditure pays for itself, the sooner it begins adding to the net worth of the business.