The Importance of Payback

Ever have the disappointment of coming up with a great idea to solve a problem or make an improvement only to have your boss shoot you down because"it costs too much" or "we can't afford it." If you know how to do a payback analysis you'll have a pretty good understanding, even before you go to your boss, of the financial feasibility of your idea.

Payback is a financial tool that tells you how long it will take before the saving resulting from your improvement will pay back the cost of your improvement. The calculation is fairly straightforward once you gather detailed facts on just how much your improvement will cost along with a reasonable estimate of the monthly savings generated by the improvement.

Example: Suppose you have an improvement that reasonable people agree will save the company $250.00 per month. The cost of the improvement is $2,000.00. To calculate payback you simply divide the monthly savings ($250) into the cost of the improvement ($2000). The result of that division (in this case 8) is your payback period. In 8 months you will have saved enough money to pay back the $2,000.00 you invested.

Payback is very important when you are trying to get money to make an improvement because of a financial rule-of-thumb. Most financial managers will tell you that a payback of one year or less is a "no-brainer." That is, if the company has the funds available, a less than one year payback situation is a very good investment to make. If the payback is greater than one year, but is two years or less, it is still a fairly good investment to make. Beyond two years doesn't mean you won't get the money, but it does mean you'll probably need some pretty strong non-financial reasons why the improvement should be funded.

One last thought for today. The actual details that sum up to the two components of payback (cost of improvement and monthly savings) can be complex sometimes. My advice? If you are not familiar with the detailed mechanics of payback ask someone who is. Usually your company will have a financial person (controller, accountant, chief financial officer) who can show you what details you should include and how to perform the actual calculations. If you're lucky, the financial person may even check your work for you to make sure it's accurate.

About Pelleyblog. This blog is concerned with management topics. It is hosted by Dan Pelley, a management practitioner who offers a Certificate in Supervisory Management. The blog includes responses to questions and issues (posed by participants in Dan's seminars and classes, in their homework assignments, and by you via e-mail.); practical, hands-on, real-world advice (since Dan is still a practitioner); thoughts on how not to train (sharing some of the really stupid things that some companies do, and then they wonder why their “training” programs do not work); now and then a thought for the day (on any issue that strikes our fancy at the time); and occasionally a rant (although Dan's wife says he does far too many of them).

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