ROI Guide: Payback Period

Definition: An investment's payback period in years is equal to the net investment amount divided by the average annual cash flow from the investment.

What it means: How long will it take to get my money back?

Strengths: It's easy to compute, easy to understand and provides some indication of risk by separating long-term projects from short-term projects.

Weaknesses: It doesn't measure profitability, doesn't account for the time value of money and ignores financial performance after the break-even period.

Payback period is the most widely used measure for evaluating potential investments. Its use increases in tough economic times, when CIOs are apt to say things like, "We won't even consider a project that has more than a 24-month payback."

For those IT managers, projected cost savings or revenue enhancements resulting from the project would have to equal or exceed the upfront investment within two years for the project to win approval.

"We start with payback period," says Ron Fijalkowski, CIO at Strategic Distribution Inc. in Bensalem, Pa. "For sure, if the payback period is over 36 months, it's not going to get approved. But our rule of thumb is we'd like to see 24 months. And if it's close to 12, it's probably a no-brainer."

Payback period has the virtue of being easy to compute and easy to understand. But that very simplicity carries weaknesses with it. Payback period says nothing about how the investment performs after the break-even period.

Consider the two examples of $1 million projects shown in the chart at right. A bank can spend $1 million on server consolidations and save one-third that amount in each of the following three years on reduced license fees, telecommunications costs and systems administration labor. Or it could spend the same amount to install ATMs, eliminate four teller positions and save $250,000 per year indefinitely.

Which is a better investment? Payback analysis clearly favors the server consolidation, which recoups its investment a year earlier than the ATM project. But the ATM project goes on to produce returns after three years and is therefore a better long-term investment. In fact, the server project isn't even profitable.

"Payback gives you an answer that tells you a bit about the beginning stage of a project, but it doesn't tell you much about the full lifetime of the project," says Chris Gardner, a co-founder of iValue LLC, an IT valuation consultancy in Barrington, Ill.

But payback period's emphasis on the short term has a special appeal for IT managers. "That's because the history of IT projects that take longer than three years is disastrous," says Gardner.

Indeed, Ian Campbell, chief research officer at Nucleus Research Inc. in Wellesley, Mass., says payback period is an absolutely essential metric for evaluating IT projects—even more important than discounted cash flow—because it spotlights the risks inherent in lengthy IT projects. "It should be a hard and fast rule to never take an IT project with a payback period greater than three years, unless it's an infrastructure project you can't do without," Campbell says.

Of course it's possible to consider payback period in concert with other, more sophisticated measures. Payback period may be a good way to quickly size up a portfolio of projects and winnow it down to a few that merit more careful scrutiny with, for example, discounted cash flow.

The simplicity of computing payback may encourage sloppiness, especially the failure to include all costs associated with an investment, such as training, maintenance and hardware upgrade costs, says Douglas Emond, senior vice president and chief technology officer at Eastern Bank in Lynn, Mass. For example, he says, "you may be bringing in a hot new technology, but uh-oh, after implementation you realize you need a .Net guru in-house, and you don't have one."

Payback Period: What It Looks Like
Server consolidation

ATM installation

Investment: $1 millionInvestment: $1 million
Total$1 million$1.25 million
Payback period3 years

4 years

A payback calculation answers the question: How long will it take to get my money back? But it doesn’t tell you much about the investment after the break-even point. In this example, a bank can spend $1 million on server consolidation and recoup its costs in three years. Or the bank could spend the same amount on ATMs and recoup its costs in four years. The server project is the payback winner, but the ATM project saves $250,000 per year indefinitely.

Special Report

Do the Math! An ROI Guide

Stories in this report:


Copyright © 2003 IDG Communications, Inc.

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