Payback Period Explained, With the Formula and How to Calculate It

Some acquisition costs are obvious, such as advertising and marketing spend. Some are less so – for example press coverage, hackathon events and how you support your current customers all feed into your brand reputation. In theory, payback period should include all customer acquisition costs, not just the direct ones. But attributing an activity to a customer acquisition is easier said than done. Using the example above, what happens if some of those new customers churn before 9 months? The cost of acquisition has already been sunk and so will remain the same, but the revenue side of the equation will be reduced.

• It’s similar to determining how much money the investor currently needs to invest at this same rate in order to get the same cash flows at the same time in the future.
• Investors may use payback in conjunction with return on investment (ROI) to determine whether or not to invest or enter a trade.
• Lastly, it is not always possible that you will recover the initial investments as soon as it is estimated.
• Discounted cash flows conceptualize how today’s dollar will be reduced in value next year.
• If the payback period calculated as above is less than the minimum acceptable then the decision should be to procure the new equipment.
• One of the major characteristics of the payback period is that it ignores the value of money over time.

However, there is no such thing as a payback period without a break-even point. This calculation allows investors to determine whether an investment decision makes sense financially and, hence, how much money it will take to reach the break-even point. The concept of the payback period refers to the key metric used to determine the length of time a business investment takes to pay for itself. Payback periods for investments can be calculated in two straightforward methods by businesses. For example, if you have three possible investments, one will pay back your initial investment in 5 years, while the other two take 15 and 25 years, respectively.

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Referring to our example, cash flows continue beyond period 3, but they are not relevant in accordance with the decision rule in the payback method. Another drawback to the payback period is that it doesn’t take the time value of money into account, unlike the discounted payback period method. This concept states that money would be worth more today than the same amount in the future, due to depreciation and earning potential.

• In the case of detailed analysis like net present value or internal rate of return, the payback period can act as a tool to support those particular formulas.
• Breaking down the payback period beyond the average for all of your customers will help you shape different ways to make acquisition more efficient.
• It also means that if you wanted to pay back your initial investment by 20 years, it would take about 7.3 years (365 divided by 24).
• So it would take two years before opening the new store locations has reached its break-even point and the initial investment has been recovered.
• Below is a break down of subject weightings in the FMVA® financial analyst program.

Investments with higher cash flows toward the end of their lives will have greater discounting. The payback period simply measures how long it takes for an investment to generate enough revenue to pay back the initial investment. This capital budgeting method calculates the length of return on investment, and this is done by dividing the total cost of the project by the annual cash inflows. The payback period is a measure organizations use to determine the time needed to recover the initial investment in a business project.

Payback Period Calculator – Excel Template

Please note that some information might still be retained by your browser as it’s required for the site to function. Designed for freelancers and small business owners, Debitoor invoicing software makes it quick and easy to issue professional invoices and manage your business finances. In simple words, depreciation means reducing the value of any goods or asset with time, and it is typically measured in percentage. Depreciation is an essential factor to consider while accounting and forecasting for any business. Often, companies overlook this, which results in missing out on profitable opportunities.

Discounted cash flows conceptualize how today’s dollar will be reduced in value next year. Another frequently used method is IRR, or internal rate of return, which emphasizes the rate of return from a particular project each year. Last but not least, there is a payback rule called the payback period, which calculates the time required to recover the investment cost. While a quick return payback period formula may not be a top priority for every organization in every situation, it is a critical factor in every situation. Initially the project involves a cash outflow, arising from the original investment of £500,000 and some project losses in Year 1 of £50,000. Cash flow is the inflow and outflow of cash or cash-equivalents of a project, an individual, an organization, or other entities.

Payback Method Example #2

Thus, it fails to see the long-term potential of the business because the focus is only on the short-term ROI. Moreover, it helps to recognize which product or project is the most efficient to regain the investment at the earliest possible. You could argue that the whole purpose of measuring payback period is to find the optimum CAC. A high CAC will worsen the payback period (as it takes longer to pay off the investment), and vice versa.

They might assume that the net cash inflow is constant each year to calculate the payback period formula. Because payback periods only assess cash flows up to the point at which a corporation’s initial investment is recouped, they do not consider any additional profits a company may generate. As a result, if a company is just concerned with short-term returns on investment, it may miss out on the long-term potential. One of the disadvantages of this type of analysis is that although it shows the length of time it takes for a return on investment, it doesn’t show the specific profitability. This can be a problem for investors choosing between two projects on the basis of the payback period alone.

The payback period is a useful tool for P&L management, but it also has some limitations that you should be aware of. First, it does not consider the time value of money, which means that it does not account for the interest rate or the inflation rate that affect the value of money over time. Second, it does not consider the cash flow beyond the payback period, which means that it does not capture the total return or the profitability of the project or investment.

For instance, a $2,000 investment at the start of the first year that returns $1,500 after the first year and $500 at the end of the second year has a two-year payback period. As a rule of thumb, the shorter the payback period, the better for an investment. Any investments with longer payback periods are generally not as enticing. Discounted payback period will usually be greater than regular payback period.

The term is also widely used in other types of investment areas, often with respect to energy efficiency technologies, maintenance, upgrades, or other changes. For example, a compact fluorescent light bulb may be described as having a payback period of a certain number of years or operating hours, assuming certain costs. The table is structured https://www.bookstime.com/ the same as the previous example, however, the cash flows are discounted to account for the time value of money. The table indicates that the real payback period is located somewhere between Year 4 and Year 5. There is $400,000 of investment yet to be paid back at the end of Year 4, and there is $900,000 of cash flow projected for Year 5.

The cash flow balance in year zero is negative as it marks the initial outlay of capital. Therefore, the cumulative cash flow balance in year 1 equals the negative balance from year 0 plus the present value of cash flows from year 1. The discounted payback period is calculated by adding the year to the absolute value of the period’s cumulative cash flow balance and dividing it by the following year’s present value of cash flows.

The term payback period refers to the amount of time it takes to recover the cost of an investment. Simply put, it is the length of time an investment reaches a breakeven point. The break-even point measures the profitability of an investment opportunity, while the payback period measures the speed of a project.

Since IRR does not take risk into account, it should be looked at in conjunction with the payback period to determine which project is most attractive. The Payback Period shows how long it takes for a business to recoup an investment. This type of analysis allows firms to compare alternative investment opportunities and decide on a project that returns its investment in the shortest time if that criteria is important to them.