What is Payback Period and How to Calculate It
The payback period is one of the most straightforward concepts in investments. It is a way to calculate the breakeven point of an investment, and it means how long it will take for an investor to get back what they have invested into that project or product. This article explains how to calculate the payback period using examples and talks about a shortcut method that can be used to calculate this value manually.
What is the Payback Period?
The payback period is when it takes an investment (or a project) to return all of its costs. It is expressed in years.
For example, suppose an investment of $10,000 is expected to generate a return of $15,000 in the first year and a final return of $20,000 at the end of three years. In that case, it will take two years for this investment to pay back its original amount, i.e., the payback period = 2 years.
How to Calculate Payback Period?
The general formula for calculating the payback period is as follows:
Payback Period = initial investment / return per year
In our previous example, we have calculated that after two years of earning $20,000 from this project, it will have paid off all its costs and made a total profit of 20k, so from here on, all proceeds from this project will be pure profit.
The same formula can also calculate how long investment or project takes to pay back any given loss. So if you have invested $10,000 in a project and at the end of year one it has lost $5,000, there is no point expecting this project to return the initial amount after the first year since it has already “paid back” that much by losing an equivalent amount. So its payback period would simply be one year.
To determine whether an investment is worth making, we need to compare it with other possible investments. Let’s say you are comparing two different projects, both expected to generate returns of $15000 in their second years. Still, one costs $8,000 more than the other. Which task should you choose?
Since both, of the projects would take two years to pay back, but the first one will return its initial investment in year one and the second one won’t, we might decide that it is better to go for the first one since we get our money back much sooner. So this way, we can compare different projects or investments and decide which seems more attractive based on its payback period.
What if there is a third option that looks even better than these two projects where instead of paying $8000 more, it costs $10,000 less? Would this be an even better choice than the previous two options?
Well, when you calculate all three options’ payback periods, they turn out to be:
1) Payback Period of Option 1 = 2 years
2) Payback Period of Option 2 = 3 years
3) Payback Period of Option 3= 0.5 years (since it returns the initial investment before year one ends)
So which one is better, the first or the third option? Well, this question could be decided based on your risk appetite, but if you compare options under the same conditions, you should always go for the one with the least payback period because that means less risk and more rewards in the short term. This method can also be used to determine what would be an excellent time to sell off an asset, so if you have one support whose return rate is decreasing while another’s return rate is increasing, you should probably sell off the first one and buy the other.
This method can also be used for projects that don’t produce any returns but instead cost money, so if you are considering two options, both will require an initial investment of $10,000. Still, option two will also incur $2000 in maintenance costs every year, so it would probably be better to go for three since its payback period is just one year while 2’s payback period is five years.
The formula above can also be rearranged to calculate the Return per Year when given the Payback Period. So if you have a project with a payback period of 3 years and your selling price is fixed at 15k, how much this project earns in return each year will be 15000/3=5000.
How to Calculate Payback Period in Excel?
We can calculate the payback period using the following formula:
Payback Period = Initial Investment / (Revenue – Expenses)
Many online tools and calculators are available that can provide this calculation for us. However, it is essential to understand the concepts behind these calculations to use them accurately. For example, suppose we need an accurate payback period calculation for a project or an investment making money at the end of one year but losing it gradually over the years. In that case, most online calculators will give you incorrect values because they usually assume profit-making projects only.
So let’s try calculating this value manually using excel so that we can understand how things work behind the scenes. The screenshot below will show you how I have figured this value:
For example, if we have invested $100 in a project and if we receive $105 after three years, then the payback period, in this case, would be three years.
#1: We can see that the project’s revenue is $105, which means our initial investment is $100. So, according to the formula, the payback period = 100/105 = 0.96 years, or almost one year.
#2 If we are not sure about having a profit at the end of one year, we can calculate the payback period using the same formula but assuming no yield. In such instances, most online calculators will show incorrect results because they usually assume only projects make profits at the end of it.
For example, let’s run a business by selling products, and there’s no cost involved for waiting to sell them (no inventory, no money waiting to be invested, etc.). We can calculate the payback period as Payback Period = Initial Investment / (Revenue – Variable Cost Per Unit * No. of Units Sold).
#3 In this example, our initial investment is $100, and the variable cost per unit is $50, which means that to sell ten units, we need to invest a total of ($100*10 = $1000). So according to the formula, payback period for this project = 100/($1000-50*10) = 50 * 10/1000 = 0.5 years or almost 6 months.
#4 If you are not sure about having a profit at the end of one year or not AND if there are costs involved for waiting to sell products (inventory, money invested, etc.), then we can calculate the payback period as Payback Period = Initial Investment / [(Revenue – Expenses) + (Average Investment Waiting To be Sold * No. of Units Sold)].
#5 In this example, our initial investment is $100, and the average cost per unit in inventory is $20, which means that to sell ten units, we need to invest a total of ($20*10 + 100 = $1200). So according to the formula, payback period for this project = 100/($1200-100) = 100/$1000 = 1 year.
So now you know how to calculate the payback period of a project or an investment. What are you waiting for? Go out there and make some significant decisions based on this simple formula.