...get their money back and they often focus on Payback because it is easy to understand. After all, getting your money back is an important consideration! However, it can be a problem if Payback is too long; long Paybacks raise doubts in the customer’s mind that investment in the solution is a good idea.
Complex solutions or projects often have benefits which cannot be counted for some time and any pre-conceived expectations of achieving a quick Payback period may be unrealistic. Consequently, it is unwise to rely only on Payback when creating a business case; the NPV and IRR values should be used to emphasise the value and rate of return, both of which may still exceed expectations.
To demonstrate how the Payback is easy to understand take the following example:
Spend $100 today, receive $10 per month – every month for 36 months.
Payback = 10 months
Fig. 1 Simple Payback Example 1
To demonstrate how Payback is dependent on the timing of the benefits, imagine an example similar to the one above where the investment is still $100 but the total benefits are received in a single lump sum instead of $10 per month:
Spend $100 today, receive $120 lump sum after 12 months.
Payback is now 12 months not 10 months
Fig. 2 Simple Payback Example 2
Notice that the Payback period calculation does not include any complicated mathematical operations. It is based on the cash values of the costs and benefits and does not take into account the time value of money, unlike NPV and IRR which, without Shark, are almost impossible to arrive at a correct answer with simple mathematics.
Multiple Payback Results
It is also possible to get multiple Payback values, see Fig.3. Here the cashflow crosses the zero line multiple times. This can happen when periodic recurring costs take the net cash position negative again.
Fig. 3 Multiple Payback Results
In practical terms this means that you must always take into account the timing of the costs and benefits and, when interpreting the result, always take the worst-case result so that there is minimal danger of embarrassment!