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Why payback periods are important

Payback period: The time period from the start of the project until the cumulative cash flow turns positive, usually measured in months.

The easiest calculation to understand in a traditional ROI analysis is the payback period. This starts being measured on Day 1 of a project, even if the first steps are team meetings and planning, and not actual implementation. The payback period ends when you "get what you pay for" -- when the cumulative benefits exceed the cumulative costs.

On a graph of total benefits and costs, the payback period is represented by the gap from the beginning to the point where the lines cross, often referred to as the breakeven point (see figure).

 

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Initial

Year 1

Year 2

Year 3

  Cumulative Costs

 $     523,000

 $     588,000

 $        656,000

 $        726,000

  Cumulative Benefits

 $             -  

 $     700,000

 $     1,190,000

 $     2,023,000

The payback period is important because it measures the time an investment takes to generate a positive cash flow. A longer payback period produces higher risk, especially if the project timeline is delayed or benefits occur later than expected. Yet a shorter payback period does not guarantee substantial returns for the investment. Instead, it assures that there will be positive returns and that the benefits will occur early in the cycle and quickly offset the initial investment costs.

Payback is related to ROI in that a negative ROI often means the project has failed to reach its breakeven point. (Other reasons for negative returns include legacy technologies dragging down productivity, or unexpected costs in a project's lifecycle.) Typically, once projects generate a positive ROI, they have passed the payback period and will continue to deliver value in the short term.

This metric, however, fails to communicate the value of returns, and often focuses IT teams on projects with quick payback, possibly distracting them from valuable longer term strategic projects. As with other financial summary metrics, it should be used in conjunction with other data such as ROI, net present value savings and internal rate of return to paint a clear investment picture.

Tom Pisello is the CEO of Orlando-based Alinean Inc., the ROI consultancy helping CIOs, consultants and vendors assess and articulate the business value of IT investments. He can be reached at tpisello@alinean.com.

This was first published in July 2005

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