Payback Period Explained: Formula, Calculation and Importance

First, we must discount (i.e., bring to the present value) the net cash flows that will occur during each year of the project. The payback period is a fundamental capital budgeting tool in corporate finance, and perhaps the simplest method for evaluating the feasibility of undertaking a potential investment or project. Depending on the calculated payback period of a project, management can decide to either accept or reject the project. An investment project will be accepted if the payback period is less than or equal to the management’s maximum desired payback period. Because of the production costs, the net revenue per unit of time will be less and, therefore, it takes longer to recover the investment.

These could be, but are not restricted to, costs for maintenance or personnel and should be included in the calculation. The shorter this period, the more attractive and risk-free the investment. After all, as the payback period gets longer, the probability of something happening in the meantime increases. On the other hand, the break-even point is the level of sales or revenue data at which a business is neither making a profit nor a loss. It is the point at which the total revenue generated by pay back period meaning the business equals its total costs. The payback period is valuable in capital and financial budgeting functions and can also be used in other industries.

1. The payback period is a financial metric that measures the amount of time it takes for an investment to generate enough cash flow to recover its initial cost.
2. If short-term cash flows are a concern, a short payback period may be more attractive than a longer-term investment that has a higher NPV.
3. Using the example above, what happens if some of those new customers churn before 9 months?
4. There are some clear advantages and disadvantages of payback period calculations.
5. By calculating discounted payback period, you learn how many years it will take to earn profit from the initial investment.
6. You could argue that the whole purpose of measuring payback period is to find the optimum CAC.

Example of the Payback Method

Two things impact payback period; how much a new customer costs to acquire (CAC), and how much they spend. The CAC of a customer never changes (though it can change from customer to customer), but how much they spend can. But variables are two ways things, and if MRR starts to drop (MRR Churn), it’s going to take longer to turn your customers profitable. The chart also illustrates how companies with a higher payback period tend to be larger (e.g Box – $771m in annual revenue, NetSuite – $200m, Salesforce – $21bn, 2U -$575m). This is logical; with bigger pockets and more predictable revenue, they can experiment with acquisition strategies, forgoing some of the efficiency that is a must for leaner SaaS businesses. This study into payback periods of SaaS companies shows an average of around 16.3 months.

The decision rule using the payback period is to minimize the time taken for the return on investment. Since the second option has a shorter payback period, this may be a better choice for the company. For example, if solar panels cost $5,000 to install and the savings are $100 each month, it would take 4.2 years to reach the payback period. By including the value of upgrades, downgrades, and churn of customers within their payback period, you get a more accurate picture of actual revenue, and so a more accurate payback period reading. If the NRR rate is above 100%, it should follow that your customers are becoming profitable sooner.

Get up to $1,000 in stock when you fund a new Active Invest account.*

As payback period measures cost of acquisition at a specific moment in time, that part of the calculation can be skewed by inflation. The problem is more profound when calculating payback over longer periods; and more so if you regularly adjust your prices for inflation. 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. As a result, the payback period will increase; but for customers who remain, the payback period will have been unaffected (all other things being equal). There are two steps involved in calculating the discounted payback period.

Key Issues in Making Investment Decisions

This is because a lower payback period means that the investment will pay for itself more quickly, which is generally seen as a positive outcome. 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. If earnings will continue to increase, a longer payback period might be acceptable.

It is shown as the percentage of the CAC paid off by the end of the expected payback period. Ideally you’re after at least 100%, with anything less meaning the customer is taking longer than average to return a profit. The payback period is the sales and marketing spend from Quarter 1 ($6,000) divided by the difference in revenue from Quarter 1 to Quarter 2 ($1,250).

1. The shorter the discounted payback period, the quicker the project generates cash inflows and breaks even.
2. So it’s worth testing out new sales channels to see if you can cut the cost of acquisition.
3. As a general rule of thumb, the shorter the payback period, the more attractive the investment, and the better off the company would be.
4. Ultimately, the appropriate payback period will depend on the specific investment and the goals of the investor.
5. Therefore, this might not give an accurate overall picture of what cash flows will actually be earned for the project.
6. And when they do, inspire them to stay by reinforcing the benefits of your product and/or offering incentives to stay.

You can use the payback period in your own life when making large purchase decisions and consider their opportunity cost. Understanding the way that companies calculate their payback period is also helpful to determine their financial viability and whether it makes sense for you to invest in them as part of your portfolio. The payback period is the amount of time it would take for an investor to recover a project’s initial cost. The payback period is the amount of time it takes to break even on an investment. The appropriate timeframe for an investment will vary depending on the type of project or investment and the expectations of those undertaking it.

If earnings might decrease after a certain number of years, the investment may not be a good idea even if it breaks even quickly. On the other hand, an investment with a short lifespan could need replacement shortly after its payback period, making it a potentially poor investment. 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. Improving any and all of these factors will help you earn back CAC faster, at which point you’ll have future cash flow to invest back into your company and grow.

What is the payback period, for example?

Using the payback period to assess risk is a good starting point, but many investors prefer capital budgeting formulas like net present value (NPV) and internal rate of return (IRR). This is because they factor in the time value of money, working opportunity cost into the formula for a more detailed and accurate assessment. Another option is to use the discounted payback period formula instead, which adds time value of money into the equation.

Simply put, it is the length of time an investment reaches a breakeven point. Looking at the example investment project in the diagram above, the key columns to examine are the annual “cash flow” and “cumulative cash flow” columns. Payback focuses on cash flows and looks at the cumulative cash flow of the investment up to the point at which the original investment has been recouped from the investment cash flows. Increasing your prices is not the only way to make more revenue from customers. Having a scaled pricing model ensures they spend more to access more of your service.