Payback Period – Two ways to calculate, Role of Depreciation, FAQs

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What is the Payback Period?

The payback period is the expected waiting period for a business before which the initial investments made in any product or project are retrieved. 

Examining the payback period is helpful to identify several investment opportunities that may be available. Moreover, it helps to recognize which product or project is the most efficient one in being able to regain the investment at the earliest possible. 

A speedy return may not always be the priority of a business because long-term investments are also rewarded in many ways. Nevertheless, this is an essential consideration. 

How to calculate the Payback Period?

The payback period can be measured in the following two ways: 

Averaging

Averaging is a method where the formula for payback period is the annual cash a product or project is estimated to generate divided by the initial expenditure. The averaging method delivers a precise idea of the payback period when the cash flow is steady. 

However, the payback period can also be wider than its mark when the organization is likely to experience a growth spurt in the near future.  

Subtraction 

Subtraction is a method where the formula to calculate the payback period is annual cash inflow subtracted by initial cash outflow. In contrast with the averaging method, this method is the most suitable for circumstances when the cash flow is likely to fluctuate in the near future. 

What are the challenges in the Payback Period?

Firstly, the payback period takes into account the cash flow up to the point where the initial investment is regained and it doesn’t consider the earnings made after that point. Thus, it results in failure to see the long-term potential of the business because the focus is only on the short-term ROI

Secondly, it is crucial to bear in mind that a product or service needs enough time to grow and reach a wide range of audiences. Often, companies overlook this, which results in missing out on fruitful opportunities. 

Lastly, it is not always possible that the initial investments will be recovered as soon as it is estimated. Sometimes due to circumstances, for instance, the pandemic, can make it longer to regain the investments made. This is a point that the payback period framework misses out on. 

What is the role of depreciation in the Payback Period?

Depreciation is an essential factor to consider while accounting and forecasting for any business. In simple words, depreciation means the reduction of the value of any goods or asset with the passage of time. It is typically measured in percentage. However, depreciation does not mean the loss of value in terms of cash. Hence, when the payback period is calculated, depreciation needs to be added back in the equation. For instance, if it costs $1 million to build a product and it makes $60,000 profit before 30% tax but after depreciation of 10% the payback period will be as follows. 

Profit before tax = $60,000. Less tax = (60000 x 30%) = $18,000. Profit after tax = $42,000. Adding depreciation = ($1 million x 10%) = $100,000 Total cash flow = $142,000. Payback period = Total investment ($1 million) / Total cash flow ($142,000) = 7 years 

FAQs

Q: What is the Payback Period? 

A: The payback period is the expected waiting period for a business before which the initial investments made in any product or project are retrieved. Examining the payback period is helpful to identify several investment opportunities that may be available. Moreover, it helps to recognize which product or project is the most efficient one in being able to regain the investment at the earliest possible. 

Q: What is the formula to calculate the Payback period? 

A: The payback period is calculated in two ways – Averaging and Subtracting. In the Averaging method, the formula for the payback period is the annual cash a product or project is estimated to generate divided by the initial expenditure. In the subtraction method, the formula to calculate the payback period is annual cash inflow subtracted by initial cash outflow.

Q: What is the role of depreciation in the payback period? 

A: Depreciation means the reduction of the value of any goods or asset with the passage of time due to wear and tear, the evolution of the product competitors, market change, etc. It is typically measured in percentage. However, depreciation does not mean the loss of value in terms of cash. Hence, when the payback period is calculated, depreciation needs to be added back to the equation.

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