Payback period for investments: how and why to calculate it?

Table of contents

What is the payback period?

The payback period (PBP) is, simply put, the time it takes for an investment to pay back and thus to pay for itself or break even. An investment costs a certain amount of money, but if all goes well, it will be profitable. The moment the revenue equals the costs incurred, the investment has paid off.

This is also known as the break-even point. 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.

The payback period is important in many different sectors, but it is especially popular in the energy sector. Almost all energy-saving measures have their cost savings calculated in advance.

Take solar panels or insulation, for example: the savings on the monthly energy bill ensure that the purchase costs are recouped over time.

What is the payback period formula?

The formula is as follows:

T = purchasing costs / (income – production costs)

Here, T is the unit of time. This can be months, years, or weeks, for instance. Note carefully that some investments also involve production costs. These could be, but are not restricted to, costs for maintenance or personnel and should be included in the calculation. Subsidies and taxes should also be included in the calculation.

Because of the production costs, the net revenue per unit of time will be less and, therefore, it takes longer to recover the investment. If you want to know T in months, you must also calculate the revenue and costs of production on a monthly basis. Monthly revenues minus monthly costs are also known as cash flow.

An investment can pay off in more ways than one. In the case of Sensorfact’s equipment, it could cut costs. With our smart meters, you save up to 10% on energy bills every month. Because you pay on a subscription model with us, there are no purchase costs.

Another category of revenue is, unlike a decrease in costs, the possibility to increase your turnover. If, for example, you have a factory that produces products, then investing in a new machine can ensure that sales, and therefore turnover, are increased.

Example:
Garment factory A is isolating its factory building. This costs €200,000. Insulation material requires no maintenance, so there are no monthly production costs. Because of the insulation, the factory saves €2000 a month on its energy bill.

The payback period formula then looks like this. After 100 months, or 8 years and one quarter, garment factory A has earned back the insulation on its factory:

Why is the formula important?

Every financial analyst has had to deal with the payback period. The PBP is important because it allows the risks of an investment to be weighed, which means that a reasonable choice in investment can be made.

Since a company cannot invest in everything; it has to make choices. If one investment is recouped faster than another, this can make it more attractive.

Payback time is particularly important if a company has little cash to invest. Indeed, in that situation, there are important considerations to be made and it is very beneficial if an investment is recouped quickly.

This is because there is, in that case, no possibility of making investments that only pay off after a very long time.

What are the drawbacks of using the payback period?

Using payback time as a measure to assess the quality of an investment has several drawbacks. The first disadvantage is that the payback period does not take into account the time after the PBP.

Namely, if an investment is very beneficial to your business in other ways after several years, you will not see that reflected in the payback period. It is purely about the time to the break-even point.

What else the payback period does not take into account is inflation. If the worth of money declines over time, the purchase cost of an investment might relatively be worth a lot more now than in 10 years. And this depreciation of money is not a factor in the payback period model.

Investments with an inconsistent cash flow are also not suitable for the payback method. Insulating a factory building, for example, pays much less in the summer months than in winter.

You could, of course, use annualised figures to calculate the payback period. But even these can vary quite a lot. The payback method is best suited for investments with a constant cash flow.

Payback period and the Approved Energy Conservation Measure Lists (EML)

The payback period, as mentioned, is particularly popular in the energy sector. Solar panels, for example, for private individuals make it very easy to calculate the PBP. But it does the same for companies in this industry. The payback period of an energy-saving measure is very interesting for companies and consumers alike.

The central government of enterprising Netherlands has a Recognized List of Measures for Energy Saving (EML) which lists the many measures for different sectors. These measures have two similarities: they save energy, and all have a payback period of five years at most. Five years is considered an excellent payback period for an investment.

In the energy list, which includes measures eligible for the EIA subsidy, the payback period also plays a major role. Many measures are required to have a payback period of between five and 25 years.

Net present value as an alternative

Because of the aforementioned limitations, financial analysts and investors often choose payback alternatives. The main alternative is Net Present Value (NPV). This takes into account all future cash flows.

It also includes interest. The Net Present Value formula is a lot more complicated. However, it can remove many of the drawbacks.

Energy-saving measure with a payback period of 0 days

Sensorfact’s technology has a payback period of 0 days because we use a subscription model. So you pay per period you save. Since the savings are higher than the cost of the equipment, it therefore directly saves your company money.

Industries need to improve their energy efficiency due to environmental legislation and global competition. We help industries reduce their ecological footprint and energy bills by eliminating energy waste in a smart and simple way, allowing plant managers to focus on their production.

Are you interested in our smart energy savers, which can save you up to 10% on energy bills? Then get in touch with us!