Projects should add financial value to an organisation. This Project Payback blog is part of a set of four blogs looking at the financial methods of assessing projects
I wrote about project selection in an earlier blog. However, that blog over-viewed both financial and non-financial methods for project selection. This blog will look at the advantages and problems with these financial methods.
There are essentially two methods for doing this:
- One for projects that ‘save’ a fixed amount every year, and
- One for projects that demonstrate variable annual savings or incomes
Choosing the right method is essential for a full understanding of the projects payback.
Fixed Project Paybacks
This method is suitable for projects that ‘save’ a constant amount of money each year. For example:
- A project to buy a machine that replaces an operator
- A project to automate or computerise a process to save time
There will be many other projects that fit this category, the essential thing being that the savings per year are constant every year.
For this type of project, the equation to use is simply:
As an example, consider a project costing £750,000 with a fixed saving of £250,000 each year:
Using the equation, the project payback can be calculated:
In the above example, the project will payback in 3 years.
Variable Project Paybacks
In this case, the income (or savings) from the project change year to year. It is therefore necessary to use a cash-flow technique to see when the payback really is. In the case of a new product launch, sales may increase after the first year, and fall away after 3 or 4 years.
In the following payback example, the cost of the project is £750,000, with a reducing income of £500,000, £250,000, £150,000 and £100,000 in the following 4 years. The right-hand column indicates the cash-flow amount at each year, starting with spending the £750,000 for no benefit!
This project pays-back after 2 years (or when the cash-flow crosses back through zero to a positive value).
Using the “average” savings per year (as in the first fixed payback example) would give a false indication of the payback period. In this case the total income of £1,000,000 divided by 4 years gives an average annual income of £250,000, and suggests an incorrect three year payback.
Problems Using the Payback Method
There are several issues using this financial assessment method:
- All future incomes and savings are estimated – and may be wrong!
- The value of money in the future is less due to inflation, and investment opportunities
- Once payback is achieved, savings in further years are totally ignored (rightly or wrongly!)
Payback should therefore be used with some caution, however it is an easy method to understand.
As with all projects, there are other factors that should be considered when making a judgement.
All of these project finance techniques are shown in this video playlist:
Project Payback is a quick and relatively easy method of calculating the financial gains of a project, but should be used with some caution.