Using Payback Period to Evaluate Purchases

A fairly simple and straightforward concept for evaluating the wisdom of a purchase is to determine the payback period.  The payback period, defined as the time required to recover the initial cash outlay for an item or project, is calculated by determining the hard dollar value that will be realized each month from acquiring the asset then dividing the total purchase price of the item by that number. 

For example, let’s assume you are considering the purchase of an asset that will return $100 per month in reduced expenses (or possibly increased gross margin) through more efficient operations.  If the purchase price for that item is $1,000 the payback period is 10 months (.83 years).  However, if the price is $10,000 the payback period is 100 months (8.3 years).  Considering the fact they each return $100 per month of benefit, which item would you buy?  There are situations when making multiple purchases over time of lower cost items that have a shorter useful life will be a more effective use of cash than the purchase one higher cost item that will last for many years.  You should do the math to determine the payback to make the appropriate decision.

Although the payback period calculation can be complicated by inducing an untold number of complex variables such as inconsistent returns year over year, discounted cash flow considerations, lease vs. purchase options, etc., the very simple approach presented above is as effective in nearly every case.  The more sophisticated the formula, the more opportunity there is for incorrectly determining the assumptions that influence the outcome.