What is a Payback Period?

The payback period is the length of time required for an investment to pay for itself. The basic calculation used to arrive at an estimate of the payback period is to divide the cost of the investment by the annual returns. This simplified calculation can give people a rough figure, but usually the situation is a bit more complicated. The issue of the payback period is one among several things to be considered when making a new investment.

In a simple example of how this works, imagine a company buying a software product which is supposed to improve efficiency. The product costs 1,000 units of currency, but is supposed to save the buyer roughly 200 units of currency every year. The period of time required to break even is five years. At the end of the payback period, the product has paid for itself.

One issue with the payback period is that it does not consider profitability. If the software in the above example continues to work for five more years after it breaks even in cost, the company actually makes 1000 units of currency. This calculation also does not evaluate for what is known as the “time value of money,” referencing the idea that a single unit of currency is usually worth more now than it will be in the future. This is the result of inflation and the fact that currency can earn interest; if a company spends 1000 currency units on something now, they will not be available to earn interest.

When making a payback period calculation, people can also be hindered by the fact that returns are rarely steady. In some years, the investment may pay off more of itself than others. This can complicate matters considerably, especially with investments which are unpredictable and volatile. For example, a plumber who purchases a new imaging camera might find that it pays for itself in six months, thanks to a series of jobs the camera was needed for, or that it takes two years because the camera isn't used that much in the first year and much more in the second.

Financial advisers can help people determine the probable payback period involved with an investment, and help people make informed purchasing decisions. Investments can include equipment, buildings, stocks, and numerous other purchases of goods, financial products, or services depending on the situation and the nature of the investor.