Payback Analysis

March 1, 2012

What is payback analysis? At its most simple definition, payback analysis-or payback period is simply a method for determining how long it will take an investment to pay for itself. Payback analysis is one of many tools available to businesses to help make decisions such as what equipment to buy, how many and what type of employees to hire, as well as which business processes to reengineer.
Payback analysis can take the form of elaborate programs, or simple spreadsheets. This type of analysis is useful not only in business, but can be used in personal situations as well. For instance, suppose you need to add insulation in the attic of your home: In order to do a very simple payback analysis, you would simply use the following formula: energy cost savings/initial installation costs=simple payback (1). So if you installed insulation in your attic at a cost of $700.00, and your electric bill decreased by $50.00 a month, the calculation would be (50*12)/500=1.2 years. In other words, this investment would pay for itself in approximately 1.2 years.
Within the business realm, payback analysis can easily give a dollar figure of how long it will take to recoup an investment in a piece of equipment or what is spent on a business process. This strict type of analysis, however, ignores several factors, including the time value of money and other factors such as goodwill obtained by increased customer satisfaction, and any profitability after the payback period.
To put this type of analysis into a framework that is relevant to Business Process reengineering, let’s take following example: let’s look at an IT department of a large health care facility. A few assumptions: 1) the business organization must go to this IT department for services-they cannot go outside of the organization for any type of service; 2) This IT department is chronically understaffed, and as a result, is suffering from low employee morale as well as having processes that are not customer friendly-even the most simple computer replacement cannot be easily scheduled by employees of this organization. Let’s take a moment and examine a scenario of reengineering a process, looking at its cost and payback analysis. You undertake a project to reengineer the process of computer replacements. As of now, there are 3 main bottlenecks with this process which cause customer dissatisfaction: a) getting approval for pulling computers from stock, b) having the computers pulled and prepped for installation, and c) the actual computer, replacements themselves. In order to deal with problem a) when a department is scheduled for replacements, instead of a manager approving small groups of equipment-have the manager approve all computers needed for the replacement project. For problem b) hire additional staff to pull and prep computers. Problem c) can be handled by having staff available and dedicated to large installs. Depending on the history of the department, prior perceptions of how work was performed in the past, and user satisfaction or dissatisfaction, this payback analysis may have a long period. While the calculations for payback analysis of this reengineered process are too complex for this blog, there are some benefits that cannot be calculated by a payback analysis. Better levels of service would help to improve employee moral both within the department, and outside of the department with the customers of the department. This one benefit would have several pay offs which could be measured: better employee morale and satisfaction can ultimately increase the patient satisfaction of those who come to the institution for health care, which would in turn directly affect the bottom line. A second benefit might be increased confidence with the IT department, which may ultimately result in increased funding for projects and normal support.
In my opinion, payback analysis, or more simply payback period is but one method for determining which processes may need to be changed, and will help predict how projects and reengineering processes will help to shape and benefit the business. While payback analysis can be useful, it is but a tool to be used with others such as net present value, internal rate of return, and discounted cash flow to help not only drive the profitability of the business, but to help drive decisions which ultimately will have a positive or negative impact on the business.

Works Cited
http://elpaso.apogee.net/lite/lecospm.asp

Other Resources
http://www.investopedia.com/terms/p/paybackperiod.asp#axzz1nosrIDbV http://www.afponline.org/Article_Detail.aspx?id=10737419461

by
Stephen Crowder

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One Response to “Payback Analysis”

  1. Siddharth Sehgal said

    Very well written article Steve.

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