Payback Period Defined

Payback Period Defined: The time period from the start of the project until the cumulative cash flow turns positive

Perhaps the easiest calculation to understand of all the financial summary metrics used in an ROI analysis is the payback period.

The payback period is defined as the time frame needed for the project to yield a positive cumulative cash flow, which is typically specified in months. The payback period starts being measured at the beginning of a project and stops being measured when the cumulative benefits exceed the cumulative costs.

On a graph of cumulative benefits and costs, it is the elapsed time from project start to the point where the lines cross (see figure). This point is often referred to as the break-even point, demonstrated in this example:

The Bottom-Line

Payback period is important because it measures how long it takes for an investment to begin generating a positive cash flow. A longer payback period generates risk, especially if the project time line is delayed or benefits occur later than expected. A shorter payback period does not guarantee substantial returns for the investment; instead, it assures that there will be positive returns and that the benefits will occur early in the cycle and quickly offset the initial investment costs.

As with other financial summary metrics, payback period has its issues if used alone, such as failing to communicate the value of returns, only the time to returns. But as a measure of risk and speed to reward, it serves as one of the best early indicators as to the speed of potential rewards a project can deliver.

In today's frugal environment, payback measurement on projects is a requirement, and fast payback mandatory - typically dictated as 12 months or less from project deployment.