What are the advantages and disadvantages of using the payback period as a decision criterion? (2024)

Last updated on May 3, 2024

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Advantages of payback period

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Disadvantages of payback period

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Alternatives to payback period

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How to use payback period effectively

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Here’s what else to consider

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The payback period is a simple and popular method of evaluating the profitability of an investment project. It measures how long it takes for the initial cash outlay to be recovered by the cash inflows generated by the project. However, using the payback period as a decision criterion also has some drawbacks that limit its usefulness and accuracy. In this article, you will learn about the advantages and disadvantages of using the payback period as a decision tool in P&L management.

1 Advantages of payback period

One of the main advantages of using the payback period as a decision criterion is its simplicity and ease of calculation. You only need to estimate the cash flows of the project and divide the initial investment by the annual cash inflow. This makes the payback period easy to understand and communicate to stakeholders, especially those who are not familiar with more complex methods of capital budgeting. Another advantage of the payback period is that it reflects the liquidity and risk of the project. A shorter payback period means that the project recovers its initial cost faster, which reduces the exposure to uncertainty and volatility in the future cash flows. A shorter payback period also implies that the project frees up cash for other uses sooner, which increases the liquidity and flexibility of the firm.

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In addition to already mentioned advantages comparability and prioritization through transparent payback calculations is a huge advantage in using this method of evaluation. This in turn hinges on being able to implement and foster a culture and habit of using the same KPIs and methods in the actual casing of the payback throughout not only product development, offering, or pricing, but also for cost saving initiatives and more adjacent PnL work. This dilligence, if established, also creates more understanding and motivation for decision and priorities made in your organization, as it becomes more evident why project x or y is more important than alpha or omega. It gives you a method to explain the why.

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SHAHRIAR KABIR Senior Executive Officer at NCC Bank Ltd.
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Advantage of Payback Period 1. Easy to calculate 2.Easily Understandable for the investors Disadvantages 1. Do not consider time value of money

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1) Simplicity: The payback period is a simple notion. It simply informs you how long it takes to recover the initial money you invested. This makes it accessible to all stakeholders, even those without a strong financial background.2) Liquidity Management: Projects with shorter payback periods allow quick access to investment, which can be used for other uses or reinvestment. This is especially helpful for businesses with minimal cash flow.3) Risk Assessment: A shorter payback period indicates reduced risk because the business recovers its investment faster. This can be important in situations involving high uncertainty or markets that are volatile.

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2 Disadvantages of payback period

Despite its simplicity and popularity, the payback period also has some significant disadvantages that limit its reliability and validity as a decision criterion. One of the main disadvantages of the payback period is that it ignores the time value of money. The payback period treats all cash flows as if they occur at the end of each year, without discounting them to their present value. This means that the payback period does not account for the opportunity cost of capital, inflation, or interest rates. Another disadvantage of the payback period is that it ignores the cash flows that occur after the payback period. The payback period does not consider the profitability or return on investment of the project beyond the breakeven point. This means that the payback period may favor projects that have shorter but lower cash flows over projects that have longer but higher cash flows. A third disadvantage of the payback period is that it may be influenced by arbitrary cutoff points. The payback period requires a predetermined acceptable payback period, which may vary depending on the industry, the firm, or the manager. However, there is no objective or rational basis for choosing a specific payback period, and different cutoff points may lead to different decisions.

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Payback period also doesn't take into account the project risk. Two projects (investment opportunities) with the same payback period could have significantly different market and execution risks.

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Payback period is unlikely to be useful for security-enhancing projects, and simple competitive table stakes spending. Additionally, there often questions of "tipping points". In other words, if a project has 5 possible features and 4 possible phases, it's possible that its entirety may have a good payback, but picking and choosing only certain features and phases may doom it to fail.

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To tackle these disadvantages you need to throw in sensitivity analysis - to cover risk - and sometimes even building the NPV to evaluate cash flow more in detail. Sometimes even common sense evaluation is valid to just see that the upside of a less attractive pay-back is better than the mathematical answer your casing presents. Point is: Do not rely to heavily on any evaluation method, and learn to recognize flaws in them and add analysis to cover your bases depending on the situation. As ever, the method shall fit the task, and no one method takes precedence.

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3 Alternatives to payback period

Given the disadvantages of the payback period, you may wonder what other methods of evaluating investment projects are available and how they compare to the payback period. Some of the common alternatives to the payback period are the net present value (NPV), the internal rate of return (IRR), and the profitability index (PI). These methods are based on the concept of discounted cash flow (DCF), which accounts for the time value of money and the risk-adjusted cost of capital. The NPV measures the difference between the present value of the cash inflows and the present value of the cash outflows of the project. A positive NPV means that the project adds value to the firm and should be accepted. The IRR measures the annualized rate of return that equates the present value of the cash inflows and the present value of the cash outflows of the project. A higher IRR means that the project is more profitable and should be preferred over other projects with lower IRRs. The PI measures the ratio of the present value of the cash inflows to the present value of the cash outflows of the project. A PI greater than one means that the project generates more value than it costs and should be undertaken.

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Some common alternatives can be.1) Net Present Value (NPV): Considers the present value of future cash flows, providing a broader view of profitability.2) Internal Rate of Return (IRR): Represents the discount rate that makes NPV zero, indicating the expected rate of return.3) Return on Investment (ROI): Compares net profit to the initial cost, giving a simple measure of profitability but without considering time value.4) Discounted Payback Period: Accounts for the time value of money in calculating the time to recover the investment.5) Modified Internal Rate of Return (MIRR): Adjusts IRR to include cost of capital and reinvestment rates.

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4 How to use payback period effectively

The payback period can be a useful and practical tool for screening and comparing investment projects, as long as you are aware of its assumptions and implications. To use it effectively in P&L management, consider it a preliminary filter rather than a final decision criterion. Additionally, combine the payback period with other measures such as the discounted payback period or the average accounting return. Be sure to use caution and judgment when relying on the payback period, since it is not a perfect or universal measure of project viability or desirability. You should always consider the context and purpose of your decision, and use your own experience and intuition to supplement and validate your analysis.

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To recap: Learn when payback method is sufficent and not, and in cases where it produces too much risk for a lack of correct analysis - add to it. Often as mentioned above sensitivity analysis and NPV will be the two most relevant to add, the former to study how risk affects your payback, the latter to more correctly help you prioritize your investment or sales budget. For campaign offering analysis it is often enough, but for M&A or product development it is not the way to go. Define and decide what to use when and you will be fine.

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5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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What are the advantages and disadvantages of using the payback period as a decision criterion? (2024)

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1 Advantages of payback period

2 Disadvantages of payback period

3 Alternatives to payback period

4 How to use payback period effectively

5 Here’s what else to consider

P&L Management

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