We’ll explain what the payback period is and provide you with the formula for calculating it. Factoring with altLINE gets you the working capital you need to keep growing your business. Grey was previously the Small Business Bookkeeping Services Director of Marketing for altLINE by The Southern Bank. For example, it may take time for a product manager‘s product or service to mature and get traction among a larger audience through good word of mouth.

• Most broadly speaking, the higher the IRR, the more desirable the investment opportunity is.
• A payback period is the amount of time needed to earn back the cost of an investment.
• Improving any and all of these factors will help you earn back CAC faster, at which point you’ll have future cash flow to invest back into your company and grow.
• The discounted payback period is substantially the same as the standard payback method, except that discounting cash flows accounts for the changing time value of money.

Due to its ease of use, payback period is a common method used to express return on investments, though it is important to note it does not account for the time value of money. As a result, payback period is best used in conjunction with other metrics. Payback period is a quick and easy way to assess investment opportunities and risk, but instead of a break-even analysis’s units, payback period is expressed in years. The shorter the payback period, the more attractive the investment would be, because this means it would take less time to break even.

Payback Period

Then, it would make sense to choose the one that will pay back in five years because that helps you get a return on your money sooner. For instance, if it costs $1 million to build a product and makes $60,000 profit before 30% tax but after depreciation of 10%, the payback period will be as follows. Clearly putting your prices up is one way to increase revenue and cut the payback period. It may be more palatable to change the terms of a subscription as a way to bring committed revenue in sooner.

As payback period measures cost of acquisition at a specific moment in time, that part of the calculation can be skewed by inflation. The problem is more profound when calculating payback over longer periods; and more so if you regularly adjust your prices for inflation. Breaking down the payback period beyond the average for all of your customers will help you shape different ways to make acquisition more efficient. Your payback period determines the efficiency of your acquisition model, and it’s too important to be muddled or misunderstood. We’re going to dive deep on how to calculate and reduce longer payback periods so you can maximize efficiency and growth in your SaaS company. One of the major characteristics of the payback period is that it ignores the value of money over time.

How payback period relates to other SaaS metrics

Our experts love this top pick, which features a 0% intro APR for 15 months, an insane cash back rate of up to 5%, and all somehow for no annual fee. A speedy return may not always be the priority of a business because long-term investments are also rewarded in many ways. Examining the payback period is helpful to identify several investment opportunities that may be available.

The total cash flows over the five-year period are projected to be $2,000,000, which is an average of $400,000 per year. When divided into the $1,500,000 original investment, this results in a payback period of 3.75 years. However, the briefest perusal of the projected cash flows reveals that the flows are heavily weighted toward the far end of the time period, so the results of this calculation cannot be correct. Getting repaid or https://adprun.net/bookkeeping-for-independent-contractors-everything/ recovering the initial cost of a project or investment should be achieved as quickly as it allows. However, not all projects and investments have the same time horizon, so the shortest possible payback period needs to be nested within the larger context of that time horizon. For example, the payback period on a home improvement project can be decades while the payback period on a construction project may be five years or less.

Internal Rate of Return (IRR)

Financial analysts will perform financial modeling and IRR analysis to compare the attractiveness of different projects. This formula can only be used to calculate the soonest payback period; that is, the first period after which the investment has paid for itself. If the cumulative cash flow drops to a negative value some time after it has reached a positive value, thereby changing the payback period, this formula can’t be applied. This formula ignores values that arise after the payback period has been reached. In its simplest form, the calculation process consists of dividing the cost of the initial investment by the annual cash flows.

• It can be used by homeowners and businesses to calculate the return on energy-efficient technologies such as solar panels and insulation, including maintenance and upgrades.
• If opening the new stores amounts to an initial investment of $400,000 and the expected cash flows from the stores would be $200,000 each year, then the period would be 2 years.
• These formulas account for irregular payments, which are likely to occur.
• If it is not financially viable enough to repay the initial investment within the time frame, then it is likely not a good investment.
• The payback period formula calculates the years it will take to recover the invested funds from the particular business.

PBP may be calculated as the cost of safety investment divided by the annual benefit inflows. The main difference between the two periods is that discounted payback period considers the time value of money. The payback period does not factor in the discount rate, which means that a company might accept a project with a longer payback period over one with a shorter payback period but a higher discount rate.

Example of Payback Period

Getting your payback period method down may be the best way to understand how much you can spend on each customer. To determine how to calculate payback period in practice, you simply divide the initial cash outlay of a project by the amount of net cash inflow that the project generates each year. For the purposes of calculating the payback period formula, you can assume that the net cash inflow is the same each year.