How to Calculate the Payback Period

The payback period is the amount of time it takes for a particular investment to break even. By calculating that break-even point, you can quickly understand how long it’s going to take for your investment to pay for itself and begin to return dividends, which can ultimately help you determine whether to move forward with the investment or not.

Two primary methods are used to calculate the payback period:

The averaging method assumes that the average annual cash flow following an investment will be consistent. The formula is as follows:

Payback period = Cost of the investment/Average annual cash flow¹

Let’s say your washer and dryer need an upgrade, and you’re debating between paying a slightly higher price for energy-efficient appliances and sticking with a more traditional model that costs less. The energy-efficient washer and dryer are going to cost $2,500, but you project saving $30 per month on your water bill. The traditional washer and dryer cost $750. You also anticipate you can get 10 good years from whichever new appliances you choose.

First, you’ll want to understand how much more it costs for the energy-efficient model by subtracting the cost of the traditional washer and dryer from the more energy-efficient option.

$2,500 - $750 = $1,750

Based on this, the relative cost of the investment is $1,750, which we’ll plug into the payback period calculation.

Payback period = $1,750 / ($30*12) = 4.86

Based on the payback period formula, the savings on your utility bills cover the additional cost of the energy-efficient washer and dryer in just under five years. So even though the traditional washer and dryer cost less upfront, you can likely break even with the energy-efficient appliances after five years and enjoy cost savings for another five years until you’ll need to replace the appliances again.

The subtraction method of the payback formula can help you assess an investment when cash flow is likely to vary from year to year.

Payback period = The last year with negative cash flow + (Cash flow at the end of that year/Cash flow during the year after that year)

Let’s assume that you’re debating whether it makes sense to attend a 6-month coding boot camp that costs $30,000 to get a certificate in web development. You anticipate that after you receive your certificate, you’ll be able to trade your administrative assistant job, making $50,000 per year, for one that brings in $60,000 as an entry-level web developer, but that it might take you about two additional months to land your next job. You also anticipate quickly being able to move up the ranks as you gain experience and that you could qualify for a raise of $5,000 per year for each of your first 3 years in the new industry.

We’ll first look at your total investment.

The cost of your certificate + lost wages for 8 months off work to earn the certificate and find a new job = $30,000 + $33,333 = $63,333

Now, let’s consider your anticipated cash flow after you receive your certificate:

Year 1: $60,000

Year 2: $65,000

Year 3: $70,000

We can then begin calculating your cash flow each year to determine when you’ll expect to break even.

Year 0: -$63,333

Year 1: -$63,333 + $60,000 = -$3,333

Year 2: -$3,333 + $65,000 = $61,667

From here, we’ll use the subtraction method payback formula to see exactly how long it will take to recoup your costs.

1 + ($3,333/$61,667) = 1.054 years

Based on the calculation, it’s going to take just over a year to break even on your investment in continuing education, and after that point, there may be a significant upside as your earnings continue to grow.

• Benefits of Using the Payback Period

There are several benefits of leveraging the payback period to assess your investments, including:

There are also a few potential disadvantages of the payback period that you’ll want to closely consider before relying on the formula for decision-making, including: