Whenever you set up a business, you spend money. The initial money you spend to set up the whole operation and structure is called "capital". Of course, you don't mind budgeting this money for the business because you hope and believe that you will get your money back from the earnings or cash flow of the business. The million dollar question is: how quickly do you get it back?
For example: You spend $100 to set up a business, to pay for the tables, chairs, and other objects. Afterwards, you earn $50 in the first year, and $50 in the second year (total of $100 in 2 years). This means that in 2 years, you get back your $100... exactly the same as what you initially invested. Therefore, your payback period is exactly 2 years.
How do we use this concept? Simply put, the shorter the payback period, the better it is for you. It means you earn your money back quicker.
Of course, it's also wise to consider the Time Value of Money. In an another article by this same author, we study the concept of Present Value and learn that the value of money decreases if it is paid at a date further into the future. For example, when interest rates are at 5% per annum, $50 paid 2 years later will be worth only $45.35 today. For this reason, it is better to use the Discounted Payback Period, which takes into consideration the present value of the future net cash flows of a business. If we use the discounted method in our latest example above, you will find that the payback period would be longer, like maybe 2 and a half years instead of just 2 years when using the simple non-discounted method. Why? Since the $50 per year in the future is worth less than the same amount paid today, you would need more years to get your payback.
This concept of the payback period doesn't only apply to a business. It could also apply to lesser things such as a project or a piece of equipment which you buy for your company. For example, your business is a canteen or cafeteria, and you are thinking of buying a drink machine so that you can increase sales and cash flow. You should think not only about the extra sales and cash flow you will earn from the drink machine, but also how long it will take you to get your payback from this specific machine.
David Michael is the creator of MBAbullshit.com, a fun and free online tutorial website for lots of MBA courses and business school topics. Go to http://mbabullshit.com/blog/2011/08/06/payback-period-how-to-calculate-payback-period-in-6-min/ to watch a super easy video on How to Calculate Payback Period in 6 min.
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