The payback method measures the time needed to recoup your investment in a product or service. A service that has a shorter payback period is deemed to be better than one that has a longer period, as in the following example:
- Suppose that you purchase a cloud service at $1,000 a month so that you can process invoices twice as fast as using your older system.
- Over a year, this comes to $12,000.
- Suppose that the old system processed $10,000 worth
- The value obtained is the difference between the old and new system, which is $10,000 per month because the new system is twice as fast.
- Per day, the value amounts to $333 worth of invoices assuming that a month has 30 days.
- This means that the new cloud service will pay for it-self after 36 (equivalent to 12,000/333) days.
Usually the payback method is better suited for capital expenditure because you can depreciate it over a number of years. So the one year used in our example to arrive at an investment of $12,000 would need to be changed to encompass the years over which you can depreciate capi-tal items. For operating expenditure, you would probably have a lock-in period or a contractual period with your cloud service provider, and it is this that would constitute the one year used in our calculation.One of the shortcomings of the payback method is that it does not take into account the time value of money, which can have a substantial bearing on the investment calculation in periods of high interest rates or over long periods of time. To cover this, net present value (NPV) cal-culations are usually used.