How to Calculate the Break-Even Period
Learn to calculate when an investment's returns will cover its initial cost, a core financial metric for evaluating project viability and managing risk.
The Payback Period is a financial metric that calculates how long it will take for an investment’s returns to equal its original cost. This measurement provides a timeline for recouping funds, which helps in assessing the financial viability and speed of return for a project or capital expenditure.
Key Components for Calculation
Two pieces of information are required to determine the Payback Period. The first is the initial investment, which is the total upfront cost to begin the project. This includes the purchase price of an asset plus all ancillary costs like shipping, installation, and employee training. For example, if a company buys a machine for $100,000, and incurs $5,000 in delivery fees and $15,000 for setup and training, the total initial investment is $120,000.
The second component is the projected cash inflows, which are the net cash amounts the investment is expected to generate. These inflows are not simple revenue; they represent the cash added after accounting for any new operating expenses. These can be new earnings or cost savings. For instance, an equipment upgrade might not increase sales but could reduce annual operating costs by $30,000, making this amount the annual cash inflow.
The Calculation Process
The calculation for the Payback Period differs depending on whether cash inflows are consistent each year. For an investment that generates even, or uniform, cash inflows, the initial investment is divided by the annual cash inflow. If a company spends $200,000 on a system projected to generate a net cash inflow of $50,000 each year, the Payback Period is four years ($200,000 / $50,000).
When a project produces uneven cash inflows, a cumulative approach is necessary that tracks the unrecovered portion of the investment year by year. For example, consider a $150,000 investment with projected inflows of $40,000 in year one, $60,000 in year two, and $70,000 in year three. After the first year, $110,000 remains unrecovered ($150,000 – $40,000), and after the second year, the unrecovered amount is $50,000 ($110,000 – $60,000).
Since the third year’s inflow of $70,000 exceeds the remaining $50,000, the investment is paid back during that year. To find the precise point, divide the remaining cost by that year’s total cash inflow ($50,000 / $70,000), which equals approximately 0.71. This fraction is converted into months (0.71 12), resulting in about 8.5 months. The total Payback Period is 2 years and 8.5 months.
Applying the Payback Period in Decision Making
The Payback Period is used to evaluate and compare different investment opportunities. When a business is faced with multiple projects, calculating the Payback Period for each provides a metric for comparison. For instance, if Project A has a Payback Period of two years and Project B has one of four years, Project A is the more attractive option, all else being equal.
A shorter Payback Period indicates a quicker recovery of the initial capital. This is often preferred because it reduces the time a company’s funds are tied up in a single project, lowering liquidity risk. Faster capital recovery also means that money can be reinvested into other opportunities sooner.