The result of the Payback Period analysis indicates how long the IT investment takes to recover the cost of the investment. It is usually stated in years but this depends on the analysis time horizon. Payback Period can be a simple calculation but only with very simple set of assumptions. Here is the formula to calculate the Payback Period on a IT investment. In general, the shorter the Payback Period the less risky the IT investment.
[Cost of IT Investment] / [Annual Cash Generated from IT Investment]
Let's look at the scenario where you are purchasing a piece of e-commerce software for $100,000. Assume that this piece of software increases revenue by $35,000 each year. The Payback Period calculation would be $100,000 / $35,000 = 2.86 years. So, this investment would pay for itself in 2 years and 10 months.
There is a significant drawback of calculating the Payback Period using such a simple set of assumptions. It's highly unlikely that the revenue resulting from the IT investment will actually come in evenly over an extended period of time. It's much more realistic for the revenue stream to be uneven. In this case, you have to look at the cumulative annual increase in revenue until the original IT investment is "paid for".
Consider the same example from above. Let's assume that in year 1, the net increase in revenue from the IT investment is $17,000. In years 2, 3, 4 and 5 it is $29,000, $45,000, $51,000 and $33,000, respectively. While this is an average annual increase in revenue of $35,000, the Payback Period is different because of the uneven revenue generated from this investment. The Payback Period in the example is actually more then 3 years which is longer than the original calculation using an average. Looking at the cumulative increase in revenue, you can see when the original investment is covered. In this example, just find where the cost of the IT investment ($100,000) is covered. You can see it occurs between year 3 and year 4.
Cumulative Increase in Revenue:
- Year 1 - $17,000
- Year 2 - $46,000
- Year 3 - $91,000
- Year 4 - $142,000
- Year 5 - $175,000
Take a look at the sample IT investment Excel spreadsheet for the detailed formula for calculating the Payback Period.
IT Investment Proposal
While the calculations are important in an IT investment analysis, it's not everything. I strongly recommend that you put together a proposal instead of just printing out your spreadsheet or emailing the results. Think of your CFO as the audience when putting together the proposal. Ultimately, if may end up on her desk anyway.
I would recommend that you start the proposal with a short summary of the IT investment (capital) you are proposing followed by a brief summary in words of the results of your analysis (along with summary calculations). Finally, attach the detailed spreadsheet analysis and you have a professional proposal that your boss will appreciate.
Your IT investment proposal package might include:
- Summary: a paragraph or two summarizing the IT investment you are proposing.
- Justification: a paragraph or two summarizing the results of your analysis along with the technique you used (include a summary table)
- Printout: a clean printout of the Excel spreadsheet showing the detailed analysis
Sample Excel Spreadsheet
The sample Excel spreadsheet has 3 sheets including:
- Net Present Value (NPV) Calculation
- Payback Calculation