Utilities Manager: Simple Payback: Benefits & Limitations
Kathy | January 1, 2009
Simple payback is a common economic analysis method—one that most business owners can understand. In the context of energy efficiency, it calculates the amount of time it will take to recover installation costs based on annual energy cost savings.
The equation for simple payback is annual energy cost savings per year divided by the initial installation cost. While this simplistic formula can be used for evaluating a potential plant project, the real question is whether this is the best method for justifying the project. Let’s break it down.
Simple Payback Formula
Invest $5000 that reduces operating cost by $450/year
By definition, this formula is quite basic and easy to analyze. Those characteristics, however, are where the benefits end. Simple payback fails to take into account a number of key components when justifying a project.
Simple Payback Strengths
- Easily understood
- Easily applied
- An easy method of comparing merits of entirely different projects
- IT IS SIMPLE
Simple Payback Weaknesses
- IT IS SIMPLE
- Not economically sound
- Does not take account for present value
- Completely ignores long-term inflows
- No long-term projects
Simple payback can only provide information on how long it takes to recoup the investment—it cannot determine a project’s profitability. A simple payback of two years or less, however, usually suggests a profitable project. A longer simple payback requires more study.
Unfortunately, the simple payback method also doesn’t account for savings that may continue from a project after the initial investment is paid back from the profits of the project. That being said, for a quick review, this method is a helpful “sanity check.”
Unless your principal objective is to quickly recapture invested funds so that they can be put to use in other places, simple payback is not the most useful method for project justification. Most importantly, in situations where maximizing return on invested capital is of paramount importance, approving projects based on simple payback alone can lead to seriously flawed decisionmaking. That type of decision-making is something we can ill afford in today’s economy. UM
Bill Livoti is our new UTILITIES MANAGER columnist, is senior principal engineer for Power Generation and Fluid Handling with Baldor Electric Company. He also is vice chair of the Pump System Matter initiative.