By Stephen Kirk, CVS Life, FSAVE, FAIA, LEED AP – Vice President – Education, SAVE International
One of the core competencies of the value methodology is an understanding of “cost analysis” or the economics of a project, product, or process.
Several economic techniques will be addressed over the next few months. These will include:
- Payback Period
- Breakeven Analysis
- Return on Investment (ROI)
- Life Cycle Cost Analysis
In evaluating alternatives, one of the most common methods is use of the “payback period.” How many years does it take for an alternative to “pay back” the initial investment?
Payback Period
The payback period is the time (usually in years) required for the expected savings due to an investment to accumulate in order to (pay back) the invested amount. In the payback period approach, this time is used as a measure of the effectiveness of investment alternatives.
The payback period is calculated as:
For example, suppose a family is considering adding solar panels to their home to reduce energy costs. The alternatives being considered are as follows:
Alternative 1: Family continues to purchase all energy from the electricity utility company
Alternative 2: Family purchases solar collector system which results in reducing the amount of purchased energy from the electrical utility company
A solar power company informed the family their home, based on its size, would require a 10 KW system. This would cost approximately $2,000 per KW or $20,000 total. Federal and state tax credits would reduce the system cost to about $15,000. Using the solar system, the family is expected to decrease their electrical utility bills for energy by approximately $3,000 per year.
For Alternative 1, since no investment is required, the payback period is 0 years.
For Alternative 2, the payback period is calculated as follows:
So the family could expect to recoup their initial investment in approximately 5 years.
Decision Considerations
The decision as to which alternative to select has several considerations:
- Does the family have $15,000 to invest?
- Are they willing to wait 5 years before they actually start saving money (after paying for the initial investment)?
- How many years will the solar system last?
- What is the required maintenance on the solar system?
- Will the utility company continue to buy back excess electricity generated from the solar system?
- Is the family also interested in improving the environment by using solar power?
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