{"id":255,"date":"2021-01-26T22:31:05","date_gmt":"2021-01-26T22:31:05","guid":{"rendered":"https:\/\/courses.lumenlearning.com\/wm-managerialaccounting\/?post_type=chapter&#038;p=255"},"modified":"2021-08-13T15:45:44","modified_gmt":"2021-08-13T15:45:44","slug":"simple-payback","status":"publish","type":"chapter","link":"https:\/\/courses.lumenlearning.com\/wm-managerialaccounting\/chapter\/simple-payback\/","title":{"raw":"Simple Payback","rendered":"Simple Payback"},"content":{"raw":"<div class=\"textbox learning-objectives\">\r\n<h3>Learning Outcomes<\/h3>\r\n<ul>\r\n \t<li>Calculate the payback period on a steady flow of cash<\/li>\r\n<\/ul>\r\n<\/div>\r\nSouth Side Brewery is building a stage for musicians. The company expects revenue to increase by $6,000 per month as a result of increased alcohol sales and expenses (cost of the bands) to increase by $4,000 per month. The cost to build the stage with a lighting and sound system is $120,000. It will be good for at least eight years.\r\n\r\nManagement wants to know how long it will take for the stage to pay for itself.\r\n\r\nThe formula for payback period on a steady flow of cash is: cost\/annual cash flows\r\n<p style=\"padding-left: 30px;\">Annual net cash inflows will be $2,000\/month * 12 months = $24,000.<\/p>\r\n<p style=\"padding-left: 30px;\">$120,000 \/ $24,000 = 5 years.<\/p>\r\nHere is a table of net cash inflows:\r\n\r\nNet cash inflows (additional cash revenues - additional cash expenses)\r\n<div align=\"left\">\r\n<table class=\"fin-table acctstatement fw\">\r\n<tbody>\r\n<tr>\r\n<th class=\"r\" scope=\"col\"><\/th>\r\n<th class=\"r\" scope=\"col\">New stage<\/th>\r\n<\/tr>\r\n<\/tbody>\r\n<tbody>\r\n<tr>\r\n<td>Year 1<\/td>\r\n<td class=\"r\">$ 24,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Year 2<\/td>\r\n<td class=\"r\">$ 24,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Year 3<\/td>\r\n<td class=\"r\">$ 24,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Year 4<\/td>\r\n<td class=\"r\">$ 24,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Year 5<\/td>\r\n<td class=\"r\">$ 24,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Year 6<\/td>\r\n<td class=\"r\">$ 24,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Year 7<\/td>\r\n<td class=\"r\">$ 24,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Year 8<\/td>\r\n<td class=\"r\">$ 24,000<\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\n<\/div>\r\n&nbsp;\r\n\r\nAnd here is a table that shows how the cost is recaptured over time:\r\n<div align=\"left\">\r\n<table class=\"fin-table acctstatement fw\">\r\n<thead>\r\n<tr class=\"u-sr-only\">\r\n<th scope=\"col\">Description<\/th>\r\n<th scope=\"col\">Amount<\/th>\r\n<\/tr>\r\n<\/thead>\r\n<tbody>\r\n<tr>\r\n<td>Cost<\/td>\r\n<td class=\"r\">$\u00a0 \u00a0 \u00a0 120,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Recaptured YR 1<\/td>\r\n<td class=\"r\">$\u00a0 \u00a0 \u00a0(24,000)<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Left to recapture<\/td>\r\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0 \u00a0 \u00a0 \u00a096,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Recaptured YR 2<\/td>\r\n<td class=\"r\">$\u00a0 \u00a0 \u00a0(24,000)<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Left to recapture<\/td>\r\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0 \u00a0 \u00a0 \u00a072,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Recaptured YR 3<\/td>\r\n<td class=\"r\">$\u00a0 \u00a0 \u00a0(24,000)<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Left to recapture<\/td>\r\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0 \u00a0 \u00a0 \u00a048,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Recaptured YR 4<\/td>\r\n<td class=\"r\">$\u00a0 \u00a0 \u00a0(24,000)<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Left to recapture<\/td>\r\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0 \u00a0 \u00a0 \u00a024,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Recaptured YR 5<\/td>\r\n<td class=\"r\">$\u00a0 \u00a0 \u00a0(24,000)<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Left to recapture<\/td>\r\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0 \u00a0\u00a0\u00a0 \u00a0 \u00a0 \u00a0 -<\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\n&nbsp;\r\n\r\n<\/div>\r\nLet\u2019s look at a slightly more complicated example.\r\n\r\nJuxtaPos makes interlocking wooden puzzles. One of the machines is old, and management is considering either replacing it or refurbishing it. Replacing it will cost $80,000. The new machine would last 10 years and have a residual value of $10,000. Refurbishing the old machine for $56,000 will keep it in service for another eight years, and it will have no residual value at the end of that time.\r\n\r\nYou have estimated production under both scenarios, and you used those numbers to compute revenue. You have also estimated operating costs and created the following table of net cash inflows:\r\nNet cash inflows (additional cash revenues - additional cash expenses)\r\n<div align=\"left\">\r\n<table class=\"fin-table acctstatement fw\">\r\n<tbody>\r\n<tr>\r\n<th class=\"r\" scope=\"col\"><\/th>\r\n<th class=\"r\" scope=\"col\">Refurbish<\/th>\r\n<th class=\"r\" scope=\"col\">Purchase New<\/th>\r\n<\/tr>\r\n<\/tbody>\r\n<tbody>\r\n<tr>\r\n<td>Year 1<\/td>\r\n<td class=\"r\">$\u00a0 \u00a0 \u00a0 18,000<\/td>\r\n<td class=\"r\">$ \u00a0 \u00a0 \u00a020,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Year 2<\/td>\r\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 16,000<\/td>\r\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 19,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Year 3<\/td>\r\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 14,000<\/td>\r\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 18,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Year 4<\/td>\r\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 12,000<\/td>\r\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 17,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Year 5<\/td>\r\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 10,000<\/td>\r\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 15,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Year 6<\/td>\r\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 8,000<\/td>\r\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 13,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Year 7<\/td>\r\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 6,000<\/td>\r\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 10,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Year 8<\/td>\r\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 4,000<\/td>\r\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 7,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Year 9<\/td>\r\n<td><\/td>\r\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 5,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Year 10 (includes proceeds from sale of machine)<\/td>\r\n<td><\/td>\r\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 12,000<\/td>\r\n<\/tr>\r\n<tr>\r\n<td><\/td>\r\n<td class=\"r line-single line-double\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0 \u00a0 \u00a0 88,000<span class=\"u-sr-only\">Double line<\/span><\/td>\r\n<td class=\"r line-single line-double\"><span class=\"u-sr-only\">Single Line<\/span>$ \u00a0 \u00a0 136,000<span class=\"u-sr-only\">Double line<\/span><\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\n<\/div>\r\n&nbsp;\r\n\r\nWhat is the payback period for each option?\r\n<p style=\"text-align: left;\">The cash flows aren\u2019t even, so the simple formula won\u2019t work. However, an Excel spreadsheet could quickly give you an answer (you could also do this on a piece of paper easily enough).<\/p>\r\n<p style=\"text-align: center;\">Refurbish<\/p>\r\n\r\n<div align=\"left\">\r\n<table class=\"fin-table acctstatement fw\">\r\n<tbody>\r\n<tr>\r\n<th class=\"r\" scope=\"col\"><span class=\"u-sr-only\">Description<\/span><\/th>\r\n<th class=\"r\" scope=\"col\"><span class=\"u-sr-only\">Amount<\/span><\/th>\r\n<th class=\"r\" scope=\"col\">% of cash flows<\/th>\r\n<th class=\"r\" scope=\"col\">months<\/th>\r\n<th class=\"r\" scope=\"col\">years<\/th>\r\n<\/tr>\r\n<\/tbody>\r\n<tbody>\r\n<tr>\r\n<td>Cost to refurbish<\/td>\r\n<td class=\"r\">$\u00a0 \u00a0 \u00a0 \u00a0 56,000<\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Recaptured YR 1<\/td>\r\n<td class=\"r\">$ \u00a0 \u00a0 \u00a0(18,000)<\/td>\r\n<td class=\"r\">100%<\/td>\r\n<td class=\"r\">12.0<\/td>\r\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 1.00<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Left to recapture<\/td>\r\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0 \u00a0 \u00a0 \u00a0 38,000<\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Recaptured YR 2<\/td>\r\n<td class=\"r\">$ \u00a0 \u00a0 \u00a0(16,000)<\/td>\r\n<td class=\"r\">100%<\/td>\r\n<td class=\"r\">12.0<\/td>\r\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 1.00<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Left to recapture<\/td>\r\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0 \u00a0 \u00a0 \u00a0 22,000<\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Recaptured YR 3<\/td>\r\n<td class=\"r\">$ \u00a0 \u00a0 \u00a0(14,000)<\/td>\r\n<td class=\"r\">100%<\/td>\r\n<td class=\"r\">12.0<\/td>\r\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 1.00<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Left to recapture<\/td>\r\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0 \u00a0 \u00a0 \u00a0 \u00a08,000<\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Recaptured YR 4<\/td>\r\n<td class=\"r\">$ \u00a0 \u00a0 \u00a0 (8,000)<\/td>\r\n<td class=\"r\">67%<\/td>\r\n<td class=\"r\">8.0<\/td>\r\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 0.67<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Left to recapture<\/td>\r\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0-<\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\n<\/div>\r\n&nbsp;\r\n\r\nNotice that cash flows in Year 4 are $12,000, but we only had $8,000 left to recapture, so we estimate that it will take 3.67 years, or three years and eight months, to recapture the entire cost of refurbishing the existing machine.\r\n\r\nIf we purchase a new machine, it will take 4.46 years (roughly four years, five and a half months) to recapture the cost.\r\n<p style=\"text-align: center;\">Purchase<\/p>\r\n\r\n<div align=\"left\">\r\n<table class=\"fin-table acctstatement fw\">\r\n<tbody>\r\n<tr>\r\n<th class=\"r\" scope=\"col\"><span class=\"u-sr-only\">Description<\/span><\/th>\r\n<th class=\"r\" scope=\"col\"><span class=\"u-sr-only\">Amount<\/span><\/th>\r\n<th class=\"r\" scope=\"col\">% of cash flows<\/th>\r\n<th class=\"r\" scope=\"col\">months<\/th>\r\n<th class=\"r\" scope=\"col\">years<\/th>\r\n<\/tr>\r\n<\/tbody>\r\n<tbody>\r\n<tr>\r\n<td>Cost to purchase<\/td>\r\n<td class=\"r\">$ \u00a0 \u00a0 \u00a0 80,000<\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Recaptured YR 1<\/td>\r\n<td class=\"r\">$ \u00a0 \u00a0 (20,000)<\/td>\r\n<td class=\"r\">100%<\/td>\r\n<td class=\"r\">12.0<\/td>\r\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 1.00<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Left to recapture<\/td>\r\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$ \u00a0 \u00a0 \u00a0 60,000<\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Recaptured YR 2<\/td>\r\n<td class=\"r\">$ \u00a0 \u00a0 (19,000)<\/td>\r\n<td class=\"r\">100%<\/td>\r\n<td class=\"r\">12.0<\/td>\r\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 1.00<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Left to recapture<\/td>\r\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$ \u00a0 \u00a0 \u00a0 41,000<\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Recaptured YR 3<\/td>\r\n<td class=\"r\">$ \u00a0 \u00a0 (18,000)<\/td>\r\n<td class=\"r\">100%<\/td>\r\n<td class=\"r\">12.0<\/td>\r\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 1.00<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Left to recapture<\/td>\r\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$ \u00a0 \u00a0 \u00a0 23,000<\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Recaptured YR 4<\/td>\r\n<td class=\"r\">$ \u00a0 \u00a0 (17,000)<\/td>\r\n<td class=\"r\">100%<\/td>\r\n<td class=\"r\">12.0<\/td>\r\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 1.00<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Left to recapture<\/td>\r\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$ \u00a0 \u00a0 \u00a0 \u00a06,000<\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Recaptured YR 5<\/td>\r\n<td class=\"r\">$ \u00a0 \u00a0 \u00a0(6,000)<\/td>\r\n<td class=\"r\">46%<\/td>\r\n<td class=\"r\">5.5<\/td>\r\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 0.46<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Left to recapture<\/td>\r\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 -<\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\n<\/div>\r\n&nbsp;\r\n\r\nYear 5 net cash inflows were $15,000, but we only had $6,000 of the original cost of the machine left to recapture, which is 46% of the $15,000, which equates to roughly five and a half months. You could round this final partial year to six months since this calculation is based on estimation and is not a precision measurement, so the payback period is four and a half years.\r\n\r\nThe payback method is quick and easy to apply, but it has several drawbacks. As you might have noticed, it doesn\u2019t take the overall investment into account. Purchasing a new machine resulted in $136,000 in total cash inflows over the next 10 years, while refurbishing (because of higher maintenance costs and lower outputs) resulted in only $88,000 in net cash inflows. However, the refurbishing option pays for itself more quickly (three years, eight months as opposed to four years, six months for the replacement).\r\n\r\nIn addition, this analysis does not take into account the time value of money.\r\n\r\nHere is another example of how to calculate the payback of a project:\r\n\r\n<iframe src=\"\/\/plugin.3playmedia.com\/show?mf=6352602&amp;p3sdk_version=1.10.1&amp;p=20361&amp;pt=375&amp;video_id=YX4NoZN8YWU&amp;video_target=tpm-plugin-5ihb36bi-YX4NoZN8YWU\" width=\"800px\" height=\"450px\" frameborder=\"0\" marginwidth=\"0px\" marginheight=\"0px\"><\/iframe>\r\n\r\nYou can view the <a href=\"https:\/\/oerfiles.s3.us-west-2.amazonaws.com\/Managerial+Accounting\/Transcripts\/ThePaybackMethod_transcript.txt\" target=\"_blank\" rel=\"noopener\">transcript for \"The Payback Method\" here (opens in new window)<\/a>.\r\n\r\nBefore we address these two issues, check your understanding of the basic idea of the payback method.\r\n<div class=\"textbox tryit\">\r\n<h3>Practice Question<\/h3>\r\n[ohm_question hide_question_numbers=1]221578[\/ohm_question]\r\n\r\n<\/div>","rendered":"<div class=\"textbox learning-objectives\">\n<h3>Learning Outcomes<\/h3>\n<ul>\n<li>Calculate the payback period on a steady flow of cash<\/li>\n<\/ul>\n<\/div>\n<p>South Side Brewery is building a stage for musicians. The company expects revenue to increase by $6,000 per month as a result of increased alcohol sales and expenses (cost of the bands) to increase by $4,000 per month. The cost to build the stage with a lighting and sound system is $120,000. It will be good for at least eight years.<\/p>\n<p>Management wants to know how long it will take for the stage to pay for itself.<\/p>\n<p>The formula for payback period on a steady flow of cash is: cost\/annual cash flows<\/p>\n<p style=\"padding-left: 30px;\">Annual net cash inflows will be $2,000\/month * 12 months = $24,000.<\/p>\n<p style=\"padding-left: 30px;\">$120,000 \/ $24,000 = 5 years.<\/p>\n<p>Here is a table of net cash inflows:<\/p>\n<p>Net cash inflows (additional cash revenues &#8211; additional cash expenses)<\/p>\n<div style=\"text-align: left;\">\n<table class=\"fin-table acctstatement fw\">\n<tbody>\n<tr>\n<th class=\"r\" scope=\"col\"><\/th>\n<th class=\"r\" scope=\"col\">New stage<\/th>\n<\/tr>\n<\/tbody>\n<tbody>\n<tr>\n<td>Year 1<\/td>\n<td class=\"r\">$ 24,000<\/td>\n<\/tr>\n<tr>\n<td>Year 2<\/td>\n<td class=\"r\">$ 24,000<\/td>\n<\/tr>\n<tr>\n<td>Year 3<\/td>\n<td class=\"r\">$ 24,000<\/td>\n<\/tr>\n<tr>\n<td>Year 4<\/td>\n<td class=\"r\">$ 24,000<\/td>\n<\/tr>\n<tr>\n<td>Year 5<\/td>\n<td class=\"r\">$ 24,000<\/td>\n<\/tr>\n<tr>\n<td>Year 6<\/td>\n<td class=\"r\">$ 24,000<\/td>\n<\/tr>\n<tr>\n<td>Year 7<\/td>\n<td class=\"r\">$ 24,000<\/td>\n<\/tr>\n<tr>\n<td>Year 8<\/td>\n<td class=\"r\">$ 24,000<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<p>&nbsp;<\/p>\n<p>And here is a table that shows how the cost is recaptured over time:<\/p>\n<div style=\"text-align: left;\">\n<table class=\"fin-table acctstatement fw\">\n<thead>\n<tr class=\"u-sr-only\">\n<th scope=\"col\">Description<\/th>\n<th scope=\"col\">Amount<\/th>\n<\/tr>\n<\/thead>\n<tbody>\n<tr>\n<td>Cost<\/td>\n<td class=\"r\">$\u00a0 \u00a0 \u00a0 120,000<\/td>\n<\/tr>\n<tr>\n<td>Recaptured YR 1<\/td>\n<td class=\"r\">$\u00a0 \u00a0 \u00a0(24,000)<\/td>\n<\/tr>\n<tr>\n<td>Left to recapture<\/td>\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0 \u00a0 \u00a0 \u00a096,000<\/td>\n<\/tr>\n<tr>\n<td>Recaptured YR 2<\/td>\n<td class=\"r\">$\u00a0 \u00a0 \u00a0(24,000)<\/td>\n<\/tr>\n<tr>\n<td>Left to recapture<\/td>\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0 \u00a0 \u00a0 \u00a072,000<\/td>\n<\/tr>\n<tr>\n<td>Recaptured YR 3<\/td>\n<td class=\"r\">$\u00a0 \u00a0 \u00a0(24,000)<\/td>\n<\/tr>\n<tr>\n<td>Left to recapture<\/td>\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0 \u00a0 \u00a0 \u00a048,000<\/td>\n<\/tr>\n<tr>\n<td>Recaptured YR 4<\/td>\n<td class=\"r\">$\u00a0 \u00a0 \u00a0(24,000)<\/td>\n<\/tr>\n<tr>\n<td>Left to recapture<\/td>\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0 \u00a0 \u00a0 \u00a024,000<\/td>\n<\/tr>\n<tr>\n<td>Recaptured YR 5<\/td>\n<td class=\"r\">$\u00a0 \u00a0 \u00a0(24,000)<\/td>\n<\/tr>\n<tr>\n<td>Left to recapture<\/td>\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0 \u00a0\u00a0\u00a0 \u00a0 \u00a0 \u00a0 &#8211;<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<p>&nbsp;<\/p>\n<\/div>\n<p>Let\u2019s look at a slightly more complicated example.<\/p>\n<p>JuxtaPos makes interlocking wooden puzzles. One of the machines is old, and management is considering either replacing it or refurbishing it. Replacing it will cost $80,000. The new machine would last 10 years and have a residual value of $10,000. Refurbishing the old machine for $56,000 will keep it in service for another eight years, and it will have no residual value at the end of that time.<\/p>\n<p>You have estimated production under both scenarios, and you used those numbers to compute revenue. You have also estimated operating costs and created the following table of net cash inflows:<br \/>\nNet cash inflows (additional cash revenues &#8211; additional cash expenses)<\/p>\n<div style=\"text-align: left;\">\n<table class=\"fin-table acctstatement fw\">\n<tbody>\n<tr>\n<th class=\"r\" scope=\"col\"><\/th>\n<th class=\"r\" scope=\"col\">Refurbish<\/th>\n<th class=\"r\" scope=\"col\">Purchase New<\/th>\n<\/tr>\n<\/tbody>\n<tbody>\n<tr>\n<td>Year 1<\/td>\n<td class=\"r\">$\u00a0 \u00a0 \u00a0 18,000<\/td>\n<td class=\"r\">$ \u00a0 \u00a0 \u00a020,000<\/td>\n<\/tr>\n<tr>\n<td>Year 2<\/td>\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 16,000<\/td>\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 19,000<\/td>\n<\/tr>\n<tr>\n<td>Year 3<\/td>\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 14,000<\/td>\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 18,000<\/td>\n<\/tr>\n<tr>\n<td>Year 4<\/td>\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 12,000<\/td>\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 17,000<\/td>\n<\/tr>\n<tr>\n<td>Year 5<\/td>\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 10,000<\/td>\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 15,000<\/td>\n<\/tr>\n<tr>\n<td>Year 6<\/td>\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 8,000<\/td>\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 13,000<\/td>\n<\/tr>\n<tr>\n<td>Year 7<\/td>\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 6,000<\/td>\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 10,000<\/td>\n<\/tr>\n<tr>\n<td>Year 8<\/td>\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 4,000<\/td>\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 7,000<\/td>\n<\/tr>\n<tr>\n<td>Year 9<\/td>\n<td><\/td>\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 5,000<\/td>\n<\/tr>\n<tr>\n<td>Year 10 (includes proceeds from sale of machine)<\/td>\n<td><\/td>\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 12,000<\/td>\n<\/tr>\n<tr>\n<td><\/td>\n<td class=\"r line-single line-double\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0 \u00a0 \u00a0 88,000<span class=\"u-sr-only\">Double line<\/span><\/td>\n<td class=\"r line-single line-double\"><span class=\"u-sr-only\">Single Line<\/span>$ \u00a0 \u00a0 136,000<span class=\"u-sr-only\">Double line<\/span><\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<p>&nbsp;<\/p>\n<p>What is the payback period for each option?<\/p>\n<p style=\"text-align: left;\">The cash flows aren\u2019t even, so the simple formula won\u2019t work. However, an Excel spreadsheet could quickly give you an answer (you could also do this on a piece of paper easily enough).<\/p>\n<p style=\"text-align: center;\">Refurbish<\/p>\n<div style=\"text-align: left;\">\n<table class=\"fin-table acctstatement fw\">\n<tbody>\n<tr>\n<th class=\"r\" scope=\"col\"><span class=\"u-sr-only\">Description<\/span><\/th>\n<th class=\"r\" scope=\"col\"><span class=\"u-sr-only\">Amount<\/span><\/th>\n<th class=\"r\" scope=\"col\">% of cash flows<\/th>\n<th class=\"r\" scope=\"col\">months<\/th>\n<th class=\"r\" scope=\"col\">years<\/th>\n<\/tr>\n<\/tbody>\n<tbody>\n<tr>\n<td>Cost to refurbish<\/td>\n<td class=\"r\">$\u00a0 \u00a0 \u00a0 \u00a0 56,000<\/td>\n<td><\/td>\n<td><\/td>\n<td><\/td>\n<\/tr>\n<tr>\n<td>Recaptured YR 1<\/td>\n<td class=\"r\">$ \u00a0 \u00a0 \u00a0(18,000)<\/td>\n<td class=\"r\">100%<\/td>\n<td class=\"r\">12.0<\/td>\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 1.00<\/td>\n<\/tr>\n<tr>\n<td>Left to recapture<\/td>\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0 \u00a0 \u00a0 \u00a0 38,000<\/td>\n<td><\/td>\n<td><\/td>\n<td><\/td>\n<\/tr>\n<tr>\n<td>Recaptured YR 2<\/td>\n<td class=\"r\">$ \u00a0 \u00a0 \u00a0(16,000)<\/td>\n<td class=\"r\">100%<\/td>\n<td class=\"r\">12.0<\/td>\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 1.00<\/td>\n<\/tr>\n<tr>\n<td>Left to recapture<\/td>\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0 \u00a0 \u00a0 \u00a0 22,000<\/td>\n<td><\/td>\n<td><\/td>\n<td><\/td>\n<\/tr>\n<tr>\n<td>Recaptured YR 3<\/td>\n<td class=\"r\">$ \u00a0 \u00a0 \u00a0(14,000)<\/td>\n<td class=\"r\">100%<\/td>\n<td class=\"r\">12.0<\/td>\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 1.00<\/td>\n<\/tr>\n<tr>\n<td>Left to recapture<\/td>\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0 \u00a0 \u00a0 \u00a0 \u00a08,000<\/td>\n<td><\/td>\n<td><\/td>\n<td><\/td>\n<\/tr>\n<tr>\n<td>Recaptured YR 4<\/td>\n<td class=\"r\">$ \u00a0 \u00a0 \u00a0 (8,000)<\/td>\n<td class=\"r\">67%<\/td>\n<td class=\"r\">8.0<\/td>\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 0.67<\/td>\n<\/tr>\n<tr>\n<td>Left to recapture<\/td>\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0&#8211;<\/td>\n<td><\/td>\n<td><\/td>\n<td><\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<p>&nbsp;<\/p>\n<p>Notice that cash flows in Year 4 are $12,000, but we only had $8,000 left to recapture, so we estimate that it will take 3.67 years, or three years and eight months, to recapture the entire cost of refurbishing the existing machine.<\/p>\n<p>If we purchase a new machine, it will take 4.46 years (roughly four years, five and a half months) to recapture the cost.<\/p>\n<p style=\"text-align: center;\">Purchase<\/p>\n<div style=\"text-align: left;\">\n<table class=\"fin-table acctstatement fw\">\n<tbody>\n<tr>\n<th class=\"r\" scope=\"col\"><span class=\"u-sr-only\">Description<\/span><\/th>\n<th class=\"r\" scope=\"col\"><span class=\"u-sr-only\">Amount<\/span><\/th>\n<th class=\"r\" scope=\"col\">% of cash flows<\/th>\n<th class=\"r\" scope=\"col\">months<\/th>\n<th class=\"r\" scope=\"col\">years<\/th>\n<\/tr>\n<\/tbody>\n<tbody>\n<tr>\n<td>Cost to purchase<\/td>\n<td class=\"r\">$ \u00a0 \u00a0 \u00a0 80,000<\/td>\n<td><\/td>\n<td><\/td>\n<td><\/td>\n<\/tr>\n<tr>\n<td>Recaptured YR 1<\/td>\n<td class=\"r\">$ \u00a0 \u00a0 (20,000)<\/td>\n<td class=\"r\">100%<\/td>\n<td class=\"r\">12.0<\/td>\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 1.00<\/td>\n<\/tr>\n<tr>\n<td>Left to recapture<\/td>\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$ \u00a0 \u00a0 \u00a0 60,000<\/td>\n<td><\/td>\n<td><\/td>\n<td><\/td>\n<\/tr>\n<tr>\n<td>Recaptured YR 2<\/td>\n<td class=\"r\">$ \u00a0 \u00a0 (19,000)<\/td>\n<td class=\"r\">100%<\/td>\n<td class=\"r\">12.0<\/td>\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 1.00<\/td>\n<\/tr>\n<tr>\n<td>Left to recapture<\/td>\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$ \u00a0 \u00a0 \u00a0 41,000<\/td>\n<td><\/td>\n<td><\/td>\n<td><\/td>\n<\/tr>\n<tr>\n<td>Recaptured YR 3<\/td>\n<td class=\"r\">$ \u00a0 \u00a0 (18,000)<\/td>\n<td class=\"r\">100%<\/td>\n<td class=\"r\">12.0<\/td>\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 1.00<\/td>\n<\/tr>\n<tr>\n<td>Left to recapture<\/td>\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$ \u00a0 \u00a0 \u00a0 23,000<\/td>\n<td><\/td>\n<td><\/td>\n<td><\/td>\n<\/tr>\n<tr>\n<td>Recaptured YR 4<\/td>\n<td class=\"r\">$ \u00a0 \u00a0 (17,000)<\/td>\n<td class=\"r\">100%<\/td>\n<td class=\"r\">12.0<\/td>\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 1.00<\/td>\n<\/tr>\n<tr>\n<td>Left to recapture<\/td>\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$ \u00a0 \u00a0 \u00a0 \u00a06,000<\/td>\n<td><\/td>\n<td><\/td>\n<td><\/td>\n<\/tr>\n<tr>\n<td>Recaptured YR 5<\/td>\n<td class=\"r\">$ \u00a0 \u00a0 \u00a0(6,000)<\/td>\n<td class=\"r\">46%<\/td>\n<td class=\"r\">5.5<\/td>\n<td class=\"r\">\u00a0 \u00a0 \u00a0 \u00a0 0.46<\/td>\n<\/tr>\n<tr>\n<td>Left to recapture<\/td>\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0 \u00a0 \u00a0 \u00a0 \u00a0 \u00a0 &#8211;<\/td>\n<td><\/td>\n<td><\/td>\n<td><\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<p>&nbsp;<\/p>\n<p>Year 5 net cash inflows were $15,000, but we only had $6,000 of the original cost of the machine left to recapture, which is 46% of the $15,000, which equates to roughly five and a half months. You could round this final partial year to six months since this calculation is based on estimation and is not a precision measurement, so the payback period is four and a half years.<\/p>\n<p>The payback method is quick and easy to apply, but it has several drawbacks. As you might have noticed, it doesn\u2019t take the overall investment into account. Purchasing a new machine resulted in $136,000 in total cash inflows over the next 10 years, while refurbishing (because of higher maintenance costs and lower outputs) resulted in only $88,000 in net cash inflows. However, the refurbishing option pays for itself more quickly (three years, eight months as opposed to four years, six months for the replacement).<\/p>\n<p>In addition, this analysis does not take into account the time value of money.<\/p>\n<p>Here is another example of how to calculate the payback of a project:<\/p>\n<p><iframe loading=\"lazy\" src=\"\/\/plugin.3playmedia.com\/show?mf=6352602&amp;p3sdk_version=1.10.1&amp;p=20361&amp;pt=375&amp;video_id=YX4NoZN8YWU&amp;video_target=tpm-plugin-5ihb36bi-YX4NoZN8YWU\" width=\"800px\" height=\"450px\" frameborder=\"0\" marginwidth=\"0px\" marginheight=\"0px\"><\/iframe><\/p>\n<p>You can view the <a href=\"https:\/\/oerfiles.s3.us-west-2.amazonaws.com\/Managerial+Accounting\/Transcripts\/ThePaybackMethod_transcript.txt\" target=\"_blank\" rel=\"noopener\">transcript for &#8220;The Payback Method&#8221; here (opens in new window)<\/a>.<\/p>\n<p>Before we address these two issues, check your understanding of the basic idea of the payback method.<\/p>\n<div class=\"textbox tryit\">\n<h3>Practice Question<\/h3>\n<p><iframe loading=\"lazy\" id=\"ohm221578\" class=\"resizable\" src=\"https:\/\/ohm.lumenlearning.com\/multiembedq.php?id=221578&theme=oea&iframe_resize_id=ohm221578\" width=\"100%\" height=\"150\"><\/iframe><\/p>\n<\/div>\n\n\t\t\t <section class=\"citations-section\" role=\"contentinfo\">\n\t\t\t <h3>Candela Citations<\/h3>\n\t\t\t\t\t <div>\n\t\t\t\t\t\t <div id=\"citation-list-255\">\n\t\t\t\t\t\t\t <div class=\"licensing\"><div class=\"license-attribution-dropdown-subheading\">CC licensed content, Original<\/div><ul class=\"citation-list\"><li>Simple Payback. <strong>Authored by<\/strong>: Joseph Cooke. <strong>Provided by<\/strong>: Lumen Learning. <strong>License<\/strong>: <em><a target=\"_blank\" rel=\"license\" href=\"https:\/\/creativecommons.org\/licenses\/by\/4.0\/\">CC BY: Attribution<\/a><\/em><\/li><\/ul><div class=\"license-attribution-dropdown-subheading\">All rights reserved content<\/div><ul class=\"citation-list\"><li>The Payback Method. <strong>Provided by<\/strong>: Edspira. <strong>Located at<\/strong>: <a target=\"_blank\" href=\"https:\/\/youtu.be\/YX4NoZN8YWU\">https:\/\/youtu.be\/YX4NoZN8YWU<\/a>. <strong>License<\/strong>: <em>All Rights Reserved<\/em>. <strong>License Terms<\/strong>: Standard YouTube License<\/li><\/ul><\/div>\n\t\t\t\t\t\t <\/div>\n\t\t\t\t\t <\/div>\n\t\t\t <\/section>","protected":false},"author":364389,"menu_order":12,"template":"","meta":{"_candela_citation":"[{\"type\":\"original\",\"description\":\"Simple Payback\",\"author\":\"Joseph Cooke\",\"organization\":\"Lumen Learning\",\"url\":\"\",\"project\":\"\",\"license\":\"cc-by\",\"license_terms\":\"\"},{\"type\":\"copyrighted_video\",\"description\":\"The Payback Method\",\"author\":\"\",\"organization\":\"Edspira\",\"url\":\"https:\/\/youtu.be\/YX4NoZN8YWU\",\"project\":\"\",\"license\":\"arr\",\"license_terms\":\"Standard YouTube License\"}]","CANDELA_OUTCOMES_GUID":"","pb_show_title":"on","pb_short_title":"","pb_subtitle":"","pb_authors":[],"pb_section_license":""},"chapter-type":[],"contributor":[],"license":[],"class_list":["post-255","chapter","type-chapter","status-publish","hentry"],"part":37,"_links":{"self":[{"href":"https:\/\/courses.lumenlearning.com\/wm-managerialaccounting\/wp-json\/pressbooks\/v2\/chapters\/255","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/courses.lumenlearning.com\/wm-managerialaccounting\/wp-json\/pressbooks\/v2\/chapters"}],"about":[{"href":"https:\/\/courses.lumenlearning.com\/wm-managerialaccounting\/wp-json\/wp\/v2\/types\/chapter"}],"author":[{"embeddable":true,"href":"https:\/\/courses.lumenlearning.com\/wm-managerialaccounting\/wp-json\/wp\/v2\/users\/364389"}],"version-history":[{"count":11,"href":"https:\/\/courses.lumenlearning.com\/wm-managerialaccounting\/wp-json\/pressbooks\/v2\/chapters\/255\/revisions"}],"predecessor-version":[{"id":2586,"href":"https:\/\/courses.lumenlearning.com\/wm-managerialaccounting\/wp-json\/pressbooks\/v2\/chapters\/255\/revisions\/2586"}],"part":[{"href":"https:\/\/courses.lumenlearning.com\/wm-managerialaccounting\/wp-json\/pressbooks\/v2\/parts\/37"}],"metadata":[{"href":"https:\/\/courses.lumenlearning.com\/wm-managerialaccounting\/wp-json\/pressbooks\/v2\/chapters\/255\/metadata\/"}],"wp:attachment":[{"href":"https:\/\/courses.lumenlearning.com\/wm-managerialaccounting\/wp-json\/wp\/v2\/media?parent=255"}],"wp:term":[{"taxonomy":"chapter-type","embeddable":true,"href":"https:\/\/courses.lumenlearning.com\/wm-managerialaccounting\/wp-json\/pressbooks\/v2\/chapter-type?post=255"},{"taxonomy":"contributor","embeddable":true,"href":"https:\/\/courses.lumenlearning.com\/wm-managerialaccounting\/wp-json\/wp\/v2\/contributor?post=255"},{"taxonomy":"license","embeddable":true,"href":"https:\/\/courses.lumenlearning.com\/wm-managerialaccounting\/wp-json\/wp\/v2\/license?post=255"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}