When my daughter was around six months old, we followed the general rule of thumb and started her on solids. And by solids, I mean mashed up food that was considered “solid” but was really just mush. After seeing the cost of store-bought pouches, and without having to do much of a payback analysis (the numbers were that obvious) I immediately decided I was going to buy a baby hand blender and do it myself. After one week of attempting to keep up with cooking, mashing, and properly storing the food, I gave up. While the payback analysis made sense, my own human nature sold me out. We’ve been using pouches ever since.
Payback analysis calculates how long it will take for you to be paid back for a specific investment. This can be used as a comparison to the status quo, or to decide between two or more options.
The Economic Principle:
One of the ways businesses can calculate a return on investment – commonly referred to as ROI in business speak – is to use payback analysis. It’s the simplest form of ROI and is especially relevant for investments that relate to expense savings, as opposed to investments that produce income.
When businesses look at payback analysis, they mainly apply it to determine how long a particular investment (say machinery) will take to pay the business back for the investment in the first place. In the case of a finite investment – meaning, perhaps they know a particular piece of machinery will only last a certain amount of time, the business may also want to determine whether the cost they pay today is worth it to invest, given the expected lifespan.
Why Payback Analysis can be Valuable in Running Your Home:
For our purposes, let’s apply this to something more relevant to the household and analyze the decision to buy a fancy coffee machine that uses coffee pods, versus buying your coffee at a brand-name coffee chain. I like this example because, for the most part, it’s no additional work for you to pop a coffee pod into the machine than it is to order your drink, rather than grinding beans, having to wash out a coffee pot, etc. In fact, you may be saving time, since you’re preparing it at home and not having to travel out of your way to the coffee shop.
I’m going to use round numbers here, but the analysis can be done in the same way using your actual prices. I’m going to make the following assumptions, regarding costs:
Coffee Machine – $150
Coffee Pod – A pack costs $15 for 24 pods, which equates to a cost of $0.625 per pod
Cup of Coffee from a Coffee Shop – $2.15
Cups of Coffee per Day – 2
How to Calculate the Payback Period:
We’ve got our inputs, now let’s calculate our output – how long will it take to pay back our investment? Your initial output is simply the machine, which we know is $150. You drink two cups a day, which equates to $1.25 per day in pods. Two cups of coffee-shop coffee a day will cost you $4.30 per day. By using the coffee pods, your savings per day would be $3.05.
Now you just take $150 and divide it by the daily savings amount of $3.05 to get the number of days it will take to pay back your initial investment – 49 days. That’s under two months. Kind of makes the decision easy, if you ask me!
Slight variations to the inputs will give you different payback periods, but the analysis is always done the same way.
Variation 1 – The coffee machine is very expensive, say $350. The calculation would be: $350 / $3.05 = 115 days, or almost 4 months.
Variation 2 – Instead of two cups of coffee a day, you drink three. The calculation would be: $150 / $4.58 = 33 days.
Even if you only get one year of use out of the coffee machine, though it will likely last far longer, you have paid back your investment quickly and saved additional funds over the course of that one year.
As with opportunity cost, payback analysis can be a helpful tool in your decision-making process. Payback analysis focuses on costs, so this analysis is best run on purely financial decisions, as opposed to decisions where subjective factors can be significant. Other examples of this could include: buying a water filtration device rather than bottled water, buying a new computer if you are losing business opportunities or productivity because your old computer is no longer functioning well, and buying a Peloton rather than going to spin class three days a week.
I started this post with an anecdote that is also a reminder – take note of the human condition. If you are not predisposed to make a drastic change in habits, even if the payback makes the decision an easy one on paper, then the investment is a waste.