Simple payback: the wrong tool for energy project analysis?

• Author: Russell, Christopher
• Position: Report

Industrial decision-makers everywhere depend on "simple payback" as a way to evaluate proposed investments in their facilities. Compared to more sophisticated financial measures such as net present value and internal rate of return, payback is comparatively simple to understand and calculate --perfect for "back of the envelope" analysis. But its inherent simplicity also creates problems. As a managerial decision tool, payback remains grossly inexact and misapplied, especially when thousands or even millions of dollars are at stake. As a result, the reliance on simple payback to evaluate energy-related investment decisions leads to making the wrong choice--and losing money as a result. As this article explains, the "save-or-buy" calculation provides a better way.

Simple Payback Defined

Most plant and facility staff recognize "simple payback" as a measure that describes the number of years that it takes for an investment to "pay for itself' through the annual savings or benefits that the investment creates. To calculate it, one merely divides the total cost of a proposed investment by the annualized net savings (or benefits) that the investment will provide.

An organization may, for example, observe a "two-year" payback criterion. If so, the organization makes an investment only if the value of its annual benefits pay for the investment in two years or less. Payback criteria tend to be durable--they remain fixed year after year. Meanwhile, interest rates and energy prices vary every day. As a result, so do an organization's cost of capital and the profitability of its operations. By relying on simple payback, an organization explicitly ignores variation in interest rates, and consequently, the profitability of their operations. Why? Because payback measures time, not the cost of money (interest rates) or the profitability of an investment. Note that production targets and budget amounts are fixed in an annual format. So are performance evaluations and bonuses. By providing a measure of years, simple payback fits naturally with the priorities of a manager whose spending authority and performance criteria remain fixed in a calendar-driven framework.

More to the point, simple payback fails to describe the true investment potential of an energy efficiency improvement. Simple payback reduces investment choices to a yes/no decision. For any investment proposal, it gives the investor a choice: "Do I spend the money on this project, or do I keep the money in my pocket?" If the proposed investment is a new initiative, such as the addition of a new production line or new branch facility, this yes/no proposition is logical and simple payback is an acceptable criterion. However, this approach does not work for the evaluation of proposed energy improvements. Here's why: energy consumption is not a yes/no choice for an operating enterprise. By simply opening its doors, the enterprise commits to using energy and is exposed to the costs, liabilities, and opportunities posed by energy use. Energy-related costs are not a matter of if the money will be spent, but rather, how much should be spent--either to consume energy or to avoid the obligation of buying the energy. Managers typically question energy improvements by asking "How much does it cost?" This is only half the analysis. The remaining question is "How much does it cost to not make the improvement?"

Simple payback does not answer this question. Energy-related investment decisions that rely on simple payback criteria can lead to bad financial choices.

If simple payback is not the right calculation for evaluating proposed energy improvements, then what is? The save-or-buy criterion, described in this article, is offered as an effective alternative.

Toward An Alternative Evaluation

Think about why we perform financial analyses in the first place. Whenever a business invests in itself, it implies making a change. With change comes risk. Before committing money to creating change, top managers will want to know the risk of losing their investment, or at least the risk of failing to invest in more valuable alternatives.

Here's how payback measures can frustrate energy management efforts. The greater the investor's concern with investment loss, the shorter the payback time demanded. For example, a 12-month payback is preferred to a 24-month payback, and a 6-month payback is preferred to a 12-month payback. Now take this to...