The Basics of Payback Periods in Project Management
One of the essential duties of a project manager is to determine whether a project is worth investing in and ensure its success from beginning to end. For example, one helpful metric of project value is the payback period; that is, how long will it take to recover your initial investment in the project? Let’s take a closer look at the basics of payback period to help us better prepare for the PMP exam.
PMP® Exam Formula Cheat Sheet
Learn how to successfully use project management formulas after reading this cheat sheet.
Payback Period PMP® definition
The payback period is a PMP® exam technique for calculating the time required to earn back a sum invested in a project. In other words, when will you reach the break-even point at which your total investment equals your total revenue?
Project managers and business owners use the payback period to make investment decisions. After the payback period is over, your project has recovered its initial capital investment and starts making profits. The sooner you can reach this stage, the sooner you can start enjoying the project’s financial benefits.
Payback Period Formula PMP
The payback period formula is pretty simple, assuming the income generated from the project is constant. Use the PMP exam formula below to calculate the payback period of a project:
Terms used in payback period formula PMP:
- Initial Investment describes your original expenditure in the project
- Periodic Cash Flow describes the revenue your project makes during a given length of time
Your results for the Payback Period will use the same unit of measurement as your Periodic Cash Flow. For example, if you put the Periodic Cash Flow in terms of dollars per month, your Payback Period will also be measured in months.
Calculate Payback Period PMP – Examples
Let’s say you are considering a project with an initial investment of $250,000. The project will produce a positive cash flow of $50,000 per year. According to the payback period formula:
Your payback period will be 5 years.
What about if your project has an initial investment of $20,000 and will produce a positive cash flow of $2,500 per month? Calculate the payback period using the formula:
Your payback period will be 8 months.
As you can see, using this formula to calculate the payback period is relatively straightforward under the assumption the project’s profit is more or less constant.
Interpretation of Payback Period
A shorter payback period is typically more financially favorable. This outcome is uncomplicated in its logic: payback period calculations are usually used for projects with a significant upfront investment and a steady return over time. A faster payback period helps mitigate risks to the investment.
- The shorter the payback period, the faster you will recover the initial investment in a project
- The shorter the payback period, the sooner your project will start making profits
- As long as the cash flow is positive, you will profit from your project – even if the profit is relatively small
- The longer the payback period, the greater the risk that something will go wrong to disrupt your revenue stream
It’s not uncommon for a company to make a significant investment in a project, but run into financial trouble along the way. Perhaps the revenue stream ends up being weaker than expected, a client decides to end their retainer, or something else happens. A shorter payback period helps limit the negative financial impact of adverse events like these.
If an adverse event occurs before the payback period is complete, you will not break even on your investment. If it occurs afterward, you will have recovered the initial investment and potentially made some profits.
Pros and Cons of Payback Period
The payback period can be a helpful project management technique, but it has its limitations. Consider these advantages and disadvantages of using this formula to calculate the payback period:
- Pros of payback period:
- Helps inform choices between different project options
- Provides quantifiable justification for an investment
- Allows you to measure a project’s potential value
- Identifies projects with high values and fast payback periods
- Can help you determine the risk of adverse events happening within the payback period
- Cons of payback period:
- Does not account for variable revenue streams
- Does not account for adverse events during the payback period
- Does not account for what happens after the payback period ends
- Does not account for the time value of money
While the payback period is essential for projects with significant initial investments and plays a crucial role in the project selection process, it should not be the only factor used to inform decisions regarding which projects to pursue. You should also be familiar with the concepts and uses of return on investment, cost-benefit ratio, net present value, and other project selection concepts.
Payback Period PMP Exam Tips
It’s a common practice to calculate payback periods in the business world. As a result, project managers should understand how the payback period plays an influential role when a project might be selected.
Although the payback period will probably not be a heavily tested concept on the PMP exam, it is good baseline knowledge. Anyone in the business world should be familiar with this universal business concept. You are unlikely to be required to answer more than one or two questions on payback periods.
For the PMP exam, you should understand what the payback period is, how to calculate it, and that organizations use this tool in their project selection criteria when determining which projects to pursue. You will most likely not actually have to calculate the payback period for any question, but it is still a valuable resource to have in your project management toolkit.
Studying for the PMP Exam?
Payback Period Example Questions
Since the PMP Exam is not an accounting exam, potential PMP credential holders are not usually required to use the payback period PMP formula to calculate the payback period for projects. Instead, the PMP exam focuses more on testing your conceptual knowledge.
As you prepare for the PMP exam, ask yourself: do you understand the meaning behind the term “payback period”? Do you know when and why it is used, how to interpret the results, and the benefits and drawbacks of this technique?
Use the sample PMP exam questions below to check your payback period knowledge.
Sample Question 1
You are deciding between two project proposals to make a recommendation to your organization about which project to pursue. Project Proposal A has a payback period of 15 months, while Project Proposal B has a payback period of 20 months. Which project should you recommend?
- Project A
- Project B
- Pursue both projects
- Do not recommend either project
Based on the information provided, what is the correct answer? Answer: A
Project A has a shorter payback period. According to this PMP technique, Project A is more likely to provide a financial benefit to your organization.
Sample Question 2
You are on a project selection committee and were tasked with calculating the payback period of your final two options. You found that Project A has an initial investment of $10,000 and a payback period of 24 months, while Project B has an initial investment of $12,000 and a payback period of 18 months. Which project should you recommend?
- Project A, because the initial investment is smaller
- Project A, because the payback period is longer
- Project B, because the initial investment is larger
- Project B, because the payback period is shorter
Based on the information provided, what is the correct answer? Answer: D
This question provides extraneous information. In this case, the initial investment does not matter for the answer, which eliminates options A and C. The correct answer is option D because shorter payback periods are considered more financially favorable.
Project managers need ways to quantify a project’s value and subsequently justify an investment in the project. For this reason, the payback period is an essential topic to understand for the PMP exam. We hope this guide to payback periods in project management was helpful!
For more PMP exam guidance, get in touch with your experts at Project Management Academy or sign up for our online or in-person PMP certification training. We’re here to help you pass the PMP exam and accelerate your project management career.
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