OK, so just how long will it be before this project covers its costs? This is an important question, and in many cases, payback may be more important than ROI. Payback period provides an indicator of risk and gives you insight into your flexibility.

Payback period is the point at which total benefits equal total costs.

To calculate payback period if the initial year cost is less than the year 1 benefit, simply divide the initial cost by the year 1 benefit. For example, assume you have the following cash flow scenario:

The payback period is half a year (100/200). If we now change the initial cost to be 300, the process to calculate payback period changes to:

In the first year, you spend 300 but get 200, so you are out 100 at the end of the year. In the second year, you start off out 100 but make 300, so (100/300) = 1/3 of a year, plus the initial year gives you a payback period of 1 and 1/3 years.

Why is payback important? Consider this scenario: You've just deployed the perfect Web site with e-commerce links to all your legacy systems. It took you a year and cost a bundle, but you've beat everyone else to the market. Your 3-year ROI will be 1000%, but the payback period is 2 years, meaning you won't cover your cost for some time. What if the next morning, you find a new development tool that lets you and all your competitors create a better application in a matter of minutes? You know you should use this tool to redesign your site, but you still haven't covered your initial costs.

What's the lesson here? No matter how attractive the ROI and how good the NPV, never get stuck with decision that has a long payback period. Technology moves too rapidly. Be flexible enough to discard a technology decision when a superior solution comes along.