Payback Period

Usually used in connection with a capital investment, a payback period is the length of time it will take to recoup the amount of money put into a project.

The exact methodology for determining a payback period varies based on the way assumptions are made, and the formula used to do the financial calculations.

Some simple assessments use the actual dollar value of the investment and revenue, but most will use the net present value of both the investments and the revenue to determine the payback period.

On the surface, shorter payback periods seem better than longer ones. There are, however, other factors that play a role in financial decision making. Alternatives (real options), the overall size of the return, and the risk associated with the project all play a role.

In general, short payback periods are valued for two main reasons. The first is that they get money back in the pocket of the investor sooner rather than later. This is true even if the investor is the company. Short payback periods mean quicker positive cash flow.

The other benefit is that the assumptions used in a short forecast usually turn out to be more accurate than those used in a longer view. The world changes quickly, so what is true today may not be true tomorrow.

Payback Periods and Lean

Lean frequently relies on acting on faith. Improving flow and reducing batch sizes are both examples of changes that are difficult to financially quantify.

In many cases, slow, steady progress towards those goals doesn’t take a major investment. Consistent kaizen activity, growing with cellular manufacturing in mind, and relentless waste reduction all move companies towards more effective production without a large need for justification.

But sometimes there is a need for an investment. Creating a chaku chaku (load-load) line can be expensive due to the high level of skill required to develop the autoejectors (hanedashi devices). And the equipment itself can be costly.

In these cases, there may be a need to justify the expense to the financial team, assuming the management team thinks the investment is worthwhile.

This is easiest when a company embraces Lean accounting, but with traditional accounting, there is a need to make estimates on the before and after productivity rates.

When making predictions, be careful about being overly aggressive in promises. Use previous successes as a benchmark about what your company is capable of.

You may also need to look at the big picture instead of simply the cost of the parts coming off of a machine. Lean, at least on paper, looks like the per piece production costs off of high-volume machines is greater than that of batch production. Look at how the whole system will change.

Keep in mind that only an increase in production with the same resources or the same production with fewer resources actually translates into a productivity gain. Cycle time reduction with no corresponding changes in the productivity equation will not pay off an investment.