Where to start?
Prudent executives carefully account for every conceivable variable when making a software purchase – but where should you begin?
Payback period is a critical component for assessing whether your technology investment will pay off in the long run. Therefore, it should be one of the first metrics you consider in your decision-making process.
What is payback period?
Payback period is the time it takes to recoup the cost of an investment, or in other words, it is the time it takes for an investment to break even. In essence, the shorter the payback period, the more appealing the investment.
Payback period is a useful metric for quickly determining if a technology purchase will pay off, but there is one problem with its calculation. The primary issue arises when purchasing decisions are solely based on payback period. Although payback period is simple to calculate and provides relevant information that will undoubtedly help with your decision-making process, it does not account for the time value of money (TVM). Time value of money is the idea that a sum of money has more value now than it will in the future due to its current earning potential. Payback period calculations disregard the time value of money and instead simply count the number of years it takes to recoup the investment.
Executives should consider payback period in combination with other metrics, such as net present value (NPV), which takes the time value of money into account, to accurately make their purchasing decisions.
How do I calculate the payback period?
To find the payback period of an investment, you must first determine two variables: the cost of the investment and the average annual cashflow. Then, calculate as follows:
Payback Period = Cost of Investment ÷ Average Annual Cashflow
In terms of software, payback period can be found by dividing the total cost of the software by the annual savings received from using the software. Once savings have grown greater than the cost of the software, the investment will surpass its break-even point. At this point, the payback period ends.
Why is payback period important when purchasing a new software solution?
The point of any software purchase is to lower costs and increase profits, either by decreasing time spent working through process improvements, or directly through the use of the software. Ultimately, businesses are always looking to recoup their investment as quickly as possible. Therefore, investments with shorter payback periods are more attractive.
Businesses should purchase software that best fits their needs and specific use-case, but they must weigh the cost of the software, as well. Even if a software solution seems to be the perfect fit, if the costs outweigh the gains, the purchase will amount to a loss. In the same vein, software solutions that seem to fit well with your business’ needs but entail a longer payback period than other prospective solutions should be carefully considered. Quickly recouping the cost of your software purchase should be a top priority. Longer payback periods increase the risk of something going wrong and disrupting your cash flow. This could turn what seemed to be a solid investment into a major financial mishap.
What questions should you ask the vendor?
Theoretically, determining the payback period of an investment is a simple procedure. Determining the average annual cashflow received from an AEC software purchase requires a bit more information. Here are a few questions to ask the vendor so that you can accurately estimate cashflows:
1 // How much does your solution cost and what value does it provide?
2 // How long does it typically take for your users to recoup their investment?
These questions will start to give you an idea of how long it will take for the value provided by the software to overcome its cost.
3 // Can I use your software on an unlimited number of projects?
4 // How many seats am I getting with my purchase?
Any constraints on software use should be noted, as your incoming cashflows will be capped at that amount of use.
5 // What savings (hard dollar or time savings) can I expect when compared to traditional methods?
There is no point in purchasing a software solution if traditional methods cost less and provide more profit. For the switch to a new solution to make sense, the software must provide savings over traditional methods.
Real-world application
The higher the cost of traditional methods, such as the use of sustainability consultants in the AEC space, the quicker the payback period will be for alternative software solutions. Current building design and performance analysis workflows require hiring expensive consultants and often take multiple revisions before they are completed. This process entails high costs for every project with energy code requirements. In this example, the payback period for a software investment is short because relative to the cost of consultants, the cost of software is quite cheap. If the average cost of sustainability consultants is $150/hour and a software license costs $7500, the payback period will be around 50 hours of work. Once the software is paid for and the investment has reached the breakeven point, savings will be captured on every project.
Another way to quantify savings and derive a payback period for AEC software is through productivity. If the software provides a benefit of time savings in lieu of a hard dollar amount, you can still convert the time saved into dollars and use that figure to compute the payback period. For example, if traditional methods take six times as long as the new software platform, you can take the hourly rate of the employee who would normally perform the task and multiply it by hours saved.
Conclusion
Executives can quickly determine whether a new AEC software solution is a sound investment by examining its payback period. Payback period should also be considered throughout software solution comparisons, along with software functionality, fit, and cost. Calculating payback period is simple: divide the cost of the investment by the Average Annual Cashflow.
Although payback period calculations only require a couple of variables, due to the multivariate nature of AEC software solutions, it is often difficult to determine their Average Annual Cashflow. cove.tool has developed an ROI calculator for analysis.tool so that you can easily determine your payback period, as well as potential savings when compared to consultants or in-house modeling specialists. The calculator is located here: