Analysis, at the most basic level, needs to be certain that the total cost of any major project undertaking are less than the total benefits resulting from the project. Now, you could simply add up the costs, and then add up your expected revenue increases…and cost savings over the next number of years and compare the two.
But if you did that, you’d be ignoring that many of the costs will be incurred at the onset of the project, while the revenues or cost savings will occur later– over a period of months, or even more likely…years.
There are many formal ways to use financial analysis tools to evaluate the cost or benefits that a major purchase or project will bring to your company. The most commonly used include:
- Payback period analysis
- The accounting rate of return
- Net present value
- The Internal Rate of Return
Each one of these methods has a definite series of advantages and drawbacks, so generally, more than one analysis set should be used for any given project.
Also, a project may ‘fail’ these tests or financial analysis criteria under on or all of these methods, but it may be decided to pursue anyways– the value as part of your long-term business plan may be too great to skip.
Payback Period Analysis
Payback period financial analysis is the simplest way of looking at several different project ideas. You can learn how long it will take to earn the money back that you spend on the project. The formula is:
So, if a project is going to cost $50,000 and was expected to return $12,000 per annum, the payback period would be $50,000/$12,000 or 4.16 years.