What is a Good Payback and What to Include in a Project
Published on Tuesday, 3 June 2014 16:43:56 Written by Marc
Ah paybacks… paybacks… It seems that for some companies this is the Holy Grail. Do you have a project with a great payback? Come on down, you are the next contestant on the Price is Right (for those that remember this game show). More seriously, the guys in finance often bless or kill a project on the sole base of the payback. I think it is some kind of a shame. Of course, companies need to make money and in selecting a project from a list of 10, the natural logic is often to take the one with the best payback.
Or… is it? Since this blog is not a financial one per say, we will skip large parts of what could be a discussion on analyzing paybacks and Net Present Value (NPV). However, one thing we can say here is that NPV does represent what value the project will bring to the company. If you have a project with a NPV of $10,000 and another one with a NPV of $1 million, you are not really comparing two similar things, even if they have the exact same payback period. The payback tells you how much time it will take for the savings that the project brings in to pay itself. The NPV will tell you, once you took into consideration all costs, savings, and notion of time, how much the project will benefit the company in today’s equivalent dollars (or other used currency). Therefore, everything being equal, an NPV of $1 million should be deemed much better than a project with an NPV of $10 thousand. It is almost like someone stopping me on the street and asking me if I want $10K or $1M free. Not that this is ever going to happen, but you get the idea here. A big NPV is good; a small NPV is not so good. Of course, people will then speak about the element of risk, of time involved to recuperate the investment, and myriads of other things. You; however, have to start somewhere. Since most companies and organizations already have policies in place (or at a minimum, some kind of idea) of what is a good payback or a good NPV, often the best way to get the information if you are working towards getting your project approved is simply to ask, "What is the threshold for getting a project approved?" Armed with the information, you can start to dig deeper in your funnel of energy saving ideas and eliminate those that could never pass the stress test. What to Include in an Energy Saving Project A number of years ago, in the mid-90s, when energy retrofits where taking off in North America, I was working in a large real estate development and management firm. We were buying, but also designing and building our own office towers, shopping centers and other types of real estate and then managing them. The company was a great source of energy saving projects because many of the buildings had been built in the 60’s and the 70’s, at a time where energy savings was not a central part (and often not any part at all) of the design. I was often finding myself sitting down with engineers who were finding ways to either retrofit something or add automation somewhere. Their goal was to find the best payback so that we would get the projects approved fast, do the work, and then pass on to another building in order to repeat the process. We were working with energy consultants and they were paid to do studies and to do the projects, so the more they did, the more money they made. My perspective was slightly different. Sure, I liked to do projects and show management that we could find numerous ideas for great energy retrofit projects. I also liked to provide them with proof of all the money that we were saving each month. However, since I was also managing the buildings, I knew that each general manager had to contend with annual budgets. In addition, I knew above all the efforts they had to do each year at budget review time to get the funds just to keep their building maintained. Each general manager was actually competing with all others in order to get funds for his or her building. After all, we all worked for a company, which had shareholders and were expecting that we maximize profits each year. I began to realize that no matter what, some items that we put in the budget would be tossed away at budget review. Some may have been nice to have, but others were, in my mind, essential. Therefore, I decided to do something a little different. Instead of only doing energy retrofit projects, which had the best payback, I went back and asked upper management what the payback threshold was for accepting projects. It turned out that for smaller projects, which did not replace legacy components like chillers, it was five years, and for projects that did replace older chillers that were going to be phased out (from the Montreal protocol and its Freon regulations) it was 8 years. While not cast in stone, this was a good guideline that I was told to try to live with. Armed with this information, I went back to our consulting engineers and began going over all the projects we had in the funnel. If a project had a better payback than the five or eight year threshold, I started to analyze what was included in it. If a project had a three year payback, I went back in the general building’s budget to see what upper management had removed, or what we already had in the budget for the current or next year that could be included in the project. My goal was to take something from the buildings budget, which we knew would probably be refused at budget review, and simply include that item inside the retrofit project. The newly included item would increase the project’s payback and keep it under the approval threshold. When I started to include the replacement of fire hoses in retrofit projects, the energy engineers began to stop me and tell me that replacing this does not carry a payback. "Really?" I would ask. Replacing the fire hoses maybe does not carry a good payback, unless the building is on fire, then you will be happy we did the replacement. The fire hose replacement were an important item and including them only added a decimal to the payback period of the project. Over time, I started to add what I called my "shopping list" to the retrofit projects. I included a mix of items with great paybacks (the drivers of the project), items which had little or no monetary payback (but were important to replace and for which we would have had difficulty to approve them on their own), and got the projects approved based on the threshold management had provided me. Only on rare occasions would there be a pushback on specific items, as most of the time management did not go over every single piece of equipment we were going to replace. We did sometimes group items together if they worked together, like fire hoses with fire panels, but it turned out to be quite a success. In addition, over time a funny thing happened. The general managers of the buildings no longer needed to twist upper management’s arms to get some funding for some equipment replacement or repair. Many of the items had already been done in a previous project. Overall, we were reducing the costs to our tenants using the savings from the energy projects. The only thing I never managed to get approved was a sun deck on the top of one of the shopping centers where we had our regional office. That one pushed the envelope a little too much…
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