Simple payback calculation has its limits

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Spencer Morgenthau is an account executive with McKinstry's Energy & Facility Services Division in Oregon. He can be reached at 503.278.3942 or spencerm@mckinstry.com.

Making a decision about whether to invest in an energy-reducing retrofit can be tough. As with any important investment, you want to be certain that the benefits outweigh the costs, and that your return on investment will be high.

Typically, a simple calculation, known as the simple payback period — or SPP — is used to indicate how long it will take for cumulative energy savings and other benefits to pay back your initial investment. The SPP is calculated by dividing the initial installed cost by the annual energy cost savings. For example if you install a new, more efficient boiler for $100,000 and you know that this boiler will save you $10,000 each year, then your simple payback period would be 10 years.

Although this calculation may be an effective measure for relatively inexpensive and simple projects, for larger projects the SPP falls short. A simple payback period analysis fails to address the many criteria that should be considered when evaluating a project's true value: the time value of money, economic inflation, project duration, lifetime operation, regular maintenance costs and avoided replacement liability. When you're investing thousands or millions of dollars, it's important to consider the project’s financial impacts in its entirety.

Another shortcoming of the SPP calculation is that it does not allow you to compare complex costs and savings that vary in scale and in timing. For example, savings realized after the project is paid off are not considered, putting at a disadvantage projects that have extremely long, energy-saving lives.

Typical SPP calculations also fail to capture the cost benefits of reduced future repair and replacement liability. The financial benefit of this future cost avoidance can be significant. Take for example a school district that was considering replacing two large and inefficient boilers that were beginning to fail. Using a simple payback calculation, the higher efficiency replacement only saved a faction of the total replacement cost and would have taken 60 years to yield a payback. But when the avoided replacement cost for the failing boilers was added tot he equation, the payback on the high-efficiency boiler — instead of a straight replacement — was less than two years.

The district had the foresight to consider the long-term financial implications and was able to move forward with the project.

To make a sound decision that factors in all variables, consider a more complex calculation such as a lifecycle cost analysis. Considering lifecycle costs helps compare projects as "apples-to-apples" from a financial perspective, even if they take place at various costs and over different periods of time.

Another area to consider when calculating the value of a project is the opportunity for grants, loans and incentives, which can drastically reduce upfront costs.

A qualified energy services company can help you explore the full range of options for building efficiency improvements — and review the true financial implications of the project prior to making an investment decision.