Payback on Energy Projects, Part 1

Industrial decision-makers everywhere depend on "payback" as a way to evaluate proposed investments in their facilities. Compared to more sophisticated financial measures such as net present value and internal rate of return, payback is comparatively simple to understand and calculate—perfect for "back of the envelope" analysis. But its inherent simplicity also creates problems. As a managerial decision tool, payback remains grossly inexact and misapplied, especially when thousands or even millions of dollars are at stake.

Payback, of course, is a measure that describes the number of years that it takes for an investment to "pay for itself" through the annual savings or benefits that the investment creates. To calculate it, one merely divides the total cost of a proposed investment by the annualized savings (or benefits) that the investment will provide.

People frequently fail to properly account for all of the variables in their payback analysis. "Project cost" may be described simply as the list price for the equipment in question. But when you think about it, a discrete project incurs a number of ancillary costs. These may include:
• Search and evaluation costs
• Consultant fees
• Sales commissions
• Permitting or construction fees
• Installation fees
• Removal/scrap of old equipment
• Finance transaction costs
• Revenue lost to downtime during installation of the energy improvement
• Net projected salvage value of the new equipment (usually a positive value)

The same concern applies to the "annual savings" figure. When it comes to energy projects, there is a tendency to count only the energy savings generated by the new equipment. There are several issues with that narrow interpretation, but for now, we’ll start with a broader definition of savings. It should include:
• Annual savings in energy costs
• Subtract costs of upkeep
• Subtract changes in other operations and maintenance expenses
• Subtract monthly finance charges
• Add any non-energy improvements, such as reduced waste of water, raw materials, labor, etc.

Despite the best intentions of energy improvement champions, there is probably a sharp-penciled financial director ready to express some doubt about the proposed payback performance of these initiatives. Such doubts are not unwarranted. Facilities that pursue big capital equipment projects without addressing wasteful practices are actually putting these big investments at risk. A comprehensive investment in people skills and energy-smart operations will effectively underwrite the costs of capital projects. By having a strong foundation of energy-smart skills and procedures, a facility is better prepared to implement new equipment.

Also, keep in mind that leaks and losses are a facility’s first consumers of compressed air and steam. The energy and other inputs for these utilities must be "grossed up" accordingly. A facility that decides to live with these losses also decides to maintain greater air compressor and boiler capacity than required (which implies a greater volume of capital investment, carrying costs, and perhaps even valuable floor space). Energy-smart skills and procedures, developed prior to these capital investments, would reduce energy costs as well as the cost of maintaining over-sized equipment.