Should Businesses Take a Longer Term View?

A key phrase in business planning is “payback period”. This is, as you might expect, the length of time it takes to get a return on an investment. In other words, it’s the time you spend waiting for money you’ve paid out to come back.

Can You Predict the Future?

The term can be used whenever a business makes an investment in order to increase profits. Higher profits are generated either by increasing sales or cutting costs. In general terms (and within certain limits) it is better for a business to cut costs as it represents a direct saving off the bottom line. If a business tries to increase sales then it has to additionally factor in the cost of providing the product or service which means the profit is less. To simplify this explanation (my head hurts already) let’s look at an example:

Our business (let’s call them “Shoo Shoes”) makes a very popular type of shoe. Their shoes sell out each week. If only they could make more.

They decide to invest £5,000 in their manufacturing machinery. But how should they approach this?

Example 1: Increase sales

Shoo Shoes invests £5,000 for a new bit of kit which speeds up the production line and as a result of their increased capacity they increase sales by £1,000 per week.

Of that £1,000, £700 is used to manufacture and distribute the shoes. So the profit is only £300.

The payback period for this example is £5,000 divided by £300: 16.6 weeks. In other words: in 16 weeks the company will have made its money back.

Example 2: Cut Costs

Shoo Shoes uses £5,000 to pay an engineer to make the production line more energy efficient and has reduced the company’s energy spend by £400 per week.

Of that £400, it is all profit as the saving comes directly off the energy cost. There are no further costs to consider.

The payback period for this example is £5,000 divided by £400: 12.5 weeks. In other words, in 12.5 weeks the company will have made it’s money back.

Given the ridiculously simplified examples above, the conclusion is obvious: we should welcome opportunities to to cut costs in our business before we look to increase sales. Of course, cut too far and you risk damaging the products and services you offer. For example, slash your sales team in half staff and you save money, but who’s going to sell your stuff?

Fortunately one of the best (and least risky) ways to cut the controllable costs is to implement an environmental management system which looks to continuously reduce waste, water and energy (including transport fuel) in order to maximise profits.

But of course, it’s not that simple. Many environmental projects take a great deal more investment than £5,000 and the savings are unlikely to provide a payback period of 12.5 weeks.

Take solar PV.

Installing 1kwh of solar panels costs in the region of £1,500-£2,500 and a 1kwh PV system will provide roughly 750kwh per year. The price of providing 1kwh to a business in 2011: 7 – 15 pence, so £52.50 – £112.50 for 750kwh.

In summary: A 1kwh solar PV system currently provides a saving of between £50 and £115 a year with a payback period of between 10 and 30 years….

BUT, with energy prices preducted to rise by between 14 and 60% by 2020, the payback period gets shorter and shorter. Add in the Feed in Tariff which pays around 40 pence per kwh generated, and the CRC carbon tax for bigger businesses (£12 per tonne of CO2) and this gets shorter still: perhaps as short as 3 years. So will all businesses who have a south facing roof now rush out and install solar PV? Of course they won’t. But why not?

Firstly, many businesses are in leased premises so don’t have permission to install solar PV panels. But even those who do own their roofs (and there are thousands of businesses in that position) won’t consider something with a payback period of more than 2 years. It’s just not the way they do business.

Are those businesses missing something? It seems to me that many businesses could invest in any one of the various renewable technologies now and not only guarantee that in 5-10 years time they have free energy and reduced carbon liabilities but also that they won’t be subject to fluctuating energy prices. But is 5-10 years a realistic timeframe for such an investment and can businesses look beyond the quick win? Time will tell.

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