Incremental cash flow refers to cash flow that is acquired by a company when it takes on a new project. To estimate an incremental cash flow, businesses must compare projected cash flow if it takes on a new project to when it doesn’t, putting into consideration how accepting such project may affect the cash flow of another part of the business.
In the event that a reduction in the cash flow of another aspect or product is the result of taking on a new project, then it is called cannibalization. Incremental cash flow is important in capital budgeting because it helps predict cash flow in the future and determine a project’s profitability.
Difficulties in Determining Incremental Cash Flow
Incremental cash flows are helpful, especially in determining if a company should take on a new project or not. However, accountants also encounter certain difficulties when estimating incremental cash flow. Here are some of the challenges:
1. Sunk costs
Sunk costs are also known as past costs that have already been incurred. Incremental cash flow looks into future costs; accountants need to make sure that sunk costs are not included in the computation. This is especially true if the sunk cost happened before any investment decision was made.
2. Opportunity costs
From the term itself, opportunity costs refer to a business’ missed chance for revenues from its assets. They are often forgotten by accountants, as they do not include opportunity costs in the computation of incremental cash flow.
One example is a company that specializes in sound system installations that skips a project that requires the use of five sets of boom boxes. Currently, the business is only putting the five extra sets of boom boxes in its storage facility, instead of taking on the project that will earn $5,000. This illustrates the opportunity cost of $5,000.
As mentioned above, cannibalization is the result of taking on a new project that reduces the cash flow of another product or line of business. For example, an owner with an existing mall that caters to classes A and B, and everything it sells is sold at a premium because it caters to luxury shoppers.
In another part of the same city, it decides to open a new mall that caters to classes B, C, and D, selling the same items as the other mall but at a significantly lower price. This will result in cannibalization because some people will no longer go to the first mall because they can get most things at the new mall for a much lower price.
4. Allocated costs
These are some costs that must be allocated to a specific department or project and there may not be a rational way to do it (i.e. rent expense)..
Incremental Cash Flow vs. Total Cash Flow
Incremental cash flow and total cash flow both deal with a business’ or project’s cash flow. However, they are notably different from each other.
Incremental cash flow analysis tries to predict the future cash flow of a business if it takes on a new project. It helps management determine if a project is worth doing or not. Projects will be considered if it is a positive incremental cash flow is generated, and declined if negative cash flows are expected.
Total cash flow analysis determines the total cumulative cash that’s been generated from doing a project or evaluating a business. For example, when a CEO wants to see the total cash flow of the company from each of the preceding five years. To come up with the correct figure, all the cash flows from each year in the last five years are put together.
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