What is Incremental Cash Flow?
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 its cash flow if it takes on a new project and if it doesn’t, putting into consideration how accepting such project can 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 computing for incremental cash flow. Here are some of the difficulties:
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 simply because it is regarded that any decision will still result in the same cost. It 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 chances for revenues from its assets. They are often forgotten by accountants, and 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. It illustrates the opportunity cost of $5,000.
As mentioned above, cannibalization is the result of taking on a new project that will make the cash flow of another product or aspect lower. For example, an owner with an existing mall that caters to classes A and B, and everything it sells is sold at a higher price to live up to its reputation.
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. It will result in cannibalization because 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
They are costs that are allocated to a specific department or project.
Incremental Cash Flow vs. Total Cash Flow
Incremental cash flow and total cash flow both deal with a business’ cash flow. However, they are still different from each other.
- Incremental cash flow is about predicting 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. If the cash flow will increase, it is a positive incremental cash flow. However, it is a negative cash flow if cash flow will decrease.
- Total cash flow, on the other hand, is determining the cash that’s been generated from actually doing a project. It means that it looks at past cash flows, not future cash flows but it can be used to describe both.
For example, the 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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