What is Incremental Principle
Project Cash flows must be measured in incremental terms. I.e. the difference between cash flows with the project and without the project has to be ascertained. While estimating incremental cash flows, following points should be kept in mind.
Consider all incidental effects
Apart from the direct cash flows, the incidental effects on the company’s other operations must be considered. The project may enhance profitability of some of the existing activities of the company because it has a complimentary relationship with them, or it may detract profitability of some existing activities as it has competitive relationship with them. These effects should be considered in the project cash flows.
Ignore sunk cost
Outlay incurred in the past or expenses already committed irrevocably should be considered. The expenditure that is not affected due to either acceptance or rejection of the project under consideration cannot be treated as project cash flow.
Include Opportunity costs
Opportunity cost for diversion of available resources to the project should be included. If the project requires some assets already available, the company loses the opportunity to use them for any alternative use. The net value of such loss of opportunity should form part of project cash flow.
Allocation of overheads
Overhead costs irrelevant to the project should not be considered. Items such as general administrative expenses, managerial salaries, legal expenses, rents etc. that are being already incurred by the company and not increasing due to the project should not be allocated to project cash flows.
How would you treat the following items in project cash flows?
- Cost of project feasibility study carried out before final approval of the project: Sunk cost should not be included.
- Cost of existing idle machinery / equipment transferred to new project: Since there is no opportunity otherwise to put the machine to any use, not to be included.
- Portion of Head Office administrative expenses allocated on project: Allocated overheads should not be included.
- Cost of land purchased in excess of current project requirements: Since the excess land is not required for the project, its cost cannot be considered incremental cost related to project. Hence not to be included.
Incremental Cash Flow Example
Suppose Gulls & Gulls manufacturing capacity is 2000 unit in one hour. If the company upgrade its current machinery, will be able to produce 3000 units in the same amount of time. So this increase is an incremental increase of 1000 units. This upgradation will cost the company Rs. 200,000 and per unit profit is Rs. 0.10. Currently the machine is working for 40 hours per week. We will notice a net incremental cash flow of Rs. 208,000 for the year.
Calculations:
If units per hour 1000 x 0.10 = 100 per hour
If the per house cash flow in 1,000 x working hour per week 40 x weeks in a year 52
= Rs. 208,000