As a small business owner, it is crucial to understand all different types of cash flow. Incremental cash flow can help you understand whether an investment or project will lead to an increase or decrease in cash flow. Keep reading for our short guide to what incremental cash flow is, the incremental cash flow formula, and why calculating it is important.
What is Incremental Cash Flow?
Incremental cash flow describes the additional cash flow an organisation generates from taking on a specific new project or investment. It is a useful tool that helps a company's management to decide whether to invest in a new project or not. As opposed to other types of cash flow, this refers to the likely impact a specific endeavor will have on your business cash flow.
A positive incremental cash flow means your business's cash flow will increase after you accept the project or investment in question. A negative result means that your company's cash flow will likely decrease when commencing the project. Hence, incremental cash flow can be a great metric to use when deciding whether to accept a new endeavor.
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Incremental Cash Flow Formula
The formula for incremental cash flow is as follows: Incremental Cash Flow = Revenues – Expenses – Initial Cost.
- Revenue = your company's revenue earned by selling a product or service (amount made before expenses such as the cost of manufacturing and labor have been deducted)
- Expenses = cost of operations that are subtracted from revenue
- Initial Cost = amount it takes to begin a new project
Incremental Cash Flow Calculation Examples
Business A wants to develop a new product. For the production, there are two options: Option 1 and Option 2. Option 1 is projected to generate revenue of GPB 100,000 and cause expenses of GPB 20,000. Option 2 is likely to generate revenue of GPB 300,000 and cause expenses of GPB 180,000. Option 1's initial cost is predicted to be 5,000, while Option 2's is 15,000.
In this example, the incremental cash flows for each project would be:
Option A
Incremental Cash Flow = 100,000 - 20,000 - 5,000 = GPB 75,000
Option B
Incremental Cash Flow = 300,000 - 220,000 - 15,000 = GPB 65,000
So, even though Option B generates more revenue, its resulting incremental cash flow is GPB 10,000 less than Option A's due to its larger expenses and initial investment. If only using incremental cash flows as the determinant for choosing a project, Option A is the better option.
Why is Incremental Cash Flow Analysis important?
Incremental cash flow is an important asset in deciding whether to invest in certain assets. For example, if you have spare capital to invest in expanding an existing product line or investing in a new one, whichever one has the higher incremental cash flow should be the route to go down. Calculating the incremental cash flow of potential investments or projects can ultimately lead to better business decisions and long-term improvements in your net cash flow.
Incremental Cash Flow Problems
Of course, there are also limitations to incremental cash flow calculations and accountants. Many of the variables affecting incremental cash flow are difficult to project. For example, market conditions and regulatory changes can have a significant effect on expenses. Also, accountants frequenlty encounter certain difficulties when estimating incremental cash flow. Here are some of the challenges:
- Sunk costs: Sunk costs refer to past costs already incurred. Because incremental cash flow only looks at future costs, you have to ensure that sunk costs are not included in the calculation (part. sunk cost happened before any investment decision was made).
- Opportunity costs: Opportunity costs describes the cost of a business’ missed chance for revenues from its assets. As opportunity costs are not part of the incremental cash flow calculation, they are often forgotten.
- Cannibalisation: Cannibalisation describes the result of taking on a new project, if that result reduces the cash flow of another product or line of your business.
- Allocated costs: These are business expenses that have to be allocated to a specific department or project, however, they can not be allocated to one specific project in a rational way(eg rent expenses). If these costs would have incurred regardless of the project, they should not be included in an incremental cash flow calculation.
Incremental Cash Flow FAQs
- Which decisions are based on incremental cash flow?
Incremental cash flow is an important asset in deciding whether to invest in certain assets. For example, if you have spare capital to invest in expanding an existing product line or investing in a new one, whichever one has the higher incremental cash flow should be the route to go down.
- What is excluded from incremental cash flow?
Sunken costs, opportunity costs and allocated costs are not part of the incremented cash flow calculation.
- Is depreciation an incremental cash flow?
Depreciation charges should not be included in the incremental cash flow calculation.