Incremental Cash Flow Analysis
Incremental Cash Flow Overview
A change in cash flows that can be specifically attributed to a management decision may call for the use of incremental cash flow analysis. As an example, if a business is considering altering the amount of production capacity of a machine, the decision should be made based on the incremental cash outflows required to alter the capacity of the equipment, as well as the incremental cash inflows resulting from that decision. There is no need to consider the aggregate cash flows associated with all operations of the machine.
The analysis may be based on a variety of cash flows, such as the initial outlay of cash, ongoing inflows and outflows related to the maintenance, operation, and net receipts from the project, and any cash flows associated with the eventual termination of the project.
Incremental Cash Flow Example
For example, ABC International owns a machine that can manufacture 2,000 units per hour. An equipment upgrade can change the maximum capacity of the machine to 3,000 units per hour, which is an incremental increase of 1,000 units. The cost of this upgrade is $200,000, and the profit derived from each unit is $0.10. The machine is currently operated for 40 hours per week, so the contemplated increase in capacity will yield a net incremental cash flow increase per year of $208,000. The calculation is:
(1,000 units per hour) x $0.10 = $100 per hour incremental cash inflow
= ($100 per hour of cash inflow) x (40 hours per week) x (52 weeks per year)
The incremental change in cash flow represents a payback period of just over 1.0 years, which is highly acceptable as long as the upgraded equipment can be expected to operate for longer than the payback period.
An alternative way to look at the sample situation is to avoid the $200,000 equipment upgrade and instead run the existing equipment for an additional shift. For example, if two machine operators can be paid $15 per hour to run the machine for an extra shift, this cost is only $62,400 per year, versus incremental cash receipts of $208,000. This alternative is considerably less expensive than the equipment upgrade option, on an incremental cash flow basis.