Wednesday, May 26, 2010

(193)---ADDITIONAL ASPECTS OF INCREMENTAL CASH FLOW ANALYSIS

Additional Aspects of Incremental Cash Flow Analysis

The incremental principle should be carefully used in determining an investment’s cash flows. All cash flows occurring because of the investment consideration should be included. Cash flows, which would occur otherwise, whether or not the project is undertaken, should not be taken into account. Similarly, cash flows, which have occurred before the consideration of an investment, are irrelevant in taking the decision now. The following examples of some more aspects of incremental cash flow analysis.
  • Allocated overheads


Firms generally have a practice of allocated budgeted general overheads to projects, including the new projects under consideration. Since the general overheads will be incurred whether or not the new projects are undertaken, those allocated overheads should be ignored in computing the net cash flows of an investment. However, some of the overheads may increase because of the new project; these specific to the project should be charged to the project. The incremental cash flow rule indicates that only incremental overheads are relevant.


The allocation of overheads is a difficult question in practice. One or two investment projects may not cause any change in overhead items such as supervision, rent, employees’ welfare or accounting. But the cumulative effect of many investments may ultimately result in an increase in overheads. This creates a problem of cash flow estimation. It is difficult to know when the overheads will change. Efforts should be made to identify such changes so that they may be included in the calculation of net cash flows.

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