A key issue to consider when constructing or reviewing any of the preceding cash flow analyses is that the only cash flow that matters from the perspective of making a decision is “incremental cash flow”. This is the increase or decrease in cash flows that are specifically attributable to a management action. For example: if the management team is reviewing a proposal to improve the capacity of a machine, the entire cash flow resulting from the use of that machine is not the point on which the decision must be made, but rather the incremental cost of improving the machine and the incremental revenue that results from having additional capacity.
Example: Assume that a machine produces 1,000 cans per hour, and an upgrade to the machinery will result in an increase in the theoretical capacity to 1,500 cans per hour, for an incremental change of 500 cans per hour. The cost of the upgrade is $100,000, and the profit from each can is $.04. The machine runs eight hours a day for five days per week; therefore, the increase in capacity will result in an added cash inflow of $41,600, which is calculated as follows:
[500 cans per hour] × $.04 = $20 per hour incremental cash inflow
= [$20 per hour of cash inflow] × [40 hours per week] × [52 weeks per year] = $41,600
This incremental investment translates into a payback of 2.4 years, which is a reasonable return period for most investments. However, from an incremental perspective; why not run the machine a bit longer each day to obtain the same production that the machine would yield with the enhanced equipment?
If the machine operator is paid $10 per hour and the same person stays late to work an extra 4 hours per day to run the machine, the added overtime cost per year will be only $15,600 [4 hours per day × 260 days × $15/hour], which is far less expensive than the equipment option.
In addition, there may be no incremental need for the added capacity, since we do not know that the machine must be run at full capacity at all times. By using overtime instead of a fixed investment, the use of the machine can be scaled back on a day-to-day basis to exactly match production to sales. This example shows that one must review the specific cash flows that will change as a result of a specific management decision to see if it will result in a positive incremental change in cash flows.
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