The Paper FFM Study Guide references E3 c) and E3 d) require candidates to be able to both discuss the concept of relevant cash flows and identify/evaluate relevant cash flows.
Relevant cash flows can be examined in either a written or calculation format. It is also important that candidates can identify relevant cash flows in order to be able to use them in the context of investment appraisals, for example net present value calculations. Finally, relevant cash flows are not just an important part of the syllabus for Paper FFM as they can also be examined in later studies, for example Paper F9.
Definition
A definition often used for relevant cash flows states that they must be cash flows that occur in the future and are incremental.
Cash flow
While on the face of it obvious, only costs or revenues that give rise to a cash flow should be included. Accordingly, for example, depreciation charges should be excluded.
Future
Any relevant cash flow should arise in the future. Anything that has occurred in the past is referred to as a sunk cost and should be excluded from relevant cash flows.
Incremental
Only cash flows that arise because of the decision being made should be included; any cash flow that would have arisen anyway, sometimes referred to as a committed cost, should be excluded.
Opportunity cost
While not specifically included in the definition of a relevant cash flow (as noted above) opportunity costs are also relevant cash flows. Opportunity costs are the revenues that are lost (or additional costs that arise) from moving existing resources from their current use and are therefore considered to be incremental cash flows arising in the future to be taken into account.
These definitions sound easy, and candidates often do well when relevant cash flows are examined in a written format. However, it is applying these concepts to a scenario and calculating/identifying the relevant cash flows that can often cause candidates problems, and it is this that I shall now focus on using excerpts from the question in Appendix 1 as examples where possible. Please read the question before continuing.
Numerical example
Scenario 1
In the context of whether a business owner will move her business, we are told that ‘Mrs Clip currently advertises her business in the local newspapers and business directories, at a cost of $1,000 per year payable in advance. Mrs Clip will carry on with this advertising…’.
Relevant cash flows from scenario 1
On a relevant cash flow basis, we do not need to be concerned with what has been paid in the past, so the $1,000 per year paid in the past is a sunk cost and can be ignored from relevant cash flows.
What about the $1,000 per year in the future if Mrs Clip continues with the advertising? This would not be included as a relevant cash flow, because it is not incremental. The $1,000 cash flow is being suffered now and will continue in the future, whether or not Mrs Clip moves her business to the town centre premises. The cash flow does not arise because of the decision being made; it arises anyway and is therefore not a relevant cash flow.
Scenario 2
A further example of the incremental concept relates to revenue. Revenue from the existing business is $40,000 per year. We are told that if Mrs Clip advertised her move to the town centre premises in the papers only, then revenue would increase by 40%, but if the move was advertised in both the papers and on the radio, then revenue would increase by 45% rather than 40%.
Relevant cash flows from scenario 2
The existing revenue of $40,000 is not incremental. This is the level of revenue that has been earned by the business in the past and will be earned in the future whether or not a move to the town centre premises is made. It is not dependent on the decision being made. In order to get the relevant cash flow, what is required is the incremental revenue – ie the extra revenue that will be earned if the move is made. Thus if the advertising is only in the papers, then the incremental revenue earned will be 40% x $40,000 = $16,000. If the advertising is in both the papers and on the radio, then the incremental revenue will be 45% x $40,000 = $18,000.
Scenario 3
Within this question, there were no non-cash flows. However, what if we had been told that Mrs Clip was going to buy salon fittings for $3,000, and these would be depreciated over five years?
Relevant cash flows for scenario 3
The $3,000 paid for the salon fittings would be a relevant cash flow, and incorporated within any relevant cash flow schedule at the time at which the fittings were purchased. However, depreciation is not a cash flow and is therefore not a relevant cash flow. As a result, it the annual depreciation charge should not be included within any relevant cash flow schedule.
Scenario 4
Opportunity costs arise less frequently within questions, but when they do, they can cause candidates real problems. There are no opportunity costs within the question we have been considering, but let us look at an example all the same. An opportunity cost arises if a resource is moved from its current use. So let us say that we have labour that is currently being used in manufacturing process A. The following figures are available for manufacturing process A:
Continuing from the previous two articles, we will look at some more counterintuitive steps that need to be taken to calculate the cash flows which should then be discounted to arrive at the worth of the project. This article will cover the concepts of how sunk costs should be treated as well as how allocated overheads may at times be different from the overhead value that we have to use in our cash flow calculations.
Sunk Costs
Sunk costs are expenses that have happened in the past that will not be affected by the current decision. The second part is very important. Defining sunk costs just as expenses that have happened in the past would be inappropriate if our current decisions affect them.
Consider a case when the firm has already spent $1 million on a project. However, the project has turned out to be unsuccessful till date. It has not churned out any positive cash flows till date. Now, the company is faced with a choice. The choice is whether it should invest more in the project that it has spent $1million on or whether it should pursue a new project.
The important point is not the answer. The important point here is the thought process that will be used to arrive at the answer. The correct thought process understands that $1m already spent has nothing to do with the new choice they are faced with. The incremental dollars also deserve their best use and hence the decision must be taken solely on the basis of NPV of additional money that is going to be spent. The old $1m is not affected by the decision that has to be taken now. Hence it is irrelevant and must be completely ignored during the decision making.
Allocated Overhead Costs
Overheads are costs that cannot be assigned to any activity directly. Assigning them within the company’s different departments and projects therefore becomes a problem. This problem is solved by accountants through the concept of allocation. Since the track of where the money was actually spent cannot be kept, accountants assume a basis and costs are allocated on that basis. The problem is that these allocated costs may not be good for our cash flow analysis purpose.
For instance, consider the fact that there are 3 departments A, B and C. The total overheads of the company now are $100. The allocation base used is labor hours and the proportion in which these costs are split is 2:2:1. Hence A, B and C have allocated overheads of $40, $40 and $20.
Now, consider what happens when the 4th department is introduced. The fourth department has an additional overhead cost of $20 taking total overheads to $120. However, based on the labor hours basis the new ratio is 3:3:1:3
Based on this the overheads allocated to department A, B, C and D are $36, $36, $12 and $36 respectively. So, for department D, we have an allocated overheads cost of $36 as opposed to incremental overheads cost of $20. Since, cash flow analysis is all about incremental costs, it is essential that we take into consideration the incremental costs and not the allocated costs while performing the calculations.
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How do you decide what new projects, products, or campaigns your company is going to pursue? It might be instinct, whim, or a highly calculated decision based on intense market research. Regardless of how you choose new projects, part of the decision is likely based on finances—how much money the new project will cost and how much you may earn. That financial flow of money spent and money earned on a new project is incremental cash flow in a nutshell.
What is incremental cash flow?
Incremental cash flow is the cash inflow, or amount of money, a new project, product, investment, or campaign generates or subtracts from your company. Forecasting incremental cash flow helps companies decide whether or not a new investment or project will be profitable. Another way to think about it is whether or not you’ll get a return on your investment (ROI).
A positive incremental cash flow means the new project will bring money into your company, while a negative incremental cash flow means you’ll lose money on the project. That means you want to take on projects or make investments that have a positive incremental cash flow (i.e., more money for your company) and reject those with a negative incremental cash flow (i.e., less money for your company).
Determining incremental cash flow allows businesses to compare expected cash flow across projects. This helps businesses identify which projects are likely to be profitable, and where to invest money.
How to calculate incremental cash flow
Before you can calculate the incremental cash flow of a project, you’ll need to gather some financial information about:
- Revenue, also known as cash inflow, or how much money the project will bring in before expenses
- Expenses, also known as cash outflow, or how much money the project is expected to cost you
- Initial cash outlay, or how much it will cost to get the project started
Subtract the expenses from the revenue and then subtract the initial cost from that total number. In other words:
Incremental Cash Flow = (Revenue - Expenses) - Initial Investment
For example, Poe’s Toe Beans wants to create a social media influencer campaign with a cat influencer. They estimate the campaign will bring in $100,000 in revenue. They agreed to give the influencer a $50,000 fee and $400 worth of cat toys.
Their incremental cash flow would therefore be: ($100,000 - $400) - $50,000 = $49,600
That’s net positive, so the investment in the influencer campaign is good business.
Limitations of calculating incremental cash flow
- Sunk costs
- Cannibalization
- Opportunity cost
While calculating incremental cash flow helps you decide whether or not to take on a new project, it has limitations. Three factors might make it difficult to calculate incremental cash flow: sunk costs, cannibalization, and opportunity costs.
- Sunk costs. These are costs that cannot be recovered. For example, if a company spends $100 on advertising, that $100 is a sunk cost regardless of whether or not the ads result in any sales. Therefore, it is not included when calculating incremental cash flow.
- Cannibalization. Cannibalization occurs when the new product takes away, or “eats,” cash flow from another product within the same company. For example, if Company A sells both Product X and Product Y and it introduces a new product, Product Z, that is similar to Product X, then Product Z is cannibalizing Product X. Cannibalization is taken into account when determining whether or not to introduce a new product.
- Opportunity cost. Opportunity cost is the cost of missing revenue from taking on one new project versus another new project. For example, if Company A has $100 to spend on either advertising or research and development (R&D), and it decides to spend it on advertising, then the opportunity cost is the potential financial benefits that would have resulted from spending that $100 on research and development.
These three factors are considerations when a company takes on a new project, which means incremental cash flow might not be a complete representation of the ROI of a new project, campaign, product, or investment. Depending on your project and business, it is a good idea to use other methods as well, like payback period or internal rate of return, among others.
Incremental cash flow vs. total cash flow
Calculating and tracking both incremental cash flow and total cash flow shows you where your business is generating new revenue and where money is being spent. Incremental cash flow is extra cash a business brings in or loses as a result of a new project or initiative. Total cash flow, on the other hand, is the overall amount of cash a business has coming in and going out. While both types of cash flow are important, incremental cash flow is more helpful when making decisions about new projects or investments, while total cash flow is important for a wide view of your company’s financial health.
- Project forecasting. Incremental cash flow is important because it allows you to see which projects are actually bringing in additional revenue. This is valuable information when you’re trying to decide whether or not to invest in a new project. Total cash flow does not give you a view into the potential ROI of a specific project.
- Company financial health. Total cash flow is important because it gives you visibility into all of the money that's coming in and going out of your business. This can help you spot trends and identify areas where your business might lose money. It can also alert you to potential problems with your cash flow before they become serious. Incremental cash flow can only see the financial health of specific projects, and not of the company as a whole.
Incremental cash flow is calculated using the following formula:
Incremental Cash Flow = (Revenue - Expenses) - Initial Costs
Incremental cash flow does not include cash receipts or debts from other parts of your business. It only includes the money made and spent on a specific project. It also does not include sunk costs, opportunity costs, and cannibalization.
Poe’s Toe Beans is looking to create a social media influencer campaign with a cat influencer. It estimates that the campaign should bring in $100,000 in revenue. It has agreed to supply $400 worth of cat toys and the initial cost is a $50,000 fee to the influencer. Its incremental cash flow would therefore be: ($100,000 - $400) - $50,000 = $49,600.