What it means
Every investment decision is really a comparison between two futures: one where you go ahead and one where you do not. Incremental cash flow measures the gap between those two paths in cash terms.
Anything identical in both futures is irrelevant to the decision, no matter how large it looks on the page. The concept matters because businesses routinely approve or reject projects on the wrong numbers.
A proposal that allocates a share of existing head office rent will look worse than it is, because that rent will be paid whether or not the project happens. Focusing on incremental amounts keeps the analysis honest.
Four categories deserve particular attention when building the figures. Sunk costs, such as research already spent, are excluded because the money is gone either way.
Opportunity costs are included, because using a warehouse the business already owns means giving up the rent it could have earned. The other two categories are easy to overlook.
Cannibalisation is included, since sales stolen from an existing product are not new to the company. Working capital changes are included as well, because extra stock and receivables absorb real cash long before the profit shows up.
The analysis should be done after tax and should follow cash rather than profit. Depreciation is not itself a cash flow, but it reduces taxable profit, so the tax it saves is genuinely incremental and belongs in the model.
Similarly, cash tied up in working capital at the start of a project is usually released at the end and should be shown coming back. The most common variant in practice is a with-and-without model, in which the whole business is forecast twice and the difference taken, rather than a project forecast in isolation.
That approach is heavier but far better at catching effects on other parts of the business, which is exactly where isolated project models tend to go wrong.
In practice
Real-world examples.
Example
A gym is deciding whether to open a crèche. It counts the new membership fees and staffing costs but excludes the rent on the existing building, because the space is already leased and currently used for storage that costs nothing to move.
Example
A publisher weighs launching a paperback edition. Because roughly 20% of paperback sales are expected to come from readers who would otherwise have bought the hardback, that lost contribution is deducted from the incremental figures.
Example
A haulage firm considers replacing six trucks. It models fuel and maintenance savings, the trade-in value of the old vehicles and the tax effect of writing down the new ones, ignoring the depot costs that continue regardless.
Think of it
“Incremental cash flow is the extra cash you get (or lose) specifically because of a decision you're evaluating.
Formula
Calculation
The formula is: Incremental cash flow = Cash flow with the decision - Cash flow without the decision. In operating terms this is: Incremental revenue - Incremental cash costs - Lost contribution from existing business - Incremental tax.
A bakery is considering adding a gluten-free line. It expects $600,000 of additional annual revenue and $350,000 of additional cash costs for ingredients, labour and energy. Its finance team also estimates that $50,000 of the new sales will come from customers who would otherwise have bought the existing range, on which contribution would have been $50,000.
Incremental operating cash flow before tax is therefore $600,000 - $350,000 - $50,000 = $200,000. The company pays tax at 25%, so tax on this amount is $50,000, leaving $150,000 after tax. The equipment costs $450,000, and the bakery must also fund $40,000 of extra stock and receivables, so the initial cash outlay is $490,000. Ignoring the depreciation tax shield for simplicity, the project returns its outlay in a little over three years, since $490,000 / $150,000 is about 3.3.Case study
Seen in the real world.
Larkfield Brewing Company is a wholly fictional business used for this illustrative case. It had already spent $180,000 developing a low-alcohol lager and was deciding whether to invest a further $700,000 in canning equipment to take it to market.
The first business case rejected the project. It included the $180,000 already spent, added an allocation of $95,000 for head office overhead that would not change, and took no account of the fact that a mothballed corner of the brewery would otherwise be sublet for $30,000 a year.
Rebuilt on an incremental basis, the illustrative figures looked different. The $180,000 was excluded as sunk, the $95,000 allocation was removed because it was unaffected by the decision, and the $30,000 of forgone sublet income was added as an opportunity cost. The project moved from an apparent loss to a positive net present value, and Larkfield went ahead.
Watch out
Common mistakes.
- Including sunk costs such as completed market research, which cannot be recovered and should not influence a forward-looking decision.
- Leaving out cannibalisation, so a new product appears to add sales that are really being taken from the company's existing range.
- Allocating a share of fixed overhead to the project when total overhead will not change, which makes sound proposals look unprofitable.
Questions
People also ask.
Should financing costs be included in incremental cash flow?
Usually not, because interest is captured through the discount rate; including it in both places counts the cost of money twice.
How are opportunity costs valued?
At the cash the business gives up by choosing this option, such as the rent forgone on space the project will occupy.
Does incremental cash flow apply outside capital projects?
Yes, it is the right basis for pricing a one-off contract, deciding whether to accept a special order, or choosing between making a component and buying it.
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