Differences between Incremental and Total Cashflows

The total and the incremental cash flows on a project will generally be different for two reasons. The first is that some of the cash flows on an investment may have occurred already and therefore are unaffected by whether we take the investment or not. Such cash flows are titled sunk costs and should be removed from the analysis. The second is that some of the projected cash flows on any investment will be generated by the firm, whether this investment is accepted or rejected. Allocations of fixed expenses, such as general and administrative costs, usually fall into this category. These cash flows are not incremental and the analysis needs to be cleansed of their impact.

1. Sunk Costs

There are some expenses, related to a project that might be incurred before the project analysis is done. One example would be expenses associated with a test market done to assess the potential market for a product prior to conducting a full-blown investment analysis. Such expenses are called sunk costs. Since they will not be recovered if the project is rejected, sunk costs are not incremental and therefore should not be considered as part of the investment analysis. This contrasts with their treatment in accounting statements, that do not distinguish between expenses that have already been incurred and expenses which are still to be incurred.

One category of expenses that consistently falls into the sunk cost column in project analysis is research and development, which occurs well before a product is even considered for introduction. Firms that spend large amounts on research and development, such as Merck and Intel, have struggled to come to terms with the fact that the analysis of these expenses generally occur after the fact, when little can be done about them.

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