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The incremental principle should be carefully used in determining an investments flows. All 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, 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 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 total 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.
• Opportunity costs of resources
Sometimes a proposed investment project may use the existing resources of the firm for which explicit, or adequate, cash outlays may not exist. The opportunity cost of such projects should be considered. Opportunity costs are the expected benefits, which the company would have derived from those resources if they were not committed to the project.
Assume, for example, that the company is considering a project, which requires 7000 cubic area. Also suppose that the firm has 10000 cubic feet area available. What is the cost of the area available within the firm if it is used by the project? One answer could be that since no cash outlay is involved, therefore, no charges should be made to the project. But from the point of the alternative investment opportunity foregone by transferring this available area to the project, it seems desirable to charge the opportunity cost of the area to the project. Suppose that the company could rent the area at 18$ per cubic feet, and then 126000$ should be considered as the opportunity cost of using the area. The opportunity cost of the other resources can also be computed in the same manner. It may be sometimes difficult to estimate opportunity cost. If the resources can be sold, its opportunity cost is equal to the market price. It is important to note that the alternative use rule is a corollary of the incremental cash flow rule.
• Incidental effects
An investment project under consideration may influence the cash flow of other investment opportunities, or the existing projects or products. The incremental cash flow rule applies here; it tells us to identify all cash flows, direct or incidental, occurring as a result of the acceptance of an investment opportunity. It is, therefore, important to note that all incidental effects, in terms of cash flows, should be considered in the evaluation of an investment opportunity.
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