Question

Which is the individual difficulty that sunk costs, opportunity costs, side effects and allocated costs has in determining incremental cash flows

Answer 1

Answer:

Incremental cash flows are helpful, especially in determining if a company should take on a new project or not. However, accountants also encounter certain difficulties when computing for incremental cash flow.

Here are some of the difficulties:

1.)Sunk Costs:Cash flow analysis is concerned with analyzing future costs, not past ones. Analysts must be careful to exclude sunk costs from any cash flow calculations. Even if the sunk costs seem relevant to the project, they shouldn't be included if they occurred before the investment decision. For example, a company may have paid for marketing tests a few years back to determine the viability of new products they want to invest in. Even though it might seem relevant to the product investment, sunk costs shouldn't be included in the initial cash outflow decision.

2)Opportunity Costs:Financial professionals often forget to include opportunity costs in calculations. Opportunity costs are the missed revenues from alternative uses for the project assets. Although opportunity costs aren't a true cash outflow, they should be factored into capital budgeting decisions. For example, a project requires a set of machinery that the company already owns but was planning to sell for $5,000. Even though the company doesn't incur a cash outflow in keeping the machinery, the $5,000 cost should still be deducted from cash flows.

3)Side Effects:Most projects considered by any business create side costs and benefits for that business.The side costs include the costs created by the use of resources that the business already owns and lost revenues for other projects that the firms may have.Projects often create side costs for other projects.If it is an incremental cost, it should be considered in project analysis.If it would have occurred anyway, it should be ignored.

4)Allocated Costs:Allocating costs to each company department, accountants will invariably allocate costs to capital budget projects. Some of these costs may be relevant for determining cash flows, but others aren't. Since financial analysts are concerned with incremental cash flows, they should include any unique indirect additional costs that project creates in their calculations. However, if the company would have incurred costs regardless of the project, they should not be included in cash flow calculations. For example, costs of shared buildings, office space and executive salaries are probably not affected by the project and should not be included in calculations.