I/EC G u i d e b o o k for Technical Management
COSTS Sunk Costs, Incremental Costs, and Cash Flow Decisions on new investment must be made on the basis of cash flows which will be affected in the future by James B. Weaver, Atlas Powder Co.
I HIS series of columns [I/EC 51, 51 A (October 1959)] initiated a discussion of the cost factors relevant to a capital investment decision, particularly the costs "sunk" in previously installed investment. This column extends this discussion to other essential factors, leading to a general statement of the capital expenditure decision problem. An investment made at any given time is a matter of choice. If the investment is not made, the world will not end; the company wheels will keep turning in some fashion and profits will probably continue to roll in at one rate or another. The reason for making most new investments is to cause a change—an increase—in the amount of these future profits and other inflows of cash. The investment is considered justified only if it increases these future net cash inflows by enough to provide an adequate return on the new investment. (Cash flow refers to profit after taxes, plus tax-deductible noncash expenditures, particularly depreciation and depletion, which are a source of cash to the company.) Every investment decision should involve forecasts of cash flows not for just one but for two cases—the "base" or "no-investment" case, and the "proposed" or "investment" case [I/EC 50, 65 A (February 1958) tells more on alternatives]. If the difference between these cash flows in the future is all that can be used to justify the investment, some of the arguments ( I / E C , October) become more obvious from another point of view. Any dollar value ascribed to the existing investment (whether original, book, or replacement value) has no effect (except in abandonment of assets allowing tax write-off; resulting in a positive cash flow) on these future
cash flows and should not affect the decision. The past investment is "sunk." Fixed Costs
The costs associated with that existing investment (taxes, insurance, all the effects of depreciation, maintenance, and even the labor costs if they are essentially fixed) have already become an annual affair by the time any later associated investment is proposed. Whether the new investment is made or not, the fixed costs on existing investment will continue unchanged. The only new costs will be those added by the proposed new investment, even though part of the old investment is used in processing the product in question (and though the later accounting of the product costs would allocate some of the continuing costs of the existing investment to the new product). Changes in handling of costs by accountants, etc., after an investment is made should not hide the fact that some costs are unaffected by this investment decision, while other costs are created or changed by the decision. The company's problem for justifying a proposed new investment is to estimate properly which costs will continue unchanged and which will increase. There are those people who will claim that this gives the new investment a "free ride" in utilizing at no charge (there may be no additional charge) considerable existing facilities. However, the proper analysis of alternatives will really give a new investment a free ride on the old investment only if there is no other alternative use of the idle capacity in the existing prospective investment. If there is some other potential use for this now-idle capacity, the cash flow stream in the no-
investment case should include these uses, valued at sales minus cost, as an offset against the profits in the proposed investment case. Additional sales might be made from the idle capacity, for instance, but only starting two or three years from now. In any analysis of a proposed investment, the base case against which the proposed case is compared must incorporate the cash flows resulting from any expected uses of existing capacity of equipment or building space. This properly penalizes the proposed investment, as such future use of available resources will no longer be possible if this investment usurps their availability. The justification should present the over-all cash flow in the proposed case, compared to cash flows of the base case, however. It is not proper or sufficient merely to allocate some existing investment "value" as part of the denominator of the return on investment formula. The value of the existing investment lies only in the future cash flows it can bring in, or assist. Overhead Costs
The accounting profession has done a great service by allocating as many company cost items as possible to individual products within a plant. This indicates whether or not each product in the plant is sharing the overhead costs related to its production. However, in new investment justification, these overhead ratios, developed for another purpose, are sometimes used as a crutch in estimating the costs which will be obtained after the new investment is made. If a part of an existing plant is being expanded, so that the total labor force will be quadrupled, one easy way in cost VOL. 5 1 , NO. 12
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DECEMBER 1959
67 A
I/EC
Guidebook for Technical Management—COSTS
C a s h F l o w F o r e c a s t i n g — T h e Basic Decision P r o b l e m The justification of a new investment must be based on good forecasts of all those factors, major and minor, affecting future cash flows to and from the company—in two cases, the investment case and the situation which will come about if the proposal is not carried out. These include fixed investment, working capital, sales volume, sales price, all the direct and indirect manufacturing costs, depreciation, etc. [I/EC 5 0 , 4 3 A (March 1 9 5 8 ) ] . The costs and revenues which are forecasted to remain the same must also be considered, but, if expected to be equal, they can be left out of the comparison. W h e n cash flows for both cases are forecasted for the life of the proposed investment, the base-case cash flows are deducted from those in the proposed case, and the differential investment justified by the difference—the net cash flow gained by undertaking the investment. The discounted earning rate of the proposed investment can be calculated as interest rate of return (7) or the differential cash flow can be discounted at a known minimum acceptable rate of return to find the present value of dollars to be earned above that minimum acceptable rate (2). estimating is to assume that the overhead costs allocated to that portion of the plant (based on direct labor) will also be quadrupled. However, in keeping with the statement that investments should be justified only on the basis of those costs and profits which will really change due to the investments, such an allocation of overheads usually warrants a closer look. There may be no immediate addition of any more overhead staff in the plant—or there may be some small number of employees (one foreman, perhaps, and one clerk) who will be added to the overhead staff because of a given expansion. II these are the only costs which will really change, they are the only additional overhead that should be allocated to the expanded plant in justifying the new investment. When the investment has been made, the accounting books could not follow this allocation system; it would become hopelessly confused. The information needed to make a decision, however, is completely different from that needed to keep track of historical costs. Sure, the accountant will allocate a fair share of overhead to this expanded portion of the plant. However, if the total overhead costs increased only by some small portion of this total, an additional effect of the account68 A
ing allocation (which is harder to see) is that every other product made in the plant receives a slightly smaller allocation of continuing overheads. The net difference must be only the true addition. This general approach to applying costs to an investment decision is often called the "incremental" or "out-of-pocket" approach. It does not use existing accounting overhead allocations, but looks at the actual forecast of increased costs of overhead after a new investment has been undertaken. As with the nonallocation of existing investment value or fixed costs, the complaint of the free ride is often made concerning such an approach. Again, this is only a free ride if there is a good forecast made which shows no increases in overhead personnel and equipment due to a given investment for the entire life of the product resulting from that investment. If an increase can be foreseen, a proper incremental analysis would include it. It is not likely that such forecasts of costs will be understated any more than any other such forecast is optimistic, if enough attention is paid to it. In the area of gradually increasing overhead costs, it is often difficult or impossible, however, to allocate the addition of a clerk or a calculating machine to any particular ex-
INDUSTRIAL AND ENGINEERING CHEMISTRY
pansion in the plant. Overhead costs tend to creep up almost independent of particular investment decisions. Through this concept, some find it best to assume that every new investment causes an increase in overhead, which is only recognized separately on larger increments of investment. If such a relationship can be shown from cost records— the addition of a certain fraction of overhead related in some way to plant expansion—this could become a very proper way of making a good cost estimate of the necessary additional overhead. If a firm relationship has not been proved, the assumption (which is frequently made) of full increase of overheads at the average rate, with an investment, may be as far from the truth as an assumption that no overheads will increase. This was a brief, general statement of the complete capital investment decision problem. Knowing this, each company must decide how much to spend to obtain the forecasts, balancing their cost against the possible improvement of decisions. No one expects profitability forecasts to be precise, but it's a tough job getting answers that, on the average, are even close to right, as many companies will verify. Theoretically, the two decisions— the investment and the analytical effort to be expended—could be combined to optimize the probability of maximum gain to the corporation from the outlay due to preliminary analytical studies, the outlay for capital investments, and the increased cash flows. In practice, most companies are seeking by trial and error to find a suitable degree of preliminary analysis to provide reasonable accuracy in forecasts of cash flows and profitability. Literature Cited (1) Weaver, J. B., Reilly, R. J., Chem. Enç. Progr. 52, 405-12 (correction 448) (1956). " (2) W i n n . F. W., Petrol. Refiner 35, 199210 (July 1956).
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