How do you decide what new projects, products, or campaigns your company is going to pursue? It might be instinct, whim, or a highly calculated decision based on intense market research. Regardless of how you choose new projects, part of the decision is likely based on finances—how much money the new project will cost and how much you may earn. That financial flow of money spent and money earned on a new project is incremental cash flow in a nutshell.
What is incremental cash flow?
Incremental cash flow is the cash inflow, or amount of money, a new project, product, investment, or campaign generates or subtracts from your company.Forecastingincremental cash flow helps companies decide whether or not a new investment or project will be profitable. Another way to think about it is whether or not you’ll get a return on your investment (ROI).
Apositiveincremental cash flow means the new project will bring money into your company, while a negative incremental cash flow means you’ll lose money on the project. That means you want to take on projects or make investments that have a positive incrementalcash flow(i.e., more money for your company) and reject those with a negative incremental cash flow (i.e., less money for your company).
Determining incremental cash flow allows businesses to compare expected cash flow across projects. This helps businesses identify which projects are likely to be profitable, and where to invest money.
How to calculate incremental cash flow
Before you can calculate the incremental cash flow of a project, you’ll need to gather some financial information about:
- Revenue, also known as cash inflow, or how much money the project will bring in before expenses
- Expenses, also known as cash outflow, or how much money the project is expected to cost you
- Initial cash outlay, or how much it will cost to get the project started
Subtract the expenses from the revenue and then subtract the initial cost from that total number. In other words:
Incremental Cash Flow = (Revenue - Expenses) - Initial Investment
For example, Poe’s Toe Beans wants to create a social media influencer campaign with a cat influencer. They estimate the campaign will bring in $100,000 in revenue. They agreed to give the influencer a $50,000 fee and $400 worth of cat toys.
Their incremental cash flow would therefore be: ($100,000 - $400) - $50,000 = $49,600
That’s net positive, so the investment in the influencer campaign is good business.
Limitations of calculating incremental cash flow
- Sunk costs
- Cannibalization
- Opportunity cost
While calculating incremental cash flow helps you decide whether or not to take on a new project, it has limitations. Three factors might make it difficult to calculate incremental cash flow: sunk costs, cannibalization, and opportunity costs.
- Sunk costs.These are costs that cannot be recovered. For example, if a company spends $100 on advertising, that $100 is a sunk cost regardless of whether or not the ads result in any sales. Therefore, it is not included when calculating incremental cash flow.
- Cannibalization.Cannibalization occurs when the new product takes away, or “eats,” cash flow from another product within the same company. For example, if Company A sells both Product X and Product Y and it introduces a new product, Product Z, that is similar to Product X, then Product Z is cannibalizing Product X. Cannibalization is taken into account when determining whether or not to introduce a new product.
- Opportunity cost.Opportunity costis the cost of missing revenue from taking on one new project versus another new project. For example, if Company A has $100 to spend on either advertising or research and development (R&D), and it decides to spend it on advertising, then the opportunity cost is the potential financial benefits that would have resulted from spending that $100 on research and development.
These three factors are considerations when a company takes on a new project, which means incremental cash flow might not be a complete representation of the ROI of a new project, campaign, product, or investment. Depending on your project and business, it is a good idea to use other methods as well, like payback period or internal rate of return, among others.
Incremental cash flow vs. total cash flow
Calculating and tracking both incrementalcash flowand total cash flow shows you where your business is generating new revenue and where money is being spent. Incremental cash flow is extra cash a business brings in or loses as a result of a new project or initiative. Total cash flow, on the other hand, is the overall amount of cash a business has coming in and going out. While both types of cash flow are important, incremental cash flow is more helpful when making decisions about new projects or investments, while total cash flow is important for a wide view of your company’s financial health.
- Project forecasting. Incremental cash flow is important because it allows you to see which projects are actually bringing in additional revenue. This is valuable information when you’re trying to decide whether or not to invest in a new project. Total cash flow does not give you a view into the potential ROI of a specific project.
- Company financial health. Total cash flow is important because it gives you visibility into all of the money that's coming in and going out of your business. This can help you spot trends and identify areas where your business might lose money. It can also alert you to potential problems with your cash flow before they become serious. Incremental cash flow can only see the financial health of specific projects, and not of the company as a whole.
Incremental cash flow FAQ
How do you calculate incremental cash flow?
Incremental cash flow is calculated using the following formula:
Incremental Cash Flow = (Revenue - Expenses) - Initial Costs
What is not included in incremental cash flow?
Incremental cash flow does not include cash receipts or debts from other parts of your business. It only includes the money made and spent on a specific project. It also does not include sunk costs, opportunity costs, and cannibalization.
What is an example of incremental cash flow?
Poe’s Toe Beans is looking to create a social media influencer campaign with a cat influencer. It estimates that the campaign should bring in $100,000 in revenue. It has agreed to supply $400 worth of cat toys and the initial cost is a $50,000 fee to the influencer. Its incremental cash flow would therefore be: ($100,000 - $400) - $50,000 = $49,600.