8.4: Incrementalism
The analyst’s “end-game” is to produce a spreadsheet reflecting future years’ respective, incremental , or additional, cash flows and/or profits, and possibly other things as well. In general, the principle of incrementalism pertains. It is only incremental cash flows, i.e., those which are added due to the project’s implementation, which are relevant to decision-making. If the company brought in $100 and now – with the new project – it brings in $125, the increment is $25. Incremental revenues – and costs – did not exist before the project was effected. Therefore, sunk costs and the cannibalized portions of projections’ data are excluded as will be discussed immediately below. It is the incremental data which drive the decision to invest or not. We will learn this better by example.
By contrast, the accountant reports all historical economic events. Later, we will conduct a basic exercise in producing a pro-forma statement , i.e., a projected, income statement. Below are the two types of incrementalism:
Sunk Costs – these are expenditures which have already been outlaid and should not be therefore “double-counted.” For example, suppose a factory has unused , or under-used, equipment, which may be exploited, for a proposed project. The cost of the equipment having already been spent or “sunk,” should not be considered again; the cost is not relevant to deciding, for example, whether or not an existing asset should be exploited in a new way. The project merely proposes to exploit unused, or under-utilized, assets – or “ sunk costs ” – in order to increase sales and profits.
Cannibalization – When a new product is introduced, some of the revenue may have been cannibalized from the potential sales of the old product. For example, if the new product is expected to sell 1.5 million units, and the old product had sold 1.0 million, we are interested only in the 0.5 mm increment. That is what the investment decision depends upon. Hence the phrase “cannibalization.” A change in pricing would complicate this analysis, i.e., how much of the revenue increase is due to volume and how much is due to a price increase?