The decisions necessary for improving profits involve the future and must be based on the current and future amounts. The past amounts (such as the amounts in the accounting records) are historical, sunk, and irrelevant amounts. The reason is that no decision will affect or change the past. The past amounts are useful only if they help you to estimate the relevant future amounts. Irrelevant amounts also include any future amounts that will not differ between alternatives. Therefore, decisions to improve profits need only be concerned with the current and future revenues, costs, and expenses that will differ among the alternatives.
For example, the relevant amounts in the decision to replace a machine are the cost it will take to remove the old machine, the cost to purchase and set up the new machine, proceeds from the sale of the old machine, the future cost savings (such as utilities, labor, less scrap, etc.), the increased sales in the future due to the new machine's features, changes in income taxes, and any other incremental changes. Ultimately, the decision is whether or not the additional cash outlay today is worth the additional cash inflows in the future.
When examining the future cash flows, it is critical that you consider the time value of money. This is done by applying present value factors to the incremental cash amounts. After all, cash in the future is not as valuable as cash in the present.
When you look at the differences in the future amounts, be sure you look hard at the difference in net income. For instance, the difference in the bottom line is more important than the difference in sales. Don't strain your organization for a small amount of additional profit.
Featured Review
"I was struggling with my accounting classes at first, as all of the material was confusing. Therefore, I joined PRO Plus and took each of the certificate courses. Before long the material began to make perfect sense. AccountingCoach helped me to get an A in each of my accounting classes, so I could maintain my 4.0 and make it into The National Society of Collegiate Scholars. I have decided to change my major to a bachelor of science in accounting, followed by a masters of science in accounting. I want to get my CPA in California." - Kyle T.
Join PRO or PRO Plus and Get Lifetime Access to Our Premium Materials
Read all 2,645 reviewsWe now offer 10 Certificates of Achievement for Introductory Accounting and Bookkeeping: