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 your accounting records, are historical, sunk, and irrelevant amounts. (No decision will affect or change the past.) Those 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 be different between alternatives. Hence, decisions to improve profits need only be concerned with the current and future revenues, costs, and expenses that will differ among alternatives.
The relevant amounts in the decision to replace a machine would be the cost 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.) 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. The difference in the bottom line is more important than the difference in sales. Don't strain your organization for little additional profit.
After working as an accountant, consultant, and university accounting instructor for more
than 25 years, Harold Averkamp formed AccountingCoach.com in 2003. His goal was to
share his knowledge and passion for teaching accounting and with people throughout the
world at a very low cost. Read More...