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.
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Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. He is the sole author of all the materials on AccountingCoach.com. Read more about the author.