Financial Decisions

Why financial decisions are based on incremental benefits? How dose sunk cost affect the incremental benefit from a decision?

Corporations often take actions in an attempt to increase their profits. Incremental benefits are important for financial decisions because the opportunity cost of not taking an action must be evaluated against those actions that will be taken. The formula of incremental benefits is:

Incremental benefits= cash flow (action taken)- cash flow( action not taken) (Garger, 2010)

If the incremental benefits are greater than zero, it indicates that this decision can increase profits for the company, which is acceptable. If there are two or more plans and their incremental benefits are both positive, the larger one will be preferred action plan. However, management of enterprises must also be careful that some values of incremental benefits considered low actually are higher. For example, on economic recession phase, a company accepted a five-year contract for using their idle production capacity but the prices are far below the normal processing costs. Although the prices are more than the direct costs of processing, they are not enough to make up for all the indirect cost and produce normal profits. The reason for the company to accept the contract is the contract can offset the incremental costs, and also compensate for par of the indirect costs at that time.

When the economy goes into recovery, many companies come and are willing to pay high prices, despite the company use full production capacity they have, they still cannot accept more profitable transactions. If the company is not able to expand production, when they consider accepting a long-run contract, they should also consider the opportunity costs of normal transactions.