How the Principle of Incremental Benefits Relates to Corporate Financial Planning
Principle of Incremental Benefits
The Principle of Incremental Benefits suggests that value is defined as the extra value realized by choosing one action over another. The same can be said for costs that would occur in the event an action is taken in contrast to if it were not. The term incremental is important here because the opportunity cost of not taking an action must be evaluated against those actions that will be taken.
Corporations often advertise products to their markets in an attempt to increase sales, generate knowledge about product offerings, and maintain a presence in the market. A famous example asks whether Coca-Cola needs to advertise its soft drink products. Some argue that consumers would buy Coke even if the firm didn’t advertise while others see a failure to advertise as an opportunity for Coca-Cola’s competitors to steal market share. Either way, the decision to advertise or not is based on Coca-Cola’s analysis of the incremental benefit (extra benefit) the choice to advertise would generate over the decision to not advertise.
Cash flow, or the realization of receiving funds from operations, is usually the measure of incremental benefits. The cash flow that would occur if an action is taken is the incremental benefit over the cash flow that would occur if an action were not taken. This can be summarized with the following formula.
Incremental Benefit = Cash Flow(action taken) – Cash Flow(action not taken)
One aspect of business that does not affect incremental benefits is the concept of sunk costs. A sunk cost is any cost that has already occurred and no decisions now or in the future will change them. In most decision making, sunk costs can be ignored. All too often, however, human nature makes investors think that since the costs have been incurred, it would be a shame not to finish a project. This type of commitment to sunk costs has led many individuals and companies to lose substantial value by failing to consider better alternatives. Sometimes, emotions about an investment lead an investor to hold on to an asset when it is clear that it should be abandoned for more profitable investments. It may be socially desirable for an investor to say that he owns part of a corporation that makes luxury cars over one that processes bitumen, but this emotional attachment can lose the investor wealth from an incremental benefits point of view.
The Principle of Incremental Benefits refers to benefits gained by making one decision and not making another. Often, sunk costs and emotions can interfere with sound investment advice. If the goal of an investor is to maximize wealth, incremental benefit analysis can aid investors in making objective decisions when multiple alternatives exist.
This post is part of the series: Principles of Value and Economic Efficiency
The main purpose of a firm is to create value and only part of creating value involves making money. The four principles of value and economic efficiency illustrate that making money is an outcome of creating value.