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 a career teacher and coach before I took on the accounting/bookkeeping side of our business. My only accounting experience had been in college, with the one class my parents required of me—Accounting 101. A helpful class, yes, but not a strong base for dealing with daily business entries. Over the years, I read various books that helped me gain general knowledge and keep us in the black and out of trouble with my accountant. When I found AccountingCoach, I was blown away by the ‘fount of all accounting knowledge’ at my fingertips, complete with courses, study guides, and straightforward explanations that even a DIY accounting hack could understand! I now serve as our company's CFO and oversee the books and financial direction of multiple subsidiaries. AccountingCoach has helped me gain confidence and knowledge as I continue to learn best practices to run our businesses." - Angie S.
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: