Incremental cash flow: is a new contract, hire or machine worth it?

Short answer: incremental cash flow is the cash your business will have with a decision minus the cash it would have without it. Count only what changes: the extra sales, the extra costs, what you spend up front, the money tied up while customers take time to pay, and any sales you lose elsewhere because of it. Leave out costs you pay either way (rent, your own wage, the accountant), money already spent (sunk costs) and depreciation, which is not cash. A bakery offered a £60,000 a year wholesale contract that needs a £12,000 oven makes £15,400 a year of incremental cash flow from it, gets the £17,000 it puts in back in about 13 months, and ends three years £37,200 better off in cash. Its accountant’s profit figure for the same contract says £10,200, because it mixes in costs that do not change.

The incremental cash flow formula

Incremental cash flow = extra cash in − extra cash out, worked out for each year of the decision:

Include	Leave out
Extra sales the decision brings	Costs you pay anyway: rent, insurance, your wage, software
Extra direct costs: materials, wages, fuel, delivery	Money already spent and not coming back (sunk costs)
What you spend up front: equipment, fit-out, deposits	Depreciation (the cash went out when you bought the equipment)
Money tied up in customers and stock, and its return at the end	A share of overheads an accountant allocates to the new work
Sales you lose elsewhere because of it (cannibalisation)	Loan interest, when the full purchase price is already counted up front
What the equipment sells for at the end
The extra tax on the extra profit

The test for every line is one question: would this cash be different if I said no? If not, it does not belong in the sum.

A worked example: a bakery offered a wholesale contract in Leeds

These figures are made up. Priya runs a bakery with a shop counter. A local chain of three cafés offers a three-year contract for bread and pastries worth £60,000 a year. To bake that much she needs a second oven.

Each year of the contract	£
Contract sales	60,000
less ingredients and packaging (35% of sales)	(21,000)
less a part-time baker, including employer costs	(18,000)
less van fuel and running costs for deliveries	(3,000)
less counter sales lost: one café is on her street (4,000 of sales at a 65% gross margin)	(2,600)
Incremental cash flow each year	15,400

Then the one-off amounts:

• The oven: £12,000 on day one. She expects to sell it for about £3,000 at the end of the three years.
• Working capital: £5,000. The cafés pay 30 days after each invoice, so a month of contract sales (60,000 ÷ 12) is always owed to her. That money leaves her bank at the start and comes back when the contract ends. The working capital calculator works it out for a whole business.
• Sunk cost: £800 she has already spent on samples and recipe testing. It is gone whether she says yes or no, so it is not in the sum.
• Rent: the oven fits in the existing kitchen, so the rent does not change and is not in the sum either.

Year	Cash	Cumulative
0 (start)	(17,000): oven 12,000 + working capital 5,000	(17,000)
1	15,400	(1,600)
2	15,400	13,800
3	23,400: 15,400 + 5,000 working capital back + 3,000 for the oven	37,200

Over three years the contract adds £37,200 of cash. It pays back the £17,000 in about 1.1 years (17,000 ÷ 15,400), so roughly 13 months. The payback period calculator does this for any purchase, with interest and a lower-gain check. These figures are before tax: the extra profit is taxed, and your accountant can say how the oven is treated for tax, so take that off before you decide.

What the profit figure said instead

Priya’s accountant set out the contract as a profit and loss, the usual way:

Year 1	Contract P&L	Incremental cash flow
Sales less ingredients, baker and van	18,000	18,000
Share of rent	(4,000)	not counted: paid anyway
Oven depreciation ((12,000 − 3,000) ÷ 3)	(3,000)	not counted: the cash is the 12,000 up front
Samples and recipe testing	(800)	not counted: already spent
Counter sales lost	not shown	(2,600)
Result	10,200	15,400

Both are right for their purpose. The P&L tells her what the contract will show in her accounts, and the profit by job guide shows how to track that in Xero once it starts. But the question “should I take it?” is answered by the cash that changes, and the P&L view both counts costs that do not change and misses the lost counter sales and the £5,000 tied up with the cafés.

Allowing for waiting: net present value

£15,400 in three years is worth less than £15,400 today. Discounting each year at 15% (the return Priya wants for the risk):

Year	Cash	÷ 1.15 per year	Present value
0	(17,000)	1.000	(17,000)
1	15,400	1.150	13,391
2	15,400	1.323	11,645
3	23,400	1.521	15,386
Net present value			23,422

A positive net present value means the contract beats a 15% return. In a spreadsheet, =NPV(15%, B2:B4) + B1 gives the same answer with year 0 in B1. The discounted cash flow guide explains discounting and how to choose the rate. To see how much cash a decision ties up before it pays back, and in which month it does, add the same cash flows up month by month: cumulative cash flow shows how.

What if it goes wrong?

Case	Cash over the period	Net present value at 15%
As above, 3 years	£37,200	£23,422
Café on her street takes 10,000 of counter sales, not 4,000	£25,500	£14,517
The chain cancels after 1 year (oven sold for 7,000, working capital back)	£10,400	£6,826

Even the worst of these leaves her ahead, which is what makes the contract a good bet. If the cancellation case had come out negative, the answer would be to ask for a longer notice period or a deposit before buying the oven.

How to get the figures from Xero

1. Direct costs as a % of sales. Run Accounting › Reports › Profit and Loss for the last 12 months and divide cost of sales by sales. Priya’s 35% came from there. The margin and markup calculator converts between the two if you price on markup.
2. Wage cost. The Payroll Activity Summary shows gross wages next to super or employer NI and pension, so you can cost an extra person properly. The Xero payroll reports guide shows which report to run, and the can I afford to hire calculator checks the sales you need to cover them.
3. How long customers take to pay. The Aged Receivables Summary, or the debtor days calculator, shows how much working capital the new sales will tie up.
4. Which costs really change. Go down the expense lines on the Profit and Loss and mark each one “changes” or “stays the same”. Only the first group goes in the sum.
5. Afterwards, check it. Set up a tracking category for the contract (see the tracking categories guide) so you can compare the real figures against your sum each month.

Menu names move between Xero releases and regions, so search Xero Central for the report name if your screen differs.

Common mistakes

• Counting overheads that do not change. A share of rent makes a good decision look worse. If the rent is the same either way, leave it out.
• Counting money already spent. Samples, a feasibility study or a deposit you cannot get back do not change with the decision. “We have already spent £800” is not a reason to say yes.
• Using depreciation instead of the purchase. Count the oven’s cost when you pay for it and its sale price at the end. Counting depreciation as well charges for it twice.
• Forgetting working capital. New sales on 30-day terms mean a month of sales sits with customers. It comes back at the end, but you have to fund it until then, often from the overdraft. The net cash flow calculator shows the effect month by month.
• Ignoring cannibalisation. A new product, site or customer can take sales from what you already sell. Only the net gain is incremental.
• Only looking at the good case. Work out what happens if the work stops early or comes in lower. A decision that still makes cash in the bad case is a safer one.

Common questions

What is incremental cash flow? It is the extra cash a business gets from a decision, such as taking on a contract, buying a machine or hiring someone, compared with not doing it. It counts only the cash that changes because of the decision: extra sales, extra costs, money spent up front and money tied up in customers.

What is the formula for incremental cash flow? Incremental cash flow = cash flow with the decision − cash flow without it. In practice, for each year: extra sales − extra direct costs − sales lost elsewhere − tax on the extra profit, and in the first year also the up-front spending and the working capital, which comes back at the end.

Are sunk costs included in incremental cash flow? No. A sunk cost is money already spent that you cannot get back, such as a market study or samples. It is the same whether you go ahead or not, so it does not change the answer.

Is depreciation an incremental cash flow? No. Depreciation spreads the cost of equipment across the years in your accounts, but no cash leaves the business when it is charged. The cash flows are the purchase price at the start and any sale price at the end. Depreciation only matters through the tax it can save.

What is cannibalisation in incremental cash flow? It is when the new work takes sales from what you already sell, such as a second shop drawing customers from the first. Those lost sales come off the incremental cash flow, so only the net gain is counted.

What is the difference between incremental cash flow and net cash flow? Net cash flow is all the cash in less all the cash out for the whole business in a period. Incremental cash flow is only the part of it that changes because of one decision. A business can have a negative net cash flow in a month and still be right to take on work with a positive incremental cash flow.

Know what changed after you decide

ReportPilot reads your Xero figures and sends a short plain-English email every Monday. It covers sales and profit against last month and the same month last year, the cash in the bank against the end of last month, money owed to you that is past due and by whom, and bills due in the next two weeks against your cash. It does not work out whether a decision is worth it, but once you have said yes it shows each week whether sales, profit and cash are moving the way your sum said they would. It asks Xero for read-only access, and there is a 14-day free trial with no card.