Effect of Indirect Expenses
Another factor which merits special consideration in estimating cash flows is the effect of overheads. The indirect expenses/overheads arc allocated to the different products on the basis of wages paid materials used floor space occupied or some other similar common factor. The question that arises is should such allocation of overheads betaken into account in the cash now? The answer hinges upon whether the amount of overheads will change as a result of the investment decision. If yes it should be taken into account. If however overheads will not change as a result of the investment decision, they are not relevant.
A company allocates overheads on the basis of the floor space used. Assume it intends to replace an old machine by a new one. Further assume that the new machine would occupy less space so that there would be a reduction in the overhead charged to it. Since there is no effect on cash flows. a change in the overhead is not relevant to the cash now streams of the machine vein acquired. But if the surplus space is used for an alternative use and if any cash now is generated it relevant to the calculations. Thus the deciding factor is whether there is any alternative use. The alternative use rule is a corollary of the incremental cash now rule.