The criteria that we are about to explore are widely used in large organisations to evaluate projects. Often they will be built into standard business case templates with each criteria having a specific target that must be achieved if the project is to be given the go-ahead.
Accounting is primarily concerned with recording transactions. Thus an invoice is raised when goods are shipped and the transaction is recorded in the sales account even though the customer may not pay for several weeks. As a result the profit figure at the end of the year may bear very little resemblance to the money actually received by the business.
Not so in project appraisal. Project finance is based on cash. A sale does not count until the money is received from the customer. Likewise with payments for materials or the purchase of assets. It is only the cash impact that is recorded. This means that depreciation is disregarded – the entire amount for an asset purchase is recorded when the item is bought.
A project is evaluated by taking into account:
the incremental difference in cash flows as a result of undertaking the project
In other words, the difference between doing nothing and investing in the project.
We are therefore concerned not only with revenues and costs, but also cost savings. We shall explore what we mean by ‘incremental difference in cash flows’ in more depth shortly.