However, extreme caution must be exercised when using absorption (full) product cost information to evaluate the cash flows arising from a particular investment. This is not only because of the arbitrary methods frequently used to 'attach' fixed overheads to units of production as if they were variable costs (discussed in previous weeks), but also because fixed overheads frequently include depreciation charges which (as you should recall from the financial accounting part of this course) are accounting reallocations of initial investment cost over an assets useful life, and are not cash flows in the period in which they are charged. A simple example will help to clarify these points:

Example:

If we consider the cash flows arising from a decision to set up a production operation in a small factory unit rented for £6,000 p.a. and having rates of £1,000 p.a. The machinery costing £10,000 will be purchased to produce a single product for four years after which the machine is expected to be sold for £2,000. The product is expected to sell for £8 per unit and have variable costs of £6 per unit (and therefore a contribution of £2 per unit), and the expected demand over the next 4 years is forecast as follows: