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According to Walther (2016), relevant costs are vital when evaluating significant capital investments.
When a medical billing company is considering a substantial investment in new medical billing software, it
is essential to focus on the costs directly affected by the decision. To understand the actual economic
implications of the decision, irrelevant costs such as sunk costs (historical expenses) or past accounting
allocations should be excluded from the analysis (Noreen et al., 2023; Walther, 2016).
Suppose the medical billing company is considering investing in a new billing software system and is
currently using an existing one. In such a scenario, the cost of acquiring the new software is a relevant
factor, representing a cash outflow the company must incur if they choose the new software. For instance,
if the new software costs $200,000, it will be a significant expense for the company. However, the initial
purchase price of the current software and its associated depreciation expenses are irrelevant in this
context since these costs have already been incurred and do not affect future cash flows (CFI Team,
2023).
Let's say the current software was purchased for $150,000 and has an annual depreciation cost of
$30,000. As mentioned, these costs are irrelevant to the decision-making process, as they do not impact
future cash flows. Suppose the medical billing company overlooks relevant costs. In that case, it may
make biased decisions, leading to a situation where the company sticks with the current software due to
the significant costs associated with its acquisition. This may happen even if the new software offers
higher profitability in the future. To avoid such pitfalls, focusing only on incremental future cash flows is
essential, which provides an unbiased perspective on which option adds the most value (Walther, 2016).
CFI Team (2023) noted that differential analysis is a valuable tool businesses use to make informed
decisions about short-term and long-term projects. However, it is essential to recognize that this approach
has limitations. It fails to consider costs that do not vary between options, such as fixed costs like
maintenance expenses. In the long run, certain fixed costs may become more significant. For instance, if
the new software system requires significantly higher maintenance costs than the existing one, these
steady expenses could accumulate over time, affecting the overall financial impact. Assume the new
software system incurs an annual maintenance cost of $20,000, while the existing software only incurs
$10,000 in maintenance costs annually. Such costs would play a vital role in the decision-making process.
While differential analysis offers quantitative support, considering the broader context and qualitative
factors is crucial for making well-informed decisions (CFI Team, 2023).
To summarize, the medical billing company should use differential analysis to focus on costs that differ
across software options (CFI, 2023). While irrelevant costs may provide contextual information, the
fundamental economics lie in incremental cash flows. Managers must carefully exclude emotional or
misleading factors from the decision-making process. Ultimately, the decision should integrate numerical
analysis and a strategic assessment of the business's long-term outlook (Walther, 2016).
References:
CFI Team. (2023). Differential Cost. Corporate Finance
Institute.
https://corporatefinanceinstitute.com/resources/accounting/differential-cost/
Noreen, E.W., Brewer, P.C., & Garrison, R.H. (2023). Managerial accounting for managers. 6th Edition.
McGraw-Hill
Walther. L., M. (2016).Cost Characteristics and Decision-Making Ramifications.
Principlesofaccounting.com.
https://www.principlesofaccounting.com/chapter-24/cost-characteristics/
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