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What Is Activity-Based Costing (ABC)?
Activity-based costing, or ABC, allocates overhead and indirect costs to the products and services directly related to them. This method of costing in accounting recognizes the relationship between costs, overhead activities, and manufactured products.
As a result, it assigns indirect costs to products less arbitrarily than more traditional costing methods.
On the other hand, allocating certain indirect costs to a specific product can be challenging, such as the salaries of management and office staff.
KEY TAKEAWAYS- Activity-based costing (ABC)
- Activity-based costing, or ABC for short, allocates overhead and indirect costs to specific products and services. These costs include things like salaries and utilities.
- The ABC cost accounting method is predicated on activities, which can be any occurrence, a unit of work, or an undertaking with a particular objective.
- A purchase order or machine setup are examples of cost drivers.
- The cost driver rate is utilized when determining the overhead and indirect costs associated with a specific endeavor. This rate is calculated by dividing the total cost of the cost pool by the number of cost drivers.
- ABC is used to grasp costs better, enabling companies to form a pricing strategy that is more appropriate for the product or service offered.
Activity-Based Costing, or ABC for short, is defined here.
The activity-based costing system, commonly known as the ABC System, is a two-stage technique for allocating overhead costs to goods that focuses on the primary activities carried out during manufacturing. Another name for the ABC System is the activity-based costing system.
Activity-based costing involves identifying activities that occur inside an organization and then assigning the cost of each activity to all products and services following the actual consumption that occurs for each.
In addition, Activity-Based Costing, often known as ABC, is a more contemporary way of absorption costing that has been created to combat the issues of under-costing and over-costing and to provide more accurate product costs.
An explanation of activity-based costing (ABC) is as follows: activity-based costing (ABC) is an approach that assigns the cost of activities to goods, services, customers, or any other cost item in a systematic, cause-and-effect fashion.
The ABC model is predicated on the idea that “goods consume activities.” Traditional cost accounting systems assign expenses based on direct labor, the cost of materials, income, or other straightforward criteria. Traditional systems tend to under-cost low-volume customers, items, and services while overcharging large-volume customers, products, and services.
Activity-based costing should not be considered a replacement for job or process costing; rather, it should be regarded as one of the most effective tools for refining a costing system.
This is because activity-based costing offers a more accurate measurement of the non-uniformity in utilizing an organization’s overhead resources for jobs, products, and services. Activity-based costing is a pricing method considering each activity’s fundamental and essential function.
The ABC System is a more sophisticated costing method because it emphasizes individual actions as the primary cost items. An event, a job, or a unit of labor with a specific aim is an activity. Some examples of activities include developing items, putting together machines, running machines, and distributing products.
In the classic absorption costing method, overhead expenses are associated or allocated first to cost centers, which may include production and service centers, and then to cost objects, which may include goods or services.
However, in the Activity-based costing approach, overhead expenses are first tied to activities, then assigned to activities, and last pooled into cost pools before being linked to cost objects, such as goods or services.
As a result, the activity-based approach leverages activities rather than functional divisions (also known as Cost Centers) to absorb overhead costs. One of the most fundamental characteristics of functional departments is the tendency for such departments to include various activities that might result in various expenses and behave in various ways.
In addition, the actions frequently overlap with those of other functions. For instance, a manufacturing department or retailer may transmit a requisition note as the foundation for acquiring or purchasing supplies.
Most of the expenditures related to either procurement or buying are expended in the purchasing department, although that is not where the purchase request note is generated.
It is common for activity costs to respond in a manner comparable to one another; that is, they share the same cost driver, often known as the element that causes a change in the cost of an activity. As a result, it is generally thought that activity-based costing contributes to presenting a more accurate picture of the behavior of costs.
How Activity-Based Costing (ABC) Works
Activity-based costing, also known as ABC, is most commonly used in the manufacturing sector because it improves the reliability of cost data, which results in the production of costs that are very close to being accurate. A more accurate classification of the costs than the company incurs throughout the production process.
Target costing, product costing, analysis of the profitability of product lines, analysis of customers’ profitability, and pricing of services all use this costing system. Activity-based costing is used to grasp costs better, enabling businesses to form a pricing strategy that is more appropriate for the product or service offered.
The cost driver rate can be calculated by dividing the cost pool’s total cost by each cost driver. This formula is used in activity-based costing. The cost driver rate is utilized when performing activity-based costing to determine the total overhead and indirect costs associated with a specific activity.
Benefits Of Activity-Based Costing
- ABC assists organizations in understanding their actual costs- Benefits Of Activity-Based CostingABC is a management method that helps organizations understand their actual costs. ABC can help organizations identify areas where they are spending more money than necessary and can also help them cut costs where they are most effective. Additionally, ABC can provide organizations with information about the efficiency of their operations.
- ABC helps people make more informed decisions- Benefits Of Activity-Based CostingBy breaking down all the company’s activities into their costs, ABC can help managers make more informed decisions about where to allocate resources. For example, if a company produces widgets, ABC would tell managers how much it costs to produce each type and what percentage of total production that type represents. This information allows managers to decide better which widgets to produce and where to produce them.
- ABC helps bring down costs- Benefits Of Activity-Based CostingOne advantage of ABC is that it helps bring down costs. By focusing on the actual activities in a company, ABC can help identify areas where overhead expenses may be unnecessary or harmful. For example, ABC may suggest eliminating specific administrative tasks to save money if a company spends a lot on administrative overhead.
- ABC enables management to understand what causes costs- Benefits Of Activity-Based CostingActivity-based costing (ABC) is an approach to budgeting that focuses on the actual costs of producing a good or service rather than the costs of purchasing inputs. ABC can help management understand what causes costs and how to optimize production efforts. For example, ABC might identify which manufacturing stages require the most labor and which processes generate the most waste. This information could help to improve efficiency in those areas.
- ABC improves decisions about how to use resources- Benefits Of Activity-Based CostingABC can help organizations make better decisions about how to use resources, leading to increased efficiency and cost-effectiveness. It is because ABC uses activity data to identify the actual costs of producing different products or services, allowing for a more accurate allocation of resources. Additionally, this information can be used to monitor performance and make adjustments as necessary.
- Budgeting and planning got better- Benefits Of Activity-Based CostingActivity-based costing (ABC) is a methodology that helps organizations better budget and plan by accounting for the total cost of activities, not just the fixed costs associated with inputs. This approach can improve decision-making by accurately pricing outputs and identifying the most costly inputs. ABC also helps companies avoid overspending on inputs, reducing waste, and improving profitability.
- Establishes the foundation for initiatives to keep getting better- Benefits Of Activity-Based CostingOne of the main benefits of ABC is that it establishes the foundation for initiatives to keep improving. Companies can ensure they meet customer needs by constantly assessing and improving processes while reducing costs. It allows them to reinvest those savings in new products and services, increasing efficiency and reducing costs.
Disadvantages Of Activity-Based Costing
- ABC is time-consuming and can be challenging to implement- Disadvantages Of Activity-Based CostingActivity-based costing, or ABC, is a popular method of cost management that relies on tracking actual activity levels to calculate costs. However, implementing it can be time-consuming and challenging, requiring tracking and measuring activity levels across multiple departments and business units. Furthermore, ABC may only sometimes be accurate due to the difficulty in accurately estimating the amount of activity associated with specific activities.
- Data collection can be laborious and may take time to track changes- Disadvantages Of Activity-Based CostingOne major disadvantage of ABC is that it can be laborious to track changes. It can be a disadvantage because it can take time to determine the actual costs of producing a good or service. If cost data for one activity is updated regularly, it may be easier to calculate an accurate total for the entire company. Additionally, if changes in one activity do not reflect in other activities, managers may incorrectly attribute these changes to ABC instead of other sources.
- ABC can be subjective, making it difficult to determine accurate costs- Disadvantages Of Activity-Based CostingOne potential drawback of ABC is that it can be subjective. It can be difficult to determine exact costs, especially when different departments or teams have different interpretations of the activities involved in producing a product or service. It can lead to disparities in how much money is spent on specific products or services and ultimately hinder decision-making.
- ABC may not accurately reflect the actual value of an activity or product in the marketplace- Disadvantages Of Activity-Based CostingAnother disadvantage of ABC is it may not accurately reflect the actual value of an activity or product in the marketplace. For example, if a company decides to use ABC to price a service that requires regular maintenance, such as lawn care, it may find that the service is not profitable. It would likely result in lower prices for this type of service, which would not reflect reality in the marketplace.
How is Activity-Based Costing ABC calculated?
- Identify all the activities required to create the product.
- Create separate “cost pools” for each activity, such as “manufacturing,” which will include all the individual costs associated with that activity. Determine the overall administrative costs for each cost pool.
- Assign activity cost drivers to each cost pool, such as hours or units of measurement.
- Calculate the cost driver rate by dividing the total overhead in each cost pool by the total cost drivers.
- To calculate the cost driver rate, divide the total overhead of each cost pool by the total number of cost drivers.
- Multiply the cost driver rate by the number of cost drivers.
As an activity-based costing example, consider Company ABC, which has a $50,000 per year electricity bill. The number of labor hours has a direct impact on the electric bill. The cost driver in this illustration is the 2,500 total hours of labor that were put in during the year.
Calculating the cost driver rate is done by dividing the $ 50,000-a-year electric bill by the 2,500 hours, yielding a cost driver rate of $20. For Product XYZ, the company uses electricity for 10 hours. The overhead costs for the product are $200, or $20 times 10.
Activity-Based Costing Process
1. Identify activities and activity pools- Activity-Based Costing Process
Identifying activities and activity pools is the first step in Activity-Based Costing (ABC), an accounting technique for identifying costs associated with specific activities. To properly use ABC, businesses must determine which activities are most important and how to group them into activity pools.
Activity-based costing assigns costs based on resources consumed by each activity rather than applying them equally across all activities.
For example, a company might have two activities: developing and marketing the product. By grouping these two activities into one pool, the company can allocate the cost of developing or marketing the product accordingly. It allows for better budgeting and resource allocation decision-making that reflects actual usage patterns.
In addition to assigning costs, identifying activities and activity pools can help businesses measure performance.
For example, if a company can identify the resources consumed by developing or marketing the product, it can compare its actual results with expected outcomes. It helps them track progress and make necessary changes to ensure that activities run efficiently.
2. Directly trace or estimate costs to activities and cost objects- Activity-Based Costing Process
Directly tracing or estimating the costs associated with an activity or cost object is critical in activity-based costing. By adequately tracking and estimating the costs associated with specific activities and cost objects, businesses can better understand their overall operational costs and make informed decisions about where to allocate resources.
Activity-based costing is a technique used by businesses to improve their understanding of their total operational costs. Businesses can more accurately estimate the costs associated with each operation by tracking specific activities and cost objects. This information can help to make informed decisions about where to allocate resources.
If done correctly, activity-based costing can provide businesses with a valuable tool for optimizing their operations. However, proper execution of activity-based costing could lead to accurate estimates and misguided decision-making. Therefore, it is vital that business owners carefully track all Costs associated with each activity to ensure accurate results.
3. Assign costs to activity pools- Activity-Based Costing Process
The third step in ABC is assigning costs to activity pools. This process helps businesses identify which activities are causing the most expenses and can then shift resources to those activities where they are most effective.
Businesses consider three main factors when assigning costs to activity pools: the level of participation, the type of resource used, and the total cost.
The level of participation is determined by how much involvement an activity has in creating a product or service. Activities with high levels of participation include design, engineering, and manufacturing. Low-level participation activities, such as accounting and marketing, have less impact on product creation and often require fewer resources.
The type of resource used is also essential when assigning costs to activity pools. There are three types of resources: human, physical, and software. Activity pools can come from the hours worked, the number of users, or the dollars spent.
When deciding which resource type to use, it is essential to consider the organization’s specific needs. For example, if an organization is a software company and its activities involve developing software, assigning costs based on hours worked rather than users would be better.
The total cost is crucial when assigning costs to activity pools in ABC. It is because it allows for accurate planning and budgeting of resources needed for the project. The total cost includes all the direct and indirect costs associated with the project, both short-term and long-term.
Short-term costs will be incurred within the next year or two, while long-term costs will extend beyond one year. Allocating costs to activity pools based on their total cost helps managers make informed decisions about allocating resources to the project most effectively.
4. Calculate activity cost drivers’ rates- Activity-Based Costing Process
The fourth step in Activity-based costing is calculating activity cost drivers’ rates. It involves understanding how different activities and costs are associated with specific products or services. The goal is to create a reasonable rate for each activity based on its associated costs.
Activity cost drivers can include such factors as employee hours worked, raw materials used, and production time. One must know the associated costs to create an accurate rate for each activity. This information can come from financial reports or data gathered from employee interviews. Once the costs are known, one can calculate the appropriate rate using a variety of formulas.
Activity-based costing is essential in creating a reasonable pricing strategy for products and services. Businesses can create rates that reflect actual costs by understanding how different activities and costs are associated with specific products or services.
5. Assign costs to cost objects- Activity-Based Costing Process
Most organizations use the fifth step of Activity-based costing (assign costs to cost objects) to better understand how activities are related to each other and how costs are associated with those activities. Exposing costs to cost objects allows for a more accurate understanding of a company’s resources and the ability to allocate them more efficiently.
When assigning Costs to Cost Objects, one should accurately define the cost objects to reflect all the associated costs. It can be difficult, as various departments may have different definitions of a “cost.” However, by working through a few iterations, organizations can create cost objects broadly representative of their spending habits.
6. Prepare reports- Activity-Based Costing Process
When a business adopts activity-based costing (ABC), it is crucial to understand the sixth step of ABC – preparing reports. Reports are essential in helping businesses make informed decisions about their resources and performance.
One of the most critical aspects of preparing reports is ensuring they are accurate and complete. It means gathering accurate data from all the relevant sources and compiling it into a coherent report. More accurate data can lead to accurate conclusions, ultimately impacting a business’s decision-making process.
It is also important to remember that reports are not just an academic exercise – they should be valuable tools that help management make informed decisions. It means ensuring that the reports are easy to read and understand and provide enough information to allow managers to make meaningful comparisons between different scenarios.
7. Act on the Information- Activity-Based Costing Process
This step allows companies to use that information to decide what to do next. Activity-based costing is a method for pricing products and services using activity data or information about the product or service usage. Activity-based costing aims to charge customers more accurately for the resources used in producing those products or services.
This last part of the process allows companies to use that information to decide what resources they should use next. For example, if a company knows that it produced 100 widgets last month and expects that number to increase by 10% this month, then Act on the Information would allow them to allocate ten widgets to production this month.
What exactly is meant by the term “activity cost driver”?
An activity that results in higher or lower variable costs for a company is referred to as a cost driver for that activity. Activity-based costing is a concept in managerial accounting associated with this phenomenon, also referred to as a causal factor on occasion (ABC).
Monitoring the factors contributing to an activity’s costs is essential because doing so can help a business improve its efficiency and bottom line.
The Mechanism Behind Activity-Based Cost Drivers
The amount that certain business activities end up costing is determined, in part, by a cost driver. An activity cost driver can affect the costs of labor, maintenance, and other variable costs in ABC. ABC is a subfield of managerial accounting concerned with allocating an activity’s indirect costs, also known as overheads. Cost drivers play an essential role in ABC.
There may be more than one factor contributing to the total costs of an activity. For instance, the number of hours spent directly on labor drives most activities during product manufacturing. If the amount of money spent on labor is high, this will increase the overall cost of producing any goods or providing any services the company offers.
If the price of warehousing is high, this will also increase the costs incurred when manufacturing products or providing services.
Machine hours, the number of engineering change orders, the number of customer contacts, the number of product returns, the machine setups required for production, or the number of inspections are some of the more technical cost drivers.
The true cost of production for the company can be estimated more precisely by the owner of the business if the owner can identify the factors that contribute to the production costs.
Cost Allocation- Activity-Based Costing (ABC)
When a piece of manufacturing equipment needs to be serviced at regular intervals, the costs of doing so are added to the prices of the goods created by that machine.
For instance, the number of hours spent operating machinery was chosen as the cost driver. A maintenance expense of $500 is incurred once every 1,000 machine hours after the meter has been run.
According to the cost driver of machine-hours, a maintenance cost of fifty cents (five hundred dollars divided by one thousand dollars) is consequently incurred by the product being manufactured for each machine hour.
A Breakdown of the Various Overhead Expenses- Activity-Based Costing (ABC)
Utilizing cost drivers makes the distribution of manufacturing overhead much more straightforward. To accurately calculate the price of a product, it is critical to appropriately assign the manufacturing overhead costs.
The prices of the products produced by internal management are determined by using the cost of the product as the basis. Because of this, the decision regarding which cost drivers to use directly affects the amount of money an organization makes and how it functions.
Breaking Down Activity Driver Analysis- Activity-Based Costing (ABC)
An ABC system acknowledges the connection between costs, overhead activities, and manufactured products.
As a result of this connection, an ABC system assigns indirect costs to products in a less arbitrary manner than the traditionally used methods. The term “activity driver analysis” refers to determining the various factors responsible for the costs associated with an activity.
Some factors that go into activity driver analysis are the causal relationships between drivers and the associated cost objects, whether specific drivers are simpler to measure, and whether particular activities are more expensive.
The ultimate benefit of conducting a driver analysis is that it enables management to evaluate alternative activity drivers that may be less expensive regarding machine hours, labor, materials, etc.
What exactly is a Cost Pool for Activities?- Activity-Based Costing (ABC)
An activity cost pool is an accumulation of all the costs related to the performance of a specific business activity, such as the production of a particular good. It is much simpler to obtain an accurate estimate of a specific task’s cost if those costs incurred in that task are pooled together.
An activity cost pool is a temporary account considering fixed and variable costs. Its sole purpose is to estimate how much money a particular activity costs a company.
Understanding an Activity Cost Pool- Activity-Based Costing (ABC)
Activity-based costing, or ABC, is commonly used to calculate production costs. ABC requires the use of activity cost pools. This technique allots fixed and variable costs, also known as overhead and indirect costs, to related products and services. As a result, a business can calculate the accurate cost of a product, a service, or a task using this technique.
Manufacturing is one industry that makes use of activity costs in various ways. A manager may be tasked with analyzing the costs of production associated with each product manufactured at a factory. ABC considers production to be comprised of many different activities, each with a cost.
For the production of a specific item, the “machine setup” activity might be one of the activities involved, and the cost of “machine setup” would be one of the costs included in an activity cost pool. A further cost that could be assigned to the pool is the cost of purchasing materials. The activity cost pool would consist of these costs and any others that may occur.
Assigning costs to ascertain the profitability of individual products correctly and, as a result, arriving at rational production decisions, particularly those that aim to improve efficiency and profit margins, is essential.
Activity-Based Costing vs. Traditional Costing- Activity-Based Costing (ABC)
The ABC method is distinct from more conventional pricing approaches. The traditional method of costing is based on products and periods. The materials, labor, and overhead expenses that make up the product-based costs are contrasted with the sales, general costs, and administration expenses that make up the period-based costs (SG&A).
These are deducted from the revenue for each period being accounted for. Some managers believe that assigning these costs to the production of products can result in inaccurate estimates, especially when a factory produces a wide variety of goods. Traditional costing and ABC would make comparable product cost estimates for a company selling only one type of good or service.
One of the benefits of using ABC is that it links production costs directly to activity costs. This is accomplished by doing away with the distinction between costs based on products and those based on periods.
In addition, under ABC, products are not allocated costs of unused capacity. The comparison between traditional costing methods and ABC provides insights related to areas of waste, underutilized capacity, and any other cost that does not directly support productivity, as well as the opportunity to make decisions regarding these insights.
Under traditional costing methods, some portion of purchasing costs might be assigned to a product regardless of how much actual purchasing activity was required.
ABC would seek to assess actual purchasing activity associated with a particular product. In addition, unused capacity may also be assigned to a product, resulting in a distorted price for that product.
ABC is not used only in manufacturing businesses. It may also be applied to service businesses.
Example of an Activity Cost Pool- Activity-Based Costing (ABC)
Shoe and Sons manufacture high-quality leather shoes. It is a family business of a few employees that creates handmade shoes. The company’s three primary facets are the production of the components that go into the boots, the research and development of new shoe designs, and the final assembly.
The price of making the shoes takes into account not only the cost of labor but also the rent for the factory, the price of the raw materials, and the price of the machines—the overall expenses for the month amount to $35,000 total.
After that, the total cost can be divided up among the various departments as activity cost pools according to what makes the most logical sense. For instance, the rent for the factory would not be included in the collection of costs for research and development because the research and development department would not be using space in the factory.
Shoe and Sons can better understand the origins of their costs thanks to the activity cost pool, enabling them to have better control over those costs.
Why Is ABC Important? Activity-Based Costing
Many manufacturers struggle with the question, “How can we improve our margins without increasing prices?” And they end up doing nothing.
To understand why activity-based costing (ABC) is so important to you and your business, you need to consider the value proposition you offer your customers. If you’re offering a tangible product or service, like a car or a house, you can easily calculate the cost of the item.
But you can’t calculate the cost similarly if you offer intangible items like advice, knowledge, and relationships. In these cases, you must rely on indirect customer satisfaction or retention metrics to measure your company’s value.
Activity-based costing (ABC) is a method that can help you track the costs associated with each stage of the value chain. It provides a way to measure the actual cost of an item or service. You can compare the cost of producing the same item in different locations.
The ABC method helps companies to understand the total cost of a product or service, including all the direct and indirect expenses associated with its production. Recognizing the actual cost of doing business is essential because you can’t afford to miss out on the opportunity to make money.
ABC provides a way to see what is happening behind the scenes. For example, it can help you to understand how much your marketing costs or how much you spend on customer satisfaction surveys.
How To Implement ABC Costing- Activity-Based Costing
You may miss out on value if you’re not using activity-based costing in your business.
The activity-based costing method is often called the ABC method. It can be applied to both large and small companies. The primary goal is to track the activities and the resources consumed within the business to calculate the value of each resource used. It is a way to measure costs in terms of time and effort rather than money.
You need to estimate costs using the resources required for various activities. So it is an excellent method to analyze your cost of doing business. It helps to ensure that all resources are being utilized most efficiently. ABC provides information on the amount of time and effort spent on various activities, which helps improve efficiency and performance.
Activity-based costing (ABC) is an inventory control methodology used to manage and control inventory costs. ABC differs from traditional inventory control methods in focusing on activity, not products. Instead of managing inventories based on units of the sold item, ABC is based on how items are used. For example, you can track how often you use a particular coffee pot and base your inventory on that.
1. Measure – Identify all of your costs and revenues associated with the project- Activity-Based Costing
When starting a project, you must first identify all the costs you will incur and the revenues you will gain. You should understand that every project has positive and negative aspects. By understanding the project, you can quickly determine which is profitable.
2. Analyze – Find out the different factors that contribute to the profitability of a particular project- Activity-Based Costing
When you analyze a project, you should find out how much it will cost to complete. You should change your plans to avoid paying so much if it is too high. You can save money if you hire the right professionals for the job.
3. Control – Make sure that you set realistic goals- Activity-Based Costing
Next is to make sure that you control your expenses. You must monitor your budget closely, especially your expenses. You must reduce your spending if you use your credit cards for your project. You should learn to control your expenditures. Remember, your project can only make money if you control your expenses.
4. Plan – Optimize the best use of your resources- Activity-Based Costing
Finally, the last step is to plan. You should plan how you will use your resources to achieve your goals. You can do this by setting up your budgets and making projections. If you plan carefully, then you should be able to meet your goals. You can even be successful if you have a minimal budget.
When planning a project, you should try to get the maximum possible output from each resource. For example, if you are getting a lot of information from a consultant, you should ensure that he will provide you with the most accurate information.
If he doesn’t, you should try to find another consultant who will. Once you have found the most efficient person, you should pay him as much as he deserves. If you pay too little, then he will be unproductive. On the other hand, if you pay too much, then he will quit the job.
Activity-based costing is an ABC is a methodology that assigns costs to activities based on their consumption of resources and a system that assigns costs to activities based on their consumption of resources. To implement activity-based costing effectively, managers must first identify the activities that are the most critical drivers of costs.
Once these activities have been identified, managers must assign cost drivers and allocate resources accordingly. By doing this, managers can ensure that activity-based costing is used effectively and efficiently within their organization.
Organizations face many challenges when implementing activity-based costing (ABC). It is a complex and detailed process, but it can effectively identify cost drivers and improve cost allocation.
There are a few key things to keep in mind when implementing ABC:
- Make sure you have accurate data. This is essential for any costing method but especially important for ABC since it relies on detailed information about activities and resource consumption.
- Work with all stakeholders to get buy-in and understand their needs. Implementation will be much smoother if everyone understands what ABC is and how it will be used.
- Be prepared to make changes to your current cost allocation methods. ABC can differ greatly from traditional costing methods, so you may need to adjust your accounting processes accordingly.
History of ABC Costing- Activity-Based Costing
The first ABC system was developed in the 1950s by Dr. James W. Parker, the chief accountant at a US Army laboratory in Texas.
Dr. Parker started identifying the top three critical elements in any business (A – Assets, B – Budget, C – Customers) to help leaders make better decisions in their businesses. He began the research by reviewing the history of the military, then used his findings to develop a simple framework to better structure decision-making processes in businesses. The ABC System is still widely used today.
The ABC Framework was initially called the Three-Dimensional Business Model, which organizes information to help executives make better decisions. Today, ABC is considered an essential tool for management accounting and decision-making. It is instrumental in complex organizations with multiple products and services and when allocating costs to specific activities or processes is needed.
ABC is considered a standard inventory control method. It’s also used in many industries, such as the food industry.
Requirements for Activity-Based Costing (ABC)
Activities are any events, units of work, or tasks with a specific goal, such as setting up machines for production, designing products, distributing finished goods, or operating machines. The ABC system of cost accounting is based on activities. Activities are what we refer to as cost objects because they consume overhead resources.
According to ABC, an activity can also be considered a transaction or event that is a cost driver if the system is being applied. When speaking of an allocation base, one may also refer to it as a cost driver, which is another name for an activity driver. Machine setups, requests for maintenance, amount of power consumed, purchase orders, quality inspections, and production orders are all examples of cost drivers.
There are two activity measures: transaction drivers, which involve counting the number of times an activity occurs, and duration drivers, which measure how long it takes for an activity to be finished. Both types of activity measures fall into the category of activity metrics.
The ABC system categorizes five general levels of activity that are, to some extent, unrelated to the number of units that are produced, as opposed to traditional cost measurement systems that depend on volume count, such as machine hours and/or direct labor hours, to allocate indirect or overhead costs to products. These traditional cost measurement systems include machine hours and/or direct labor hours.
The Advantages of Utilizing Activity-Based Costing (ABC)
The primary benefit of utilizing an activity-based costing system is determining the overhead costs of producing a product exhaustively and precisely. In addition, an ABC system can assist you in gaining a deeper comprehension of the following aspects of the production process:
The costing process is improved in three ways by using activity-based costing (ABC). To begin, it increases the total number of cost pools that may be employed during the process of assembling overhead costs. It pools costs according to activity rather than accumulating them all in a single pool that covers the whole company.
Second, it creates new bases for assigning overhead costs to items, allocating costs based on the activities that generate costs rather than on volume measures, such as machine hours or direct labor costs. This makes it possible for costs to be allocated based on the activities that generate costs.
Last but not least, ABC changes the nature of several indirect costs. This means that costs formerly considered indirect—such as depreciation, utilities, or salaries—can now be traced back to specific activities.
Alternately, ABC increases the unit cost of low-volume products by shifting overhead costs from higher-volume products to lower-volume products. This results in a higher total cost.
Comprehensive understanding of facility costs- Activity-Based Costing (ABC)
If a company uses an ABC system, it will be easier to comprehend all of the overhead costs associated with the production facility. This provides industry professionals with the ability to evaluate and contrast the costs related to production at a variety of different facilities. They can now make choices based on accurate information when selecting methods that will assist the company in saving money.
Insight into profitability- Activity-Based Costing (ABC)
Although most customer costs are associated with product costs, some overhead is also involved. For instance, if your company requires higher levels of customer service, if you need to handle product returns, or if you have a cooperative marketing agreement, ABC will assist you in determining costs and which customers are more profitable for your business.
Consequently, you may prioritize the clients who bring in the most revenue for your business while avoiding the less lucrative clients. You will also better understand the profit margins of the products you sell and reposition resources to earn the highest margins possible.
A clear look at distribution costs- Activity-Based Costing (ABC)
The internet, catalogs, retail stores, and distributors are typically some of the distribution and sales channels businesses use today. Other channels that may be used include wholesalers.
The costs associated with distribution channels are typically classified as overhead. An ABC system breaks down how much overhead each channel requires to make room for changes based on efficiency.
ABC system challenges- Activity-Based Costing (ABC)
Although activity-based costing has the potential to be a helpful tool, you will need to modify it to apply it to the analysis of decision-making within your organization. The following is a list of potential drawbacks associated with activity-based costing:
Pricey cost-pool maintenance- Activity-Based Costing (ABC)
A significant number of cost pools is necessary to operate an ABC system, which increases the system’s ongoing maintenance cost. To keep these costs under control, you should routinely assess the value of the information you receive concerning maintaining each cost pool.
Targeted at complex usage- Activity-Based Costing (ABC)
When dealing with complicated production costs, activity-based costing proves to be the most useful.
When a company has multiple lines of products, uses machines to manufacture various products, or frequently sets up machines, ABC can provide helpful information to the company. The ABC system might not be valid for businesses with relatively straightforward production procedures.
Lengthy installation time- Activity-Based Costing (ABC)
Installations of the activity-based costing system across large portions of an organization can take several years and require a significant amount of labor. Smaller facilities concentrating on a single product tend to achieve greater success.
Separate data sets- Activity-Based Costing (ABC)
The information available in a general ledger is typically insufficient for the requirements of an ABC system. In most cases, a separate database that contains data from a limited number of sources is required, which makes it challenging to maintain. The recommended course of action is constructing a system that can function with only a limited amount of additional data.
Multi-department data sources- Activity-Based Costing (ABC)
Suppose the information for the ABC system is required from only a few departments. In that case, there is a potentially more significant chance that the data will be inaccurate due to the competing priorities of those departments.
You can prevent this by designing your system only to require data from a limited number of sources and give you sufficient time to collect that data.
Unreliability in reporting time that was not used- Activity-Based Costing (ABC)
Employees will try to conceal any unused or wasted time they have spent at work, which can lead to inaccurate data regarding costs. When asked to report on the duration of the work activities they participated in, many people divide their entire day, even though it is doubtful that they worked every minute of the day. This could potentially impact costs, but it all depends on how many people you have working for you.
Outdated intelligence- Activity-Based Costing (ABC)
Activity-based costing is typically performed on a project-by-project basis, which means that professionals only need to collect data once.
However, because processes can evolve, the information may become less relevant. Suppose you can incorporate the collection of ABC data into an accounting system. In that case, this will guarantee that the information is accurate and easily accessible for any future requirements of the ABC system.
The most effective strategy for avoiding these problems is to devise a particular ABC system that primarily emphasizes collecting only the most relevant information. If the system proves successful, you can implement it gradually in other company parts.
Requirements For Activity-Based Costing
Activity-Based Costing (ABC) is a costing method that assigns a cost to each activity in an organization. The goal of ABC is to ensure that the costs associated with activities are accurately determined and that businesses use the right resources to accomplish the organization’s goals.
Organizations have widely adopted ABC because it is easier to understand and use than traditional costing methods, helps identify underutilized resources, and can help optimize management decisions.
Practical ABC has three basic requirements: 1) an accurate activity model, 2) accurate resource data, and 3) appropriate costing methodology.
Accurate activity model
The Accurate Activity Model (AAM) is a requirement for activity-based costing (ABC). The AAM is an internal control system that requires all entities to track the activity within their business consistently and reliably. This information now helps to calculate the costs associated with each activity.
Activity-based costing gives managers accurate and actionable information about how much it costs to produce goods and services. By tracking the specific activities within a company, managers can quickly identify areas of waste and improve efficiency. The AAM ensures that all relevant costs are accounted for, preventing inaccurate estimates from leading to higher costs.
Organizations that do not comply with the AAM risk inaccurate cost estimates and wasted resources. By adhering to this vital control system, businesses can ensure accurate financial reporting and improved decision-making.
Accurate resource data
One essential requirement of ABC is accurate resource data. This information must be accurate enough to help calculate the costs associated with specific activities. Resources can include physical assets, people, and software licenses. If resource data is inaccurate or incomplete, it will not help calculate costs and may lead to costly mistakes.
Therefore, accurate resource data is essential for conducting effective ABC planning. With it, planners may spend money on necessary or wasteful activities, leading to decreased efficiency and increased costs.
Appropriate costing methodology
Activity-Based Costing (ABC) is a widely accepted costing methodology that requires appropriate costing methods to produce accurate and reliable costs.
Appropriate costing methods consider all the relevant factors affecting a product’s cost, including the type of product, the complexity of the manufacturing process, and the number of units produced. ABC is one of several advanced costing methods that can help managers make more informed decisions about their businesses.
While not mandatory, using appropriate costing methods is a critical component of ABC. Correctly applying ABC can improve decision-making by providing managers with accurate information about how much it costs to produce different products or to carry out different business operations.
Activity-Based Costing- Frequently Asked Questions FAQ
When Is Activity-Based Costing Appropriate?
Activity-based costing is especially helpful for allocating indirect costs to items that are difficult to track and assign. This is because activity-based costing takes into account activities in their totality. The product overhead costing can be estimated more accurately, which is the primary benefit.
The most significant drawback, on the other hand, is the amount of time that is necessary to conduct an analysis and define activities and resources, as well as to reorganize the chart of accounts and establish activity-based costing.
Activity-based costing is advantageous to every sector of the economy. This becomes even more important as the proportion of your product costs attributable to direct labor decreases while the proportion attributable to overhead and administrative costs increases.
Activity-based costing suits various service-oriented activities, including product warranty and claims, engineering and design support, customer service operations, and maintenance operations.
What are the Pros and Cons of Traditional Costing?
When a company’s overhead expenses are relatively low in comparison to the direct costs of production, traditional costing is the method that should be used.
When the production volume is high, it generates reasonably accurate cost estimates. When calculating production costs, variations in overhead costs do not result in a significant divergence from the original estimate. Implementing traditional methods of costing requires very little financial outlay.
Most businesses use the conventional cost accounting method when reporting to outside parties because it is less complicated and more straightforward.
However, because overhead burden rates are arbitrary and applied equally to each product’s cost, it does not give managers an accurate picture of product costs. The costs of overhead activities are not evenly distributed across the products responsible for their consumption.
The traditional costing method best suits manufacturers producing relatively few distinct goods.
How Do You Assess The Business Impact Of Activity-Based Costing?
The impact of activity-based costing (ABC) can be measured easily. There are several ways to measure the ABC.
- See if it brings about efficiency in your operations.
- See if it helps improve your workforce’s productivity.
- To measure the ABC is to see if it improves customer service.
If you want to increase the efficiency of your operations, you should use ABC. If you want to improve the quality of your products, you should use ABC.
How to measure the ABC is to see if it brings about an increase in revenue.
ABC is significant to all businesses. It’s a method of measuring and evaluating the expenses of your business. ABC helps you determine the expenses you spend and the costs you incur. ABC tells you how much you need to spend and how much you can save.
ABC is a good tool that helps you analyze your operations’ results. It helps you to find where you are losing money and where you are gaining money. You should use ABC to make your business better.
ABC can help you to make your business more efficient. This is because it helps you to track your production process. You should use ABC to see if you get all the output you want from your business. If you have too many expenses, then you should reduce them. This is how ABC will help you to improve your company’s performance.
What challenges need to be considered when implementing activity-based costing?
When implementing activity-based costing, a few challenges need to be considered.
First, activity-based costing requires accurate activity data. This data can be challenging to obtain, and if it is not accurate, the results of the activity-based costing will not be accurate.
Second, activity-based costing assigns costs to activities rather than products or services. This can be difficult, mainly if the company produces various products or services. Finally, activity-based costing can be time-consuming and expensive to implement.
Another challenge is that activity-based costing can be time-consuming and expensive to set up. Businesses need to track many data points to assign costs to activities, which can be difficult and costly.
Another challenge is that activity-based costing can be complex, making it difficult for managers to understand and use the information correctly. Finally, activity-based costing can sometimes lead to distorted or inaccurate cost information if not used properly.
How can activity-based costing be used to improve cost management?
Activity-based costing (ABC) is a costing method that can be used to improve cost management. ABC allocates overhead costs to activities rather than products or services. This gives managers insight into each activity’s true cost and can help identify areas where costs can be reduced.
ABC has been shown to provide more accurate product costs than traditional costing methods and can help managers make better pricing decisions, product mix, and resource allocation. Implementing ABC can be challenging, but the benefits are well worth the effort.
For example, if ABC data shows that a particular activity costs more than anticipated, steps can be taken to reduce the cost of that activity. This could involve changing how the activity is performed, eliminating it altogether, or finding a less expensive way.
In addition, activity-based costing can pinpoint areas where products or services are overpriced. By understanding the full cost of each activity involved in producing a product or service, companies can ensure that they are not charging too much for their products or services.
Activity-based costing can be a helpful tool for improving cost management. However, it is crucial to understand that ABC is just one cost allocation method and is not always the most accurate. In some cases, other methods, such as traditional costing, may provide more accurate results.
What are some best practices for activity-based costing?
There is no one-size-fits-all answer to this question, as the best practices for activity-based costing will vary depending on the organization and industry. However, some general tips for implementing activity-based costing effectively include:
- Define cost drivers carefully: Cost drivers are the key factors impacting costs. Therefore, it is crucial to carefully select cost drivers that accurately reflect the organization’s activity levels.
- Allocate overhead costs appropriately: Once cost drivers have been identified, overhead costs can be allocated to individual products or services based on their use of those cost drivers. This ensures that each product or service bears its fair share of overhead costs.
- Use activity-based costing in conjunction with other cost accounting methods: While it can provide a more accurate picture of costs, it should be used with other cost accounting methods to understand an organization’s overall cost structure.
- Review activity-based costing periodically: As activity levels and cost drivers change over time, activity-based costing should be reviewed periodically to ensure that it still provides accurate information.
What are some common mistakes made when using activity-based costing?
- Not allocating overhead costs properly: One common mistake when using activity-based costing is not allocating overhead costs properly. This can lead to inaccurate costing of products and services and ultimately result in decisions that are not optimal for the company.
- Not considering all activity types: Another mistake that can be made when using activity-based costing is failing to consider all activity types. This can lead to inaccurate product costing and, ultimately, sub-optimal decision-making.
- Overlooking indirect costs: A third mistake that can be made when using activity-based costing is overlooking indirect costs. Indirect costs such as rent, utilities, and other general overhead costs can add up and should be considered when activity-based costing.
- Failing to update activity cost pools: A final mistake that can be made when using activity-based costing is failing to update activity cost pools. As activity levels change, so too should the activity cost pools. If these aren’t updated, then activity-based costing will again be inaccurate.
Activity-based costing can be an extremely useful tool, but it is vital to avoid these common mistakes to get the most accurate results.
10. How can activity-based costing be adapted to different business models and industries?
No one-size-fits-all answer exists to how activity-based costing can be adapted to different business models and industries. The approach must be tailored to the specific characteristics of the business in question. However, some general principles can be followed to ensure that activity-based costing is used effectively across different businesses.
Firstly, it is vital to understand the key cost drivers within the business and how they relate to the various activities. This information can be used to allocate costs more accurately using activity-based costing.
Secondly, activity-based costing should be applied consistently across all business areas to avoid discrepancies. Finally, monitoring the results of activity-based costing regularly and making any necessary adjustments to ensure that it continues to be an effective tool.
By following these general principles, activity-based costing can effectively adapt to different business models and industries. However, tailoring the approach to the business’s specific needs is always important.
How does activity-based costing compare to other cost allocation methods?
Activity-based costing (ABC) is a cost allocation method that assigns costs to activity centers. This approach, activity-based costing, first identifies the activity centers in an organization. It then assigns costs to each activity center based on the number of resources it uses. ABC contrasts with other cost allocation methods, such as traditional costing, which simply assigns costs to products or services based on a predetermined rate.
While ABC provides a more accurate picture of the true cost of goods and services, it can be difficult and costly to implement. As a result, organizations must carefully consider whether ABC is the best option for their particular needs. Activity-based costing has become increasingly popular as organizations seek to improve their cost management processes.
There are several advantages to activity-based costing. First, it provides a more accurate allocation of costs. This is because ABC considers all of the resources used in the production process, not just those easily measurable.
Second, ABC can help improve decision-making by providing managers with better information about the true cost of products and services. Finally, activity-based costing is flexible and can be adapted to changes in the business environment.
Despite these advantages, activity-based costing also has some disadvantages. First, it can be complex and time-consuming to implement. Second, activity-based costing requires detailed activity data, which can be difficult and costly. Finally, activity-based costing may lead to distorted product costs if activity levels are not well-aligned with demand.
Overall, activity-based costing is a more accurate and flexible cost allocation method than traditional costing. However, it can be complex to implement and requires detailed activity data. Organizations must weigh the benefits and challenges of activity-based costing before deciding whether it is the best option for their needs.
How Does ABC Help You? Activity-Based Costing
Activity-based costing helps your business in several ways.
1. You will be able to understand your costs better.
This way, you can save money and plan your budgeting better. For example, you can track your inventory to understand the cost of inventory. You can even find out which items are selling more than others. If you are making sales, you can track your expenses too to know if you are spending too much.
2. It helps your company to become more efficient.
It allows you to be organized and thus save time. A good organization will help you to get things done fast. With activity-based costing, you can track everything, making saving time easier.
Using ABC To Determine What You Need To Do To Improve Efficiency
Activity-based costing has helped many companies save money and improve the productivity of their workers. They can make better decisions about what products to purchase and the resources they need to spend.
This method uses activities, which are tasks performed by the workers, to calculate how much they cost the company.is an economic concept used to identify the value and effectiveness of an organization’s activities? It uses data about past business processes and costs to forecast future outcomes.
It requires developing an analysis examining the value of different organizational activities. This analysis is a handy tool to help you determine how much money you need to spend to generate additional revenues.
The process starts with determining how much money is spent on each activity. In addition to that, you also have to calculate how much additional revenue can be generated from each activity.
The costs can then be compared with the sales revenue, which can help the company decide if they are making the right decisions about what products to purchase and how much time they need to spend doing those activities.
The following are the steps involved in this method:
- Establish a standard set of costs for each activity. These standard costs will vary from one industry to another.
- Determine the cost of each product and each service used.
- Compare the standard costs with the cost of the products and services.
- Find ways to increase productivity.
- Analyze the results.
- Analyze whether or not the new process is working. Then, if you are satisfied with the results, you can continue implementing them in your company.
How are activity-based costing (ABC) and the Cost-Benefit Analysis related?
ABC is an accounting method used to determine the cost of doing business. It is very similar to the traditional accounting method used to calculate business costs. The main difference is that ABC calculates costs based on activities instead of products.
For example, suppose that you are creating a product called XYZ. You would have different costs associated with the creation of the product. These include the materials used to create the product, the salary of the people who created the product, the office space where the product was created, etc.
Suppose that the ABC method of calculating costs is used to calculate the XYZ production cost. Suppose further that the ABC system calculates the XYZ production cost as $5,000. What happened to the costs associated with the product?
You will find that the amount of money allocated to making the product is much smaller than the cost under the traditional accounting method. The cost of making the product under the ABC method is about half the amount allocated under the traditional method.
The ABC calculation method also compares the benefits of two or more alternatives. This is usually referred to as the Cost-Benefit Analysis. Suppose that you are building a new factory to produce products. Under the traditional accounting method, you would have to determine what it will cost to build the factory, the materials costs, and how much the factory will earn in revenue.
When you calculate the cost of production, you take all the expenses (costs) you incur to make a product and divide them by the number of units produced. The result is the Cost Per Unit (CPU). Now suppose you have two factories. Both are producing the same product. One uses traditional accounting methods, while the other uses the ABC method. Which one is better?
ABC And The Cost-Benefit Analysis
Every business owner wants to ensure that his business’s profit exceeds expenses. To do this, he needs to perform a Cost-Benefit Analysis. The Cost-Benefit Analysis is performed before starting a new business project. The Cost-Benefit Analysis includes a lot of different things.
First, you must analyze how much capital you will need for the business project. You also have to consider what type of business project you are starting. You will need to analyze the equipment and material you need to purchase. You will also need to look at the competition. You should be prepared to lose some sales because of the competition.
There are many other factors to think about when doing a Cost-Benefit Analysis.
Here are some of the most important ones:
- How does your company’s product compare with those in the same market?
- If you’re comparing your company’s product against a competitor’s, it’s essential to understand the strength and weaknesses of that competitor. This will help you make an informed decision about whether or not your product is better or worse than the competition. 3. How much does your company’s product cost compared to its competitors’ products?
When you finish your Cost-Benefit Analysis, you will know how profitable the business project is.
ABC And Profit Margin – Activity-Based Costing
Activity-based costing (ABC) is one method used to calculate a business’s profitability. It focuses on measuring the direct costs of doing business. ABC looks at how much the company spends to produce a particular product. Profit margin is a term that describes the amount left over after subtracting the costs of producing a particular product.
When using ABC, you should first identify the costs of producing a product. Then, you should calculate how much money was spent on producing the product.
Finally, you should subtract the costs from the product’s revenue. You will have the final profit margin once you have subtracted the cost from the revenue. This is the amount left over after the costs were deducted from the revenue.
You can use this calculation to analyze your company’s profit margin. To calculate your company’s profit margin, you must determine the total costs of producing your products or services. You will then calculate the total revenue from producing your product or service. After that, you will deduct the costs from the revenue.
A profit margin is the percentage of your company’s sales that you get paid for each product unit. Most companies pay their workers a small amount of money per unit sold. This is called gross profit. To make a profit, a company must sell more than it costs to produce each item.
This is called a net profit. The greater your profit margin, the bigger your profit. For example, Apple is the world’s largest manufacturer of mobile devices. Apple sells its products at a high price. Therefore, Apple has the highest profit margin in the world. It earns about 35% of its revenue. Apple makes more money than almost any other company.
If you do this, you will have a better understanding of what your company’s profit margin is.
A Practical Approach to Activity-Based Costing
In ABC, an organization’s overhead expenses, which include indirect expenditures such as lighting, heating, and marketing, are allotted to an activity in the same proportion as its direct costs. This method is an alternative to standard accounting.
This is unsatisfactory because two operations might consume significantly different amounts of overhead while absorbing the same amount of direct expenses.
For example, the labor and resources required to manufacture a mass-produced industrial robot might be comparable to that of a customized robot. However, the mass-produced robot requires far less work from the corporate engineers than the customized one, which is an additional overhead cost.
This distinction would not be represented in the pricing methods that are more traditionally used. As a result, a business that produces an increasing number of individualized goods (and that bases its prices on historical costings) may quickly discover that it is operating at a significant loss.
It is becoming increasingly crucial for businesses to appropriately allocate indirect expenses due to the proliferation of new technologies that make it simpler for companies to personalize the items they sell.
Implementing activity-based pricing is not straightforward; it is not as easy as counting to three. Every aspect of the company’s operations must be dissected into its parts to get started.
For example, a Swiss-Swedish power firm, ABB, used an ABC program that segmented its purchasing operation into activities such as negotiating with suppliers, updating the database, issuing purchase orders, and resolving complaints. This was done as part of ABB’s ABC program.
Before rolling out the technology throughout their organization, large companies should first test it via a pilot program. It is possible that the information necessary for ABC is not easily accessible and will be necessary to do unique calculations for the purpose.
This requires taking a substantial number of new measurements. Larger organizations frequently use the services of consultants who are experts in the field to assist them in putting a system into operation.
Using ABC software with a company’s already established accounting system is straightforward. The conventional method is being utilized just as it was in the past.
The ABC framework is being kept on hand as an optional resource for use when certain cost information is needed to facilitate the creation of a particular decision. Activity-based costing has become more practical because of the advent of software packages for business accounting, which has lowered the barrier to entry.
The implementation of an activity-based costing system is a pre-requisite for every program, including re-engineering as well as the improvement of business processes (see article). Additionally, many businesses use ABC data to fulfill the measurement requirements of a balanced scorecard (see article).
At the beginning of the 1980s, there was growing discontent with the old methods of allocating costs, partly responsible for the rise in popularity of activity-based costing. However, albeit off to a promising start, it had a period of falling into disgrace.
Even Robert Kaplan, a professor at Harvard Business School who is frequently regarded as the founding father of the concept, has recognized that it reached a plateau in the 1990s. (See related article.)
The challenge that needed to be overcome was putting the theory into practice. Many businesses did not accept ABC because they were unwilling to give up their more conventional cost management methods.
In 2007, Kaplan published a new book to make activity-based pricing more understandable and straightforward. It was known as TDABC (time-driven activity-based costing), and its goal was to establish a connection between the assessment of costs and the passage of time. According to Kaplan, the TDABC requires a response to the following two questions:
- How much does offering resources for each business process on a per-time-unit basis cost?
- How long does it take to accomplish the job necessary for a company’s goods, transactions, and customers?
Activity-Based Costing Approach – What It Is And How It Works – Recommended Reading
- Activity-Based Costing- An Introduction to the Key Concepts (benjaminwann.com)
- Activity-Based Costing- 7 Key Benefits (benjaminwann.com)
- Activity-Based Costing- Defined & Explained with Examples (benjaminwann.com)
- 10 Common Costing Methods – How to Choose One for Your Business
Updated: 5/20/2023
