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Activity-Based Costing, ABC Management.
How to Apply Traditional and Activity Based Costing, Steps, Results
Compared

 

Activity-based costing attempts to measure the costs of products and services more accurately than traditional cost accounting.

Companies move to Activity -Based Costing to better understand the true costs of goods and services.

What is Activity-Based Costing?

Activity-based costing ABC is a method for assigning costs to products, services projects, tasks, or acquisitions, based on:

  • The activities that go into them
  • Resources consumed by these activities

ABC contrasts with traditional costing (cost accounting), which sometimes assigns costs using somewhat arbitrary allocation percentages for overhead or the so-called indirect costs. As a result, ABC and traditional cost accounting can estimate the cost of goods sold and gross margin very differently for individual products. Contradictory and uncertain cost estimates can be a problem when management needs to know exactly which products are profitable and which are selling at a loss.

What Are the Benefits of ABC?

Cost accountants know that traditional cost accounting can hide or distort information on the costs of individual products and services—especially where local cost allocation rules misrepresent actual resource usage. As a result, the move to ABC usually motivated by a desire to understand the "true costs" of individual products and services more accurately. Companies implement activity-based costing to:

  • Identify specific products that are unprofitable.
  • Improve production process efficiency.
  • Price products appropriately, with the help of accurate product cost information.
  • Reveal unnecessary costs that become targets for elimination.

Firms that use ABC consistently to pursue these objectives are practicing activity-based management ABM.

ABC Impacts the Same Accounts, But With Different Mathematics

Note that the purpose of ABC is to provide information for decision support and planning. ABC by itself usually has little or no impact on the structure of the firm's financial accounting reports (Income statement, Balance sheet, or Cash flow statement). This impact is minimal because both ABC and traditional costing ultimately assign costs to the same existing accounts. The two approaches merely use different mathematics to do so.

Note especially, however, that ABC sometimes brings improvements in reported margins and profitability. These outcomes follow when ABC reveals unnecessary or inflated costs, or when ABC shows where to adjust pricing models, workflow process, or the product mix.

Explaining Activity-Based Costing in Context

This article further defines, describes, and illustrates activity-based costing using example calculations to contrast ABC with traditional cost accounting. Examples appear in context with related terms from the fields of budgeting, cost accounting, and financial accounting.

Contents

Related Topics

  • For the accountant's role in assigning cost figures, see the article Accountant.
  • The article Cost Object defines and explains the term "cost object."
  • The article Direct and Indirect Labor Costs further explains the role of these terms in traditional cost accounting.

Why Do Companies and Organizations Move to ABC?
What are the Reasons for Using Activity-Based Costing?

The deisre to imrprove costing accuracy moves business people to adopt ABC, mainly to get closer to the true cost and true profitability of individual products and services. THey move to activity based costing for the same reasons to understand better the true costs and return on investment from projects, programs, or other initiatives. 

ABC pursues these objectives essentially by making direct costs out of many of the expenses that traditional cost accounting treats as indirect costs. Examples below show how ABC does this.

Organizations that use ABC consistently and effectively are said to practice activity-based management (ABM). Here, managers turn to ABC to support decisions about pricing, adding or deleting items from the product portfolio, choosing between outsourcing and in-house production, and evaluating process improvement initiatives. For more on ABM, see the section below "What is activity-based management?"

The percentage of organizations currently using activity-based costing varies significantly from industry to industry. Various surveys in the period 2012-2018 report the highest rate of firms using ABC in manufacturing (20%-50%), followed by financial services (15-25%), public sector (12-18%), and communications (6-12%).

Activity-Based Costing vs. Traditional Cost Accounting
What Are the Differences? Do They Lead to Different Costing Results?

The different approaches and outcomes from ABC and traditional costing are most accessible for illustration in the context of a product manufacturing example. However, the principles appearing here extend readily to a wide range of other business settings.

Example: Traditional Cost Accounting vs. ABC

For example, consider a firm that manufactures automobile parts through a sequence of machine operations on a metal stock. In such settings, traditional cost accounting views "product production costs" as either direct costs or indirect costs (or overhead).

Example Sources of Direct Costs

Traditionally, direct costs for such firms are costs they can assign to specific product units. In product manufacturing, these might include direct materials and direct labor costs:

  • Direct labor costs.
    These can include the cost for person minutes or person-hours per product unit for running production machines.
  • Direct materials.
    Direct materials costs might include costs per product unit for metal stock, fasteners, and lubricants. 

Example Sources of Indirect Costs

Traditionally, indirect costs for such firms are manufacturing overhead expenses they cannot assign directly to specific product units. Instead, they allocate these costs to specific production runs, batches, or time periods. These might include indirect costs such as the following:

  • Materials purchase order costs
    Firms typically do not order materials for each product unit, but instead, for entire batch runs. They may also order supplies to cover a specific timespan.
  • Machine set up costs.
    Manufacturing firms do not set up production machines for each product unit. They are set up instead for the production run of each product model.
  • Product packaging costs.
    Manufacturers can sometimes package multiple product units in a single package. And, they may fill numerous packages in a single packaging run.
  • Machine testing and calibration costs.
    Manufacturing firms perform these operations regularly and often, but not for each product unit.
  • Machine maintenance and cleaning costs.
    Firms usually perform these operations only after producing multiple product units. 

Product Specific Cost Sources

For this example, consider a firm that manufactures and sells two product models, Model A and Model B. Some aspects of A and B compare as shown in Table 1:

Products Compared Product A Product B
   Selling Price Higher price Lower price
   Materials purchased More materials purchase orders, smaller orders Fewer materials purchase orders, larger orders
   Production Runs More production runs, smaller runs Fewer production runs, larger runs
  Mach. Setups More machine setups Fewer machine setups
  Packaging 1 Unit per package 4 Units per package
  Direct labor More direct labor required Less direct labor required
  Direct  materials Higher direct materials cost Lower direct materials cost
 Table 1.  Product A and Product B compared.

Direct Costs Are the Same in Traditional and Activity-Based Costing

Management must estimate the profitability of each product to decide which products to produce and sell and how to price them. These estimates, in turn, require an understanding of the full cost per unit of each product. While the direct costs per unit are easy to find, the indirect costs are less noticeable. As a result, the firm will have to uncover indirect product costs through a costing methodology—either traditional cost allocation or activity-based costing. 

Direct costs are the same under both traditional costing and ABC. For direct costs, accountants measure a product unit cost for each direct cost category. The two costing methods differ, however, in the way they assign values to so-called indirect costs for products. Consequently, the two costing approaches sometimes give entirely different pictures of the profitability of individual products. 

How to Apply Traditional Costing for Direct and Indirect Costs
Calculate Per-Unit Direct Costs, Indirect Costs, and Margins in 5 Steps

In one accounting period, the firm produces and sells 900,000 units of product A at $3.00 each and 2,100,000 units of product B at $2.00 each. Cost accountants will apply traditional costing methods to find total production costs per unit, as well as gross profit margins per unit.

Product unit costs are the sum of direct costs and indirect costs.

Traditional Costing: Direct Costs
Traditional Costing Steps 1 – 3

Traditional Costing Step 1. Find Total Direct Costs

For this example, product manufacturing direct costs cosist ot direct labor costs and direct materials cost.

Traditional Costing Step 1A. Find Total Direct Labor Cost for Each Product

The firm's accounting system carries general ledger T-accounts for each product's direct labor costs. For one accounting period, these costs are:

Product A direct labor: $450,000&     Product B direct labor: $1,050,000

Traditional Costing Step 1B Find Total Direct Materials Cost for Each Product.

The accounting system also carries accounts for each product's direct materials costs. The ledger shows these direct materials costs for the period:

Product A direct labor: $450,000     Product B direct labor: $1,050,000

Traditional Costing Step 2. Find Direct Costs Per Unit

The Manufacturing organization provides product unit counts. For the current period:

Product A: 900,000 units      Product B 2,100,000 units

Traditional Costing Step 2A. Find Each Product's Direct Labor Cost per Unit

Product A Direct labor per unit: $450,000 / 900,000 = $0.50 / unit
Product B Direct labor per unit: $1,050,000 / 2,100,000 = $0.50 / unit

Traditional Costing Step 2B Find Each Product's Direct Materials Cost per Unit

Product A direct materials per unit $675,000 / 900,000 = $0.75 / unit
Product B direct materials per unit: $1,050,00 / 2,100,000 = $0.50 / unit

Traditional Costing Step 3. Find Each Product's Total Direct Costs Per Unit

Product A Direct costs per unit calculate as $0.70 + $0.50 = $1.25 / unit
Product B Direct costs per unit: $0.50 + $0.50 = $1.00 / unit

Direct Cost Summary, Traditional Costing

 Table 2 below shows the resulting direct costs for these sales, along with the given per unit sales revenues:

Products Compared Product A Product B Total
1. Units produced & sold 900,000 2,100,000 3,000,000
2. Selling price/unit $3.00 $2.00  
3. Direct labor cost/unit $50.0 $0.50
4. Direct materials cost/unit $0.75 $0.50
5. Sales revenues 
[ = 1 * 2 ]
$2,700,000 $4,200,000 $6,900,000
Direct costs
6. Direct labor costs
[ = 1 * 3 ]
$450,000 $1,050,000 $1,500,000
7. Direct materials costs
 [ = 1 * 4 ]
$675,000 $1,050,000 $1,725,000
8. Total Direct costs
[ = 6 + 7 ]
$1,125,000 $2,100,000 $3,225,000
 Table 2. Sales revenues and direct costs for Products A and B

Traditional Costing: Indirect or Overhead Costs
Traditional Costing Steps 4 – 5

The company's cost accountants will also find cost totals for the period's production support activities. In traditional cost accounting, these are overhead or indirect costs, as Table 3 shows. 

     Indirect Components

Prod. A & B Indirect % of Total Indirect
Materials purchasing $180,000 12.6%
Machine setups $375,000 26.4%
Product packaging $280,000 19.7%
Machine testing & calibration $300,000 21.1%
Machine maintenance & cleaning $287,000 20.2%
Total Indirect      $1,422,500 100.0%
 Table 3. Indirect cost components for Traditional Costing

The simple form of traditional cost accounting appearing here uses only the Total Indirect cost line from Table 3. Traditionally, firms allocate this cost total to each product, A or B, based on proportional usage of a given resource. The resource chosen for this purpose is usually one of the direct cost items. Note especially that this approach is also called production volume based (PVB) cost allocation, for obvious reasons.

Under PVB cost allocation, accountants allocate (apportion) the total indirect cost to Products A and B based on factors such as the proportion of the total:

  • Production machine time used by each product.
  • Direct labor costs used by each product.
  • Factory floor space used by each product.

Other factors may also apply. For this example, the firm's accountants chose to allocate indirect costs referring to direct labor costs.

Traditional Costing Step 4. Use Allocation to Calculate Indirect Labor Costs 

The indirect cost total from Table 3 above is $1,422,500. The direct labor total (line 6 from Table 1) is $1,500,000. From these figures, the firm allocates indirect labor cost to each product as a percentage of the product's own direct labor cost:

Traditional Costing Step 4A. Find Total Indirect Labor Costs as a Proportion of Total Direct Labor Costs

Indirect labor cost / direct labor cost proportion:
        = $1,422,500 / $1,500,000 
        = 0.948 = 94.8%

  • For product A, Direct labor costs are $450,00  (Table 2, line 6). The indirect cost allocation for A is therefore 94.8% of this, or $426,750.
  • For product B, Direct labor costs are $1,050,000  (Table 2, line 6). The indirect cost allocation for B is therefore 94.8% of this, or $995,750.

Table 4, below, shows how this allocation produces indirect cost estimates per unit. And, the table also shows the conventional costing solutions for gross profit and gross margin for each product unit.

     Products Compared

Product A Product B Total
9. Units produced and sold
[Table 2, line 1]
900,000 2,100,000 3,000,000
10. Total direct costs
[Table 2, line 8]
$1,125,000 $2,100,000 $3,225,000
11. Total indirect costs
[allocation shown above]
$426,750 $995,750 $1,422,500
12. Revenues per unit
[Table 2, line 2 ]
$3.00 $2.00  
13. Direct costs/unit
[ = 10 / 9 ]
$1.25 $1.00
14. Indirect costs/unit
[ = 11 / 9 ]
$0.47 $0.47
15. Gross profit/unit
[ = 12 − 13 − 14 ]
$1.28 $0.53
16. Gross profit margin
[ = 15 / 12 ]
42.5% 26.3%
 Table 4. Gross profit and gross margin calculation for each product, using
 traditional cost accounting approaches for indirect costs.

Traditional Costing Step 4B. Find Indirect Cost Per Unit

Estimated Indirect cost per unit is the same for both products, $0.47 (Table 4, line 14). These two indirect costs must be equal because both products use the same allocation rate (94.8%) applied to direct labor costs, based on the same direct labor rate ($0.50/unit).

Traditional Costing Step 5. Find Product Cost Per Unit and Margin Per Unit

On a per unit basis, this traditional costing finds Product A more profitable than product B. For this comparison, see Line 16 of Table 4, above: The gross margin rate of 42.5% for Product A compares with a gross margin of 26.3% for Product B.

How to Apply Activity-Based Costing for Direct and Indirect Costs
Example Calculations, Product Margins, and Costing Results




This section presents an ABC version of the same product costing situation. The example shows how ABC and traditional costing can yield different indirect cost estimates for the same products. This means the two approaches can also estimate profitability differently. Finally, the example shows that ABC requires more data and more detailed analysis than the traditional PVB allocation approach.

Activity-Based Costing: Direct Costs
ABC Steps 1 – 3

ABC costing for products A and B begins with the starting data appearing above for the traditional costing example. Data for starting the Abc analysis include:

  • Units produced and sold.
  • Sales revenues.
  • Direct costs.

The ABC example, therefore, begins with Table 5 (an exact copy of Table 2 above).

Products Compared Product A Product B Total
1. Units produced & sold 900,000 2,100,000 3,000,000
2. Selling price/unit $3.00 $2.00  
3. Direct labor cost/unit $50.0 $0.50
4. Direct materials cost/unit $0.75 $0.50
5. Sales revenues 
[ = 1 * 2 ]
$2,700,000 $4,200,000 $6,900,000
Direct costs
6. Direct labor costs
[ = 1 * 3 ]
$450,000 $1,050,000 $1,500,000
7. Direct materials costs
 [ = 1 * 4 ]
$675,000 $1,050,000 $1,725,000
8. Total Direct costs
[ = 6 + 7 ]
$1,125,000 $2,100,000 $3,225,000
 Table 5. Sales revenues and direct costs for Products A and B. Table 5 is identical to Table 2, above.

ABC Step 1. Find Total Direct Costs

In this ABC example, as well, Prroduct manufacturing direct costs cosist ot direct labor costs and direct materials cost.

ABC Step 1A. Find Total Direct Labor Cost for Each Product

From the firm's general ledger accounts, these costs for the period are:

Product A direct labor: $450,000     Product B direct labor: $1,050,000

ABC Step 1B Find Total Direct Materials Cost for Each Product.

The ledger shows these direct materials costs for the period:

Product A direct labor: $450,000     Product B direct labor: $1,050,000

ABC Step 2. Find Direct Costs Per Unit

The Manufacturing organization provides these product unit counts for the period:

Product A: 900,000 units      Product B 2,100,000 units

ABC Step 2A. Find Each Product's Direct Labor Cost per Unit

Product A Direct labor per unit: $450,000 / 900,000 = $0.50 / unit
Product B Direct labor per unit: $1,050,000 / 2,100,000 = $0.50 / unit

ABC Step 2B Find Each Product's Direct Materials Cost per Unit

Product A direct materials per unit $675,000 / 900,000 = $0.75 / unit
Product B direct materials per unit: $1,050,00 / 2,100,000 = $0.50 / unit

ABC Step 3. Find Each Product's Total Direct Costs Per Unit

Product A Direct costs per unit calculate as $0.70 + $0.50 = $1.25 / unit
Product B Direct costs per unit: $0.50 + $0.50 = $1.00 / unit

Direct Cost Summary, Activity Based Costing

 Table 5 above summarizes direct costs for these product sales, along with the given per unit sales revenues

Activity-Based Costing: Indirect or Overhead Costs
ABC Steps 4 – 6

In ABC, analysts view the "indirect" or "overhead" cost contributors as activity pools.

Activity Pool Definition:

Under activity-based costing, an activity pool is the set of all activities necessary for compling a task, such as (a) processing purchase orders, or (2) performing machine setups.

To cost  activity pools, ABC identifies activity units that are cost drivers for each pool. The total cost of for the activity pool "processing purchase orders," for instance, is driven by the number of purchase orders processed, while the total cost for activity pool "performing machine setups" is driven by the number of setups.

ABC Step 4. Identify the indirect or Overhead Activity Pools, Cost Drivers, and Unit Costs. Complete Stage 1 Allocation (Batch Level Allocation)

ABC Step 4A. Identify Activity Pools, Their Cost drivers (DCs), and Unit Cost

Tables 6 A and 6B, below, list 5 Indirect or Overhead Activity Pools in producing each product unit, their cost drivers (CDs), and per-unit cost for each activity pool. One machine set up, for instance, irequire $1,500 in labor, materials, energy, and other resources.

  • Act. Pool: Purchase orders. CD: Number of POs. CD Unit Cost: $1,800.
  • Act. Pool: Machine setup CD: Number of setups. CD Unit Cost: $1,500
  • Act. Pool: Product pacaging. CD: Number packed. CD Unit Cost: $0.20
  • Act. Pool: Machine test & calibration. CD: Number of tests. CD Unit Cost: $100
  • Activity Pool: Maint. & cleaning CD: Number of batch runs. CD Unit Cost: $1,150

ABC Step 4B. Calculate Activity Pool Costs for Each Product

Table 6A, moreover, shows the number of CD units (activity units) used for product A, while Table 6B shows these figures for product B. From the given cost of each CD unit, calculate the total cost for each activity pool, for each product.

For example, the Activity Pool "Purchase Orders" has a Cost Driver unit cost of $1,800. Product required 75 CD units for this activity. Total Product A indirect cost for this activity pool is thus

      (75)($1,800) = $135,000 

Completing these calculations completes Step 4, ABC Stage 1 Allocation (Batch Level Allocation). Tables 6A and 6B summarize Step 4 data and calculations. 

Product A: Activity Units, Activity Pools, and Cost Drivers

     Activity Pool

Cost Driver (CD)
Activity Units
CD
Unit Cost
Total Activity
Product A
Total Indirect
Cost  (A)
17. Purchase ordersNo of purchase orders$1,80075$135,000
18. Machine setups No of setups$1,500150$225,000
19. Product packagingNo of product
packages packed
$0.20900,000$180,000
20. Machine testing
& calibration
No of tests$1001,000$100,000
21. Maintenance 
& cleaning
No of batch runs$1,150200$230,000
Total$870,000
Table 6A. ABC Stage-1 allocation (batch level allocation) for product A: Activity pools, cost drivers, cost per cost driver unit, and the total cost for these activities.

Product B: Activity Units, Activity Pools, and Cost Drivers 

     Activity Pool

Cost Driver (CD)CD
Unit Cost
Total Activity
Product B
Total Indirect
Cost  (B)
17. Purchase ordersNo of purchase orders$1,80025$45,000
18. Machine setupsNo of setups$1,500100$150,000
19. Product  packagingNo of product
packages packed
$0.20500,000$100,000
20. Machine testing
& calibration
No of tests$1002,000$200,000
21. Maintenance  
& cleaning
No of batch runs$1,15050$57,500
Total $552,500

Table 6B. ABC Stage-1 allocation (batch level allocation) for Product B: Activity pools, cost drivers, cost per cost driver unit, and the total cost for these activities.

ABC Step 5. Find Per-Unit Indirect Costs for Each Product. This is Stage 2 Allocation (Product Level Allocation).

When each product's activity pool cost totals, the analyst can then calculate the cost per product unit, as Table 6C shows.

To find product unit costs, the analyst divide the activity pool cost totals by the number of product units. From Table 5, Line 1, the firm produced 900,000 units of Product A and 2,100,000 of Product B. With these figures, the analyst calculates per-product unit costs that appear in the third and fifth columns of Table 6C. For example:

For the activity pool " Purchase orders" (line 17 of Table 6C):

Product A Cost per Product Unit = $135,000 / 900,000 = $0.15
Product B Cost per Product Unit = $45,000 / 2,100,000 = $0.02

Stage 2 Allocation in ABC: Allocating Activity Pools to Product Units

     Activity Pool

Total Indirect Cost
Product A
[From Table 6A]
Cost per product unit
Product A
Total Indirect cost Product B
[From Table 6B]
Cost per product unit
Product A
Total indirect cost
A+B
17. Purchase orders$135,000$0.15$45,000$0.02$180,000
18. Machine setups$225,000$0.25$150,000$0.07$150,000
19. Product packaging$180,000$0.20$100,000$0.05$280,000
20. Machine testing
& calibration
$100,000$0.11$200,000$0.09$300,000
21. Maintenance  
& cleaning
$230,000$0.26$57,500$0.03$57,500
Total  $870,000$0.97$552,500$0.26$1,422,500
Table6C. Stage-2 allocation in ABC: Allocating activity pool costs to individual product units. The cost per product unit figures for product A and product B (second and fourth columns) derive d from the cost sums for each activity pool (first and third columns) divided by the number of product units produced and sold for each product (Table 2, line 1).

The total product unit costs for each product corresponding to the total indirect costs for each product from the traditional costing approach.

ABC Step 6. Calculate Profitability for Individual Products

Table 7 below shows how these costs contribute to the new ABC version of profitability for each product.

     Products Compared

Product A Product B Total
22. Units produced and 
sold  [Table 5, line 1]
900,000 2,100,000 3,000,000
23. Total direct costs
[Table 5, line 8]
$1,125,000 $2,100,000 $3,225,000
24. Total overhead costs
[Table 6C, bottom line total ]
$870,000 $552,500 $1,422,500
25. Revenues per unit
[ Table 5 line 2 ]
$3.00 $2.00  
26. Direct costs/unit
[ = 23 / 22 ]
$1.25 $1.00
27. Overhead costs/unit
[ = 24 / 22 ]
$0.97 $0.26
28. Gross profit/unit
[ = 25 −26 − 27 ]
$0.78 $0.26
29. Gross profit margin
[ = 28 / 25 ]
26.1% 36.8%
Table 7. Gross profit and gross margin calculation for each product, using activity-based costing for indirect, or overhead costs.

Conclusions: Activity-Based Costing Example.

  • ABC finds different indirect (overhead) costs per unit for each product. ABC results are thus unlike the traditional costing example above, where indirect costs per unit were the same for both products.
  • ABC analysis recognizes that product A uses more activity pool resources than product B.
  • On a per unit basis, ABC finds product B more profitable than product A. The gross margin rate of 36.8% for B compares with a gross margin of 26.1% for A.

Comparing ABC and Traditional Costing
Advantages and Disadvantages to Each Approach

Costing Results from Two Approaches

Table 8 below shows the per-unit profitability estimates for each product from the examples above.

     Product Profitability (Gross Profit Margin)

Product A Product B
Traditional cost allocation
(Production volume based allocating)
42.5% 26.3%
Activity-based costing approach 26.1% 36.8%
Table8. Comparing profitability estimates from two different costing methods. Traditional costing shows product A more profitable than product B. ABC based costing shows the reverse. These differences result from the different treatment of overhead costs.

Key Differences Between Costing Methods

The tables and examples above illustrate some critical differences between the costing methods:

Data and Analysis

  • Activity-based costing requires detailed knowledge of the activities and resources that go into overhead (or "indirect") support work.  
  •  Traditional cost accounting (production volume based allocation) requires only a total overhead cost and a simple allocation rule.

Overhead Components and Products: Differentiation vs. Aggregation

  • ABC recognizes that individual overhead components can be distributed differently for different products. One product may consume relatively more maintenance resources, for instance, while another product may consume relatively fewer maintenance resources, but relatively more for machine set up.
  • Traditional cost accounting typically puts "overhead" components into fewer categories, or even a single class, and uses a single allocation rate for all products. 

Direct vs. indirect measurement

  • Activity-based costing treats overhead costs essentially as direct costs, in that cost estimates reflect actual cost driver usage for each product. These costs, in turn, can be reasonably be apportioned to individual product units.
  • In traditional cost accounting (production volume based allocation), an accurate measure of total overhead cost is accessible. However, in conventional costing the distribution of that total to individual products is based on an indirect measure of that cost.

Costing Accuracy vs. the Cost of Costing

For the profitability figures appearing in Table 7 above, the activity-based costing results may be taken as the more accurate results—more closely reflecting the "true" production costs of products A and B—than the profitability figures from the traditional costing approach. Whether or not the improved accuracy justifies the higher expense of applying this costing method, however, is something management will have to investigate and answer before committing to a comprehensive new approach to cost accounting.

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