Cost Management and Impact on Productivity of Firm

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An enterprise is considered as one of instruments to provide benefit for local economic development. For instance, companies create job opportunity, contribute taxes, provide facilities and infrastructures to society and offer benefit to the investors in form of capital gain, dividend and interest.

However, enterprises contribute negative impact on society which called externalities. To illustrate this, pollution, waste, noise and discrimination are as examples. In order to prevent this impact on environment which will cause high social cost, a control is required.

A company is responsible to manage its environment. A proper environmental quality management requires relatively high investment which called environmental cost. For instance, a company invests on equipments which filter and dispose waste from factory.

Based on illustration above, an enterprise should be able to manage environmental cost optimally and creates a quality environment which is free from pollution and at the same time produces costumer value products. Customer value could be created if the company provides competitive price and maintain the quality which meets customer satisfaction. To obtain optimum profit with certain quality require optimum product costs. One of these is environmental cost.

The environmental cost will increase product cost and also impact on productivity and profitability of the company. Environmental cost is environmental management activity cost which has strategic position in cost structure. Thus, this expenditure should be well managed so that the company could be able to improve its productivity and profitability.

There are four main problems and questions to discuss in this essay, they are:

What is environmental cost concept?

What is the impact of environmental cost on productivity?

What is the impact of environmental cost on profitability?

How to analyze environmental activity cost management?

Environmental Cost Concept

Definition of Environmental Quality Cost

An Enterprise in one side should produce customer valued product which satisfy customer need. On another hand, a company is responsible for the environment damage which caused by its business activities. The responsible of an enterprise to produce customer valued product and at the same time maintain the environment called Eco-efficiency.

Eco-efficiency is achieved by the delivery of competitively-price goods and services that satisfy human needs and bring quality of life, while progressively reducing ecological impact and resource intensity throughout the life-cycle to level at least in line with the earth estimated carrying capacity. In short, it is concerned with creating more value with less impact. [1] 

Eco-efficiency essentially maintains that organizations can produce more useful goods and services while simultaneously reducing negative environmental impacts, resource consumption, and costs. [2] 

In practice, eco-efficiency is achieved through the pursuit of three objectives: 

Increasing product or service value;

Optimizing the use of resources; and,

Reducing environmental impact. [3] 

ISO 14001 defines the environment as surroundings in which an organization operates, including air, water, land, natural resources, flora, fauna, humans and their interrelation. [4] This means that environment is ecosystem where the company operates and interacts to each other.

An enterprise has an obligation to create a quality environment. A quality product is that a product which complies its specification and meets customer satisfaction. This product quality in relation with environmental quality means that environmental quality fulfills ecosystem expectation where the company operates. The requirement from the ecosystem is that products and services which produced by an enterprise will not destruct surrounding environment. This means that an enterprise obligates to minimize environmental damage or extremely zero damage to environment or implements total environmental quality.

Damage is defined as direct degradation of the environment, such as the emission of the solid, liquid or gaseous residues into the environment (e.g. water contamination and air pollution) or indirect degradation such as unnecessary usage of materials and energy (Hansen and Mowen, 2005).

In order to create environmental quality, a company invests relatively high which called environmental costs. Environmental costs are that are incurred because poor environmental quality exists or because poor environmental quality may exist. Thus environmental costs are associated with creation, detection, remediation and prevention of environmental degradation (Hansen and Mowen, 2005).

Hence, environmental costs are costs which are incurred to perform ecosystem requisite in company environs. To illustrate this, an enterprise expends money to recover air, water, and soil pollution and natural resources affected by company waste which impact on surrounding biotic life, such as human, flora and fauna.

Classification of Environmental Costs

Based on definition of environmental costs above, classification of environmental costs is the same as classification of quality costs. Environmental costs can be classified in four categories: prevention costs, detection costs, internal failure costs, and external failure costs (Hansen and Mowen, 2005).

Prevention Cost

Environmental prevention costs are the costs of activities carried out to prevent the production of contamination and/or waste that could damage to the environment (Hansen and Mowen, 2005). This means that environmental costs are incurred to avoid the creation of pollution by particular prevention activities, such as: evaluating and selecting suppliers, evaluating and maintaining of equipments and/or machinery to control contamination, process and product designing to minimize or eliminate waste, training workforce, analyzing of environmental impact, environmental risk auditing, environmental research, developing environmental management system and certifying ISO 14001.

Detection Cost

Environmental detection costs are the costs of activities executed to determine if products, processes, and other activities within the firm are in compliance with appropriate environmental standards (Hansen and Mowen, 2005). This means that the expenses are incurred in order to detect any activities which related to business actions comply with environmental standards. There are some environmental standards of the firms: government regulations, voluntary standard (ISO 14001) and internal company regulations. Activities related to environmental detection within the firms are auditing environmental activities, inspecting products and processes, developing environmental performance measures, testing for contamination, verifying supplier environmental performance, measuring contamination level (Hansen and Mowen, 2005).

Internal Failure Cost

Environmental internal failure costs are the costs of activities performed because contaminants and waste have been produced but not discharged into the environment. Thus, internal failure costs are incurred to eliminate and manage contaminants or waste once produced (Hansen and Mowen, 2005). This means that internal failure costs are incurred in order to minimize or to eliminate contaminants and waste which produced to avoid environmental damage. These expenses are to ensure that contaminants and waste will not be disposed into the environment or to minimize contamination level not exceed environmental standards. Activities related to environmental internal failure are operating pollution control equipment, treating and disposing of toxic waste, maintaining pollution equipment, licensing facilities for producing contaminants and recycling scrap (Hansen and Mowen, 2005).

External Failure Cost

Environmental external failure costs are the costs of activities performed after discharging contaminants and waste into the environment. External failure costs can be subdivided into realized and unrealized categories (Hansen and Mowen, 2005).

Realized external failure costs are those incurred and paid for by the firm. For instance, costs to clean a lake and soil which has been polluted, personal accident claim and lost of sales due to bad environmental reputation.

Unrealized external failure (societal) costs are caused by the firm but are incurred and paid for by parties outside the firm. These costs are divided into 2: environmental degradation costs and the costs related to negative impact on society property or welfare. For instance, costs for medical treatment because of air pollution, job opportunity lost due to pollution and ecosystem damage because of disposing solid waste.

Environmental Cost Report

In order to improve environmental performance and to control environmental costs, a firm requires environmental costs information. This information could be found in environmental cost report. A good first step is a report that details the environments by category. Reporting environmental costs by category reveals two important outcomes: (1) the impact of environmental costs on firm profitability and (2) the relative amounts expended in each category (Hansen and Mowen, 2005).

Table 2.1. Sample of environmental Cost report by category

Source: Hansen and Mowen, 2005

From table above we can see that impact of environmental costs on profitability. Environmental costs could diminish profitability as much as $ 3,000,000 with following break down based on category: prevention costs $ 280,000, detection costs $320,000, internal failure costs $ 600,000 and external failure costs $1,800,000.

Total amount expended for environmental cost is 15% of total operational costs with following break down based on category: prevention costs is 1.4%, detection costs is 1.6%, internal failure costs is 3% and external failure costs is 9%. From each category we can see that internal failure costs is the highest percentage of the total cost at 9%.

Assigning Environmental Cost

From environmental cost report as shown on table 2.1 above we can find each individual cost based on category which assign into a product. In order to assign environmental cost to product cost, a manager should initially decide whether assigning full environmental costs or only private cost. Full environmental costing is the assignment of all environmental costs both private and societal, to product (Hansen and Mowen, 2005).

There are 2 methods of assigning environmental cost to product: (1) Functional-based environmental costs assignment, and (2) activity-based environmental costs assignment.

Functional-based environmental cost assignment

Calculation of cost functional-based will assign environmental costs to unit product and will utilize hours of workforce and machine. This approach could be applied on homogeny product. Nevertheless, the firms which have variety of product, functional-based assignment would affect cost distortion.

For instance, a firm produces two types of glass, glass A and glass B for 50,000 sheets each. Each type requires half and hour of machine hour. Producing this glasses product will contribute cadmium emission, consequently, the firm need license from the government which cost $300,000. The license must be renewed every 3 years. If the emission level exceeds a standard permitted, the firm then will be fined. Every 3 months the firms would be inspected. On average, the firm is charged $50,000 annually for fine. How much environmental cost would be assigned for each glass per year?

License cost per year = $ 300,000/3 = $100,000. Thus, total environmental cost would be assigned to the product = $100,000 + $50,000 = $150,000. Number of hours to produce 100,000 sheets (2 x 50,000 sheets) = 0.5 hours x 100,000 sheets = 50,000 machine hours. Environmental cost per machine hour = $150,000 / 50,000 hours = $ 3 / machine hour. Environmental cost assigns to every product as follow:

Glass A = 25,000 hours x $3/hour = $75,000. Environmental cost per unit glass A = $75,000/50,000 sheets = $1.50 /sheet.

Glass B = 25,000 hours x $3/hour = $75,000. Environmental cost per unit glass B = $75,000/50,000 sheets = $1.50 / sheet (Hansen and Mowen, 2005).

Activity-based environmental cost assignment

Activity-based costing (ABC) has facilitated environmental cost assignment to product based on activity. This approach is useful to be applied by a firm which produces variety of product. ABC's approach assigns environmental cost to environmental activities and afterward calculates level or cost of activities. This cost is implemented to assign costs of each activity to products.

Impact Analysis of Environmental Activity Costs

Impact Analysis of Environmental Activity Costs on Productivity

Concept of Productivity

Environmental cost has indirect relationship with productivity. Productivity is the ratio of output to input [5] . Productivity is the ratio of outcomes of a process divided by the amount of resources necessary to complete the process [6] .

Based on theories above, this can be explained that productivity is the ratio output to input which applied to produce the output. Hence, this could be formulated as follow:

This output, which produces by organization, would be goods or services. In manufacturing company, input consists of direct material, direct labor, and factory's overhead.

For example, a company spends 10 days to produce 50 unit output. 10 days are considered as input whereas 50 units as output. Based on formulation above, productivity can be calculated as follow:

A measure of productivity can be either an operational or a financial productivity measure (Blocher, et al (2005). Thus, to calculate productivity based on the theory above, there are 2 measures; operational productivity measure and financial productivity measure. Besides, there are another productivity measure based on involvement of input in productivity calculation, they are partial productivity and total productivity.

Operational productivity is ratio of output units to input units (Blocher, et al (2005). If both output and input are measured in physical quantities, then we have an operational productivity measure (Blocher, et al, 2005). Operational productivity means ratio outputs and both inputs and outputs are in physical quantity.

Operational productivity could be in partial which called productivity operational partial. A partial productivity measures the relationship between the output and one or part of the required input resources used in producing the output (Blocher, et al, 2005).

Productivity measures can be developed for each input separately or for all inputs jointly. Measuring productivity for one input at a time is called partial productivity measurement (Hansen and Mowen, 2005). This means that partial productivity is ratio outputs to each part of inputs which used to produce output.

Based on definition of operational productivity and partial productivity, thus, the definition of partial operational productivity can be given. A partial productivity reflects the conversion ratio of an input or selected input resource to the output attained. The numerator, the output, is number of units produced; the dominator is the number of units of input resources used (Blocher, et al, 2005). Partial operational productivity is productivity which calculated to each input component to produce output and both input and output component in unit.

Productivity operational partial can be formulated as follow:

Financial productivity is the ratio of output to input with either the numerator or the dominator dollar amount (Blocher, et al, 2005). If output or input is expressed in dollars, then we have a financial productivity measure (Hansen and Mowen, 2005). Financial productivity is ratio output to input, either output or input in dollar (money). Financial productivity can be divided into 2: partial financial productivity and total financial productivity.

Partial financial productivity is productivity which calculated for each input component to produce output, where either input or output in dollar. Total productivity is the ratio of output to the total cost of all input resources used to produce the output. Total productivity is a financial productivity measure (Blocher, et al, 2005). This means that total productivity is called financial productivity measure which is ratio output to all input resource costs used to produce output.

Based on definition of total financial productivity, this can be formulated as follow:

Output can be number of unit or number of output sales whereas inputs are total costs of all resources to produce the output.

From chapter 2 we found that environmental cost assignment to product can be implemented by using functional- or activity-based approach. Environmental cost assignment will affect total product cost and total cost per unit product. Hence, Total cost of all input resources will raise and affect of increasing total cost per unit output.

The Impact of Environmental Activity Cost on Productivity

We have discussed above that productivity is a ratio output which produced to all input resources. Assigning environmental cost to product will increase total product cost (input resource costs) and total cost per unit product. Thus, assigning environmental cost will affect on productivity measurement for each product. All input resource costs will rise whereas number of outputs is remaining unchanged. Hence, productivity measure for each product is decreased.

Impact Analysis of Environmental Activity Costs on Profitability

Strategic Profitability Analysis

The purpose of strategic profitability analysis is to analyze the difference in operating income between two periods to assess successful implementation of the firm's strategy. To facilitate the analysis, changes in operating income are separated into effects of changes in the sales volume (growth), selling price and cost of input resources (price recovery), and productivity (Blocher, et al, 2005). So, the purpose to analyze strategic profitability is to analyze the difference operational profit between 2 periods to estimate a successful of firm's strategic implementation. The analysis involves growth factor, price-recovery factor and productivity factor analysis.

The growth factor measures the change in operating income attributable to change in sales quantity. The analysis is similar to the analysis of quantity (efficiency) variance for direct materials (direct labor) variance. As sales quantity changes, both sales revenues and operating costs change and the change in operating income is a result of the changes in the sales revenue and operating costs. The net effect of growth on the operating income is the combined growth effect of sales revenue and operating costs (Blocher, et al, 2005). The Growth factor is changes of operating income attributes which related to sales quantity changes. These changes involve sales revenue and operating costs changes.

The price-recovery factor measures changes in operating income attributable to changes in the selling price of products and the costs of input resources. Similar to the growth factor, the price-recovery factor is determined separately for revenues and cost (Blocher, et al, 2005).

One of the factors which determine distortion on operating income is productivity factor. Productivity factor can be formulated as follow:

The Impact Environmental Cost on Strategic Profitability

Assigning environmental cost to product cost will increase product cost both in total or unit. The raise of this product cost will affect on increasing of operational cost and at the same time will reduce operating income of the period. Assigning environmental cost to product cost also affects operating income changes between periods.

The changes of operating income on the period would be more profitable if environmental cost which assigned to product from previous period is relatively smaller.

Thus, assigning environmental cost to product cost from period to period is an object of strategic profitability analysis. This will be as an object of growth factor analysis of cost effect of growth and price recovery factor of cost effect of price recovery and productivity factor.

Environmental Activity Cost Management

Environmental expenses are relatively as a high investment, will affect to product cost and profitability form period to period. Thus, environmental cost is strategic cost and this need to manage well in order to obtain more operating income. Hence, this will require environmental activity analysis.

Environmental activity analysis has a purpose to control environment. To do so, this needs to identify environmental activities and cost assessment which is as base to calculate activity-based environmental cost. Knowledge about environmental cost and products and processes related to this is a very important thing to obtain in order to manage this.

Afterward, environmental activities which have been identified are categorized as a value-added activity and non value-added activity. Activities which considered non value-added activity could be eliminated if the firm needs to operate optimally and efficiently.

This non value-added activity could be eliminated if the root cause is able to be identified. By eliminating the non value-added activity, environmental activity costs and product cost could be reduced and operating income will increase. Thus, this will change operating income turn into favorable and increase compared to previous period.


A firm has responsible not only to customer but also to its environment. While producing value added product to customer, the firm at the same time have to maintain its environment and responsible to the damage caused by organization activities. This responsibility is called eco-efficiency.

The objectives of eco-efficiency can be defined into 3 purposes (1) increasing product or service value, (2) optimizing the use of resources, and (3) reducing the environmental impact.

Environmental cost need to assign into product costs, either full environmental costing or full private costing. This cost requires high investment and this will affect to product cost.

Input resources costs will raise as environmental costs assigned into the total product cost while output which produce remain relatively constant. Hence, productivity of the product will decrease. Furthermore, unit cost of the product increases and affect to firm's profitability. This should be manage carefully in order to offer customer value added product with competitive price.