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Environmental sustainability is becoming a standard element of business practice in Canada and around the world. Whether they are trying to bolster its public image with corporate social responsibility (CSR) reports or simply to meet minimum legal environmental reporting requirements, companies are under increasing pressure to do their part in helping to lessen the human impact on the earth's ecosystems.
In order for organizations to lessen their environmental impact they first need to measure their environmental impact. Accountants are playing a growing role in creating the standards, metrics, and reports for sustainability. The guiding principles of traditional accounting domains, such as comparability, completeness, consistency, and accuracy are also sought by both internal and external users of environmental reporting, so it makes sense to be engaging accountants in this process (Fernandez).
Environmental management accounting (EMA) is the branch of managerial accounting that has emerged to deal with various environmental reporting and management goals of companies, such as meeting environmental standards being set by governments or a standards organization like the ISO or better managing environmental costs. EMA attempts to identify, measure, and manage environmental costs. EMA is really just an extension of management accounting that separates environmental costs from other costs and, as we'll see, a formal EMA system is not necessarily required to reap the benefits of incorporating environmental costs into an organizations existing cost accounting system.
EMA is not limited to providing information for CSR reports, and meeting regulatory requirements. As many companies start to pay attention to environmental costs, they are noticing that the magnitude of these costs is substantial (de Beer and Friend). Having good information about these costs and the activities that incur them can make it possible to manage them more effectively.
This paper begins by highlighting two management accounting tools commonly found in EMA systems: activity based costing and life cycle costing and concludes with a few remarks on the appropriateness of implementing these two specific costing systems, and an EMA system in general.
Environmental costs and classifications
There are two broad categories of environmental costs: internal, direct costs and external, indirect costs. External costs are costs to entities outside of the organization; they don't appear in any financial measure within the company. They include costs to society at large and costs to the environment that do not result in contingent liabilities (de Beer and Friend). Examples include the burden on the health care system due to increased incidents of asthma from factory smoke, or the loss of biodiversity from clear cutting forests.
Internal costs usually include traditional costs, contingent liabilities, costs that are hidden in a larger cost pool, and less tangible costs (Kreuz and Newell):
Traditional costs include the usual costs associated with operations, such as property plant and equipment, direct materials and labour, and energy consumption.
Contingent liabilities can include fines for violating regulation and the outcomes of lawsuits. This usually includes estimates of the cost of the contingent liability, as well as the probability of occurrence.
Hidden regulatory costs include all of the costs associated with testing, reporting, training, inspection and other regulation fees.
Less tangible costs include the costs associated with image and goodwill. This is important because as the public becomes more environmentally conscious, they are responding more harshly to companies whose practices harm the environment and more favourably to those that are taking steps to lessen their impact. These costs are generally harder to measure than first three.
Because internal costs can have a direct impact on a company's financial position, they have been a priority in the emerging practice of EMA. External costs are usually not included in current approaches to EMA because of the significant requirement for estimation and the lack of direct impact on management decision making (Jasch). However, depending on a company's strategy, being aware of and minimizing externalities may still be a priority. This is usually an attempt to gain good publicity but in some cases, such as Interface Inc., it is part of the company's mission to have no negative environmental or societal impact.
Activity based costing
A traditional costing system typically allocates indirect costs to a single (or in some cases two or three) overhead cost pool. This means that management has no data regarding what overhead activities are contributing to the costs of specific products. This lack of information can lead to an inaccurate assessment of a product's true cost, which can lead to poor management decisions about things like the price of the product.
To give a simple illustration, suppose that product X is a low volume product that takes 9 direct labour hours (DLH) to produce with overhead costing $20 per DLH and only 1 machine hour with overhead at $10 an hour. Because there is only one overhead cost pool, the company decides to average the two overhead rates together, giving an application rate of $15 per total number of hours for each product. The total number of hours required to produce product X is 10 hours giving a total applied overhead of $150 per unit (10 hours @ $15 per hour). Product Y is a high volume produce and requires 1 DLH and 9 machine hours, making its overhead application $150 per unit as well (10 hours @ $15 per hour).
In this example it is easy to see that the cost and therefore the price of product X is understated, while the cost of product Y is overstated. This is why often times under traditional costing systems the costs of high volume products are calculated as being higher than they should be, while those of lower volume or products that are highly customized are understated. Under such a system management has no knowledge of which products are incurring environmental costs; the environmental costs are simply lumped in with all other overhead costs.
An ABC system, on the other hand, allocates costs to products based on the activities involved in the production of that product (Mallouk, Spraakman and Raiborn). In the case of the example presented in the preceding paragraph, both products would allocate DLH and machine hours to two respective cost pools. This means that product X would have an overhead application rate of $190 per unit (9 DLH @ $20 per hour plus 1 machine hour @ $10 per hour) and product Y will have an overhead application rate of $110 per unit (1 DLH @ $20 per hour plus 9 machine hours @ $10 per hour). We can see that product X costs $40 more per unit than was previously believed, and product Y cost $40 per unit less.
While a traditional system would have all environmental costs buried in one or two overhead cost pools, an ABC system allows those costs to be singled out and properly allocated. Roth presents the following example of environmentally costs categories (Roth):
Toxic waste costs
Water consumption costs
Other regulatory expenses
Cost avoided from environmentally protective actions taken
An environmental cost example we can imagine a similar scenario to the basic ABC illustration presented above. Suppose that product X, the low volume product also produces toxic waste, while product Y, the high volume produce produces none. The costs associated with the toxic waste treatment and disposal should only be allocated to product X. In the traditional costing system, it was being absorbed by both products, making product Y overpriced, and product X underpriced. Under the ABC system, the toxic waste costs will only be allocated to product X, better reflecting the true cost of both products (de Beer and Friend). This also illustrates why it may be in the company's best interest to be keeping track of environmental costs, especially considering that every year there are new regulations coming into effect. If an organization is proactive about environmental costing, management will be better prepared for potential future changes in environmental standards, helping them stay competitive.
Life cycle costing
Life cycle costing (LCC) attempts to capture the full cost a product, process, or system, including everything from "cradle to grave". While ABC determines the cost of a product based on the activities involved LCC extends this notion to include activities and their associated costs beyond the production phase of the product. LCC should include activities involved in the pre- and post- production process. Pre-production activities might include research and development costs, extraction costs, and surveying costs. Examples of post-production activities are estimates of asset retirement obligations, disposal costs, recall and repair costs, and contingent liabilities.
LCC is particularly useful when evaluating the profitability of a new project because it includes, at least estimations of, all the costs that are attributable to the project, not just those incurred during the useful life of the investment, or in the case of a product, during the production phase. "All cost baring activities associated with the product throughout its life time must be identified...accumulated...and in some instances estimated. All costs throughout [the] life cycle must be considered for a valid comparison of competing products of processes." (Kreuz and Newell).
Using a LCC approach will naturally highlight various environmental costs that might not have otherwise been considered. For example the net present value of the estimated storage cost of nuclear waste would be included in the LCC of a nuclear power plant, even though the nuclear waste will be stored for many years after the power plant is decommissioned. According to Jerry Kreuze, and Gale Newell "Most of the cost of a new product is committed after the design stage" (Kreuz and Newell). If this is indeed the case attempting to minimize environmental costs as well as other costs during the design phase can have a great impact on the total cost of the product or process. Because environmental standards are still evolving, it may also be wise to estimate what the standards will be throughout the life of the product. This way the product won't become prematurely obsolete.
Another useful application of LCC might be in comparing the cost of using recycled raw materials, versus using new raw materials. Nucor Inc. is an example of a company that made just such a comparison in the early stages of their steel business. Nucor found that they could process steel more cheaply by using recycled scrap metal instead of iron ore to fabricate various steel products. The use of scrap metal meant that Nucor did not need to use blast furnaces and could instead employ "mini-mills" which had a cost advantage over the former technology in the "non flat commodity" steel segment (Govindarajan).
Better information leads to better management decisions
Because society at large is becoming more aware of industrial impact on the environment, companies are seeing an increase in environmental regulation and reporting requirements as well as greater potential exposure to contingent liabilities. The costs associated with this trend are, in some industries, becoming large enough to impact management decisions (de Beer and Friend).
By using a combination of ABC and LCC to measure and, when necessary, estimate environmental costs, management will have better information about the costs of specific activities and how they are attributed to revenue generating goods and services. This in turn will help them make decisions. It is largely for this reason that once an ABC system is in place there is often a natural progression towards incorporating activity based management into existing management practices. Activity based management is managing the costs of the activities identified by the ABC system. A typical example of this might be identifying activities which are not value adding and then managing or monitoring them more tightly. Ideally, non value adding activity costs can be reduced or even eliminated.
Once environmental costing information has been gathered, assuming it is reliable and useful, it should be integrated into the decision making process. For example, after the data has been collected, management can determine if a recycling program is saving the company money.
Environmental costing information can also affect pricing decisions; if the production of a particular product produces a toxic by-product that requires expensive handling, should those costs be absorbed by other products? Or should those costs be passed on only to the customers of products that produce the toxic waste? In Ontario, for example, "consumers pay tire retailers a disposal fee which covers transportation and the cost of land filling tire chips, should that be necessary." (Murray) Because the industry knows the disposal costs per tire, and because of government incentives, tire companies can save money by passing this variable cost on to customers. This sort of industry wide regulation, whether initiated by the government or by the industry itself, can be an excellent way to deal with such environmental costs without impacting the competitive advantage of one particular company. But such an arrangement could not have been reached prior to knowing the proper allocation of overhead to an individual unit.
Should all companies adopt an EMA system?
As with many strategic decisions in business there is no magic, "one size fits all" solution that applies to every company. It is important to recognize that even ABC systems are not appropriate for all organizations. ABC systems will generally increase in effectiveness if one or more of the following conditions are met (Mallouk, Spraakman and Raiborn):
The company is large
The company has large product diversity
The technology employed by the company has changed in recent years
The industry has changed in recent years
Although a similar argument can be made for the implementation of a LCC system, considering the life cycle costs when choosing between potential projects can still be a useful analytic tool used on a case by case basis. This can be especially true of small companies who may not be able to afford large unforeseen costs later in the lifecycle of the product, environmental or otherwise.
As with ABC and LCC, it will not always be appropriate for an organization to adopt an EMA system. An interesting illustration of this comes from an Australian study examining whether or not better corporate social performance lead to higher corporate financial performance - environmental sustainability being a subset of corporate social responsibility (CSR). The article concludes that there is actually a negative relationship between corporate social performance and corporate financial performance. The authors indicate, however, that companies which have high corporate social performance trade a price premium, so the markets value CSR (Lee, Faff and Langfield-Smith). Given that it is still fundamentally financial performance that drives major business decisions, it may not always be appropriate to incorporate EMA into current management accounting practices (Dias-Sardinha, Reignders and Antunes).
That being said, there are certainly examples of companies that have simultaneously improved both their environmental sustainability and their profits both over the short and long term. One such company is Interface Inc. a carpet and flooring manufacturer. Despite being in an oil intensive industry, Interface Inc. has simultaneously increased revenue, profit and market share since they started working towards their goal of "eliminating any negative impact Interface has on the environment" almost 20 years ago (Interface Inc.).
As the environment becomes a more important issue - it was ranked as the 3rd most important issue in the 2008 Canadian federal election (Angus Reid Strategies & Toronto Star), societal pressure may gradually make it more profitable to put environmental sustainability closer to the forefront of business decision making. Until then, it may still be wise for organizations to begin developing and implementing systems to at least track these costs. This way they won't be caught off guard if and when regulatory bodies do require higher standards of environmental reporting. By doing this they might even find that, like Interface Inc., they are able to save money or at least gain some good.