term paper

Name: Charan Kamal SinghTopic: Environmental Costing

Abstract

Environmental costing serves as a mechanism for identifying and measuring the full spectrum of environmental costs of current production processes and the economic benefits of pollution prevention or cleaner processes, and to integrate these costs and benefits into day-to-day business decision-making.

For the last decade, environmental accounting has gained increased importance in practice, of which cost accounting receives most attention. This paper gives an overview of the approaches of environmental cost accounting.

Key Words: Environmental costing, Environmental costs, Environmental accounting

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Introduction

In recent years, Environmental Costing has been attracting increasing attention throughout the world. There are various definitions of environmental costing, but essentially, an environmental costing system can be thought of as a management accounting system that has been refined so as to enable users of the system to be provided with information that reflects the environmental performance of the organisation. The United Nations Division for Sustainable Development has referred to environmental costing simply as “doing better, more comprehensive management accounting, while wearing an environmental hat that opens the eyes for hidden costs”.

The information generated from an environmental management accounting system might be of a financial nature (for example, the quantification of environmental costs), or it might be provided in physical terms (such as the amount of electricity used within a particular process). Either way, the motivation for developing such a system would be to provide a foundation for an organisation to improve both its environmental and financial performance.

Generally, companies are spending significant amount of money on pollution abatement and control. In most cases these costs represent the most obvious and most easily measured environmentally related costs. But it is only a top of an iceberg. Hidden environmental costs may be greater than expenditures to pollution abatement and control and uncovering of these hidden costs can provide significant opportunities for decision making and business planning.

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Environmental Costs

Environmental cost is a core part of environmental management accounting. Environmental costs are the costs that are incurred so that a company's activities do not damage the environment or that any such damage is put right.

The Division for Sustainable Development of the United Nations1 has proposed a definition of environmental costs that distinguishes four types of costs:

the first one is related to all the efforts made by organizations to reduce the environmental effects of their activities, by using “end-of-pipe” measures and technologies;

the second one is related to all activities made by organizations to prevent their environmental effects before the end of the production process, for example, by using cleaner technologies, or by establishing environmental management systems;

the third and fourth types of cost are defined on the idea that anything that does not enter the product produced by a company is a non-product output, such as wastes, waste water or lost energy, and that all costs associated to this non-product output are regarded as environmental costs. These include both the purchasing value of the materials and the production costs of producing the non-product output.

According to USA Environmental Protection Agency the definition of environmental cost depends on utilization of information in a company and the environmental costs can include conventional costs (raw materials and energy costs with the environmental relevance), potentially hidden costs (costs which are captured by accounting system but then lose their identity in overheads), contingent costs (costs in a future time – contingent liabilities), and image and relationship costs.

The International Federation of Accountants (IFAC)2 has given the following categories for environmental costs:

1. Material costs of product outputs.It includes the purchase costs of natural resources such as water and other materials that are converted into products, by-products and packaging.

2. Material costs of non-product outputs.It includes the purchase (and sometimes processing) costs of energy, water and other materials that become non-product output (i.e., waste and emissions).

1 United Nations Division for Sustainable Development, Environmental Management Accounting Procedures and Principles, United Nations, New York, 2001, pp. 14-20.

2 International Federation of Accountants, Environmental Management Accounting, New York, 2005, pp. 15-35. Available from Internet URL: http://www.ifac.org

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3. Waste and emission control costs.

It includes costs for: handling, treatment and disposal of waste and emissions; remediation and compensation costs related to environmental damage; and any control related regulatory compliance costs.

4. Prevention and other environmental management costs.It includes the costs of preventive environmental management activities such as cleaner production projects. also includes costs for other environmental management activities such as environmental planning and systems, environmental measurement, environmental communication and any other relevant activities.

5. Research and development costs.It includes the costs for research and development projects related to environmental issues.

6. Less tangible costs.It includes both internal and external costs related to less tangible issues. Examplesinclude liability, future regulations, productivity, company image, stakeholder.

Another way of classifying the cost related to the environment is based on costs with respect to internal and external working of an organisation. There are ways by which the environment costs, losses and benefits may be unrecorded in traditional accounting systems. By distinguishing the internal costs, those that are borne by the organization and external costs, those which are passed on the environment or the society e.g. environment cost or health costs.

Internal environmental costs of the firm comprise of direct costs, indirect costs, and contingent costs. The costs include remediation or restoration costs, waste management costs or other compliance and environmental management costs. Internal costs is estimated and allocated using the standard costing models that are available to the firm. Direct costs are traced to a particular product, site, and pollution prevention program (for e.g., waste management or remediation costs). Indirect costs include costs such as environmental training, R&D, record keeping and reporting are allocated to cost centers such as products and departments or activities.

External costs are defined as the costs of environmental damage external to the firm. These costs are “monetized” (i.e., their monetary equivalent values can be assessed) by economic methods that determine the maximum amount that people would be willing to pay to avoid the damage, or the minimum amount of compensation, that they would accept to incur it.

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Identification and allocation of Environmental Cost

There are many difficulties associated with identification and allocation of the environmental costs. When environmental costs are not adequately allocated, cross-subsidization occurs between products. In most cases, different products are made by different processes, and each process tends to have a different environmental cost.

For example, consider a facility with two processes, A and B that use the same number of direct labor hours for a batch of product. Process A, however, uses hazardous chemicals whereas process B does not. The facility incurs environmental costs from the use of the hazardous chemicals in a number of ways:

(a) specification and procurement of the chemical which includes evaluation of Material Safety Data Sheets;

(b) design of the process to minimize worker exposure;

(c) shipping costs associated with transporting hazardous chemicals;

(d) monitoring, reporting, and permitting to meet applicable regulations;

(e) employee training in handling and emergency response;

(d) storage and disposal costs; and liability for the chemical from purchase to grave.

In addition, there may be less tangible costs such as tarnished corporate image and inability to meet delivery or quality requirements.

If all of these costs are bundled as “environmental” overhead and allocated to processes A and B on the basis of direct labour hours or production volume (both common practices), products made by process B are in effect subsidizing those made by process A. In other words, a traditional accounting system would show process B to be more costly than it really is and process A to be less costly. Armed only with this information, managers are inclined to overestimate the profitability of products made by process A and correspondingly underestimate the profitability of those made by process B. Eventually, this type of accounting can put the company at a considerable competitive disadvantage. Conversely, by more accurately allocating these costs, managers can make better decisions about product mix and about where cost-saving opportunities lie, thereby putting their companies ahead of the competition.

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Use of Environmental Costing in Internal Decision Making

Environmental costing is the process of collection and analysis of the information relating to environmental cost for taking internal decision making. The examples of internal decisions are Product Design, Process Design, Product Pricing etc.

Every firm is expected to have Management of Environmental and Economic Performance through the development and implementation of appropriate environment related accounting systems and practices. It involves Life Cycle Costing, Full Cost Accounting, Benefit Assessment and Strategic Planning for Environmental Management3. Management Accounting consider the accounting data for decision making, but the sustainability of the management accounting can be attained only by considering Environmental Cost in decision making.

The internal decision making of the firms that considers the environmental activitiesare:

(a) Product / Process related Decision Making

The correct costing of products is a pre-condition for making sound business decisions. The accurate product pricing is needed for strategic decisions regarding the volume and choices of the products to be produced. Environmental costing converts many environmental overhead costs into direct costs and allocates them to the products that are responsible for their incurrence. The results of the improved costing by environmental costing may include:

Different pricing of products as a result of recalculated costs. Re-evaluation of the profit margin of the products. Phasing-out certain products when the change is dramatic. Re-designing processes or products in order to reduce environmental costs and Improving housekeeping and monitoring of environmental performance.

(b) Investment Projects and Decision Making

The investing project decision-making requires the calculation of different profitability indicators like Net Present Value (NPV), Payback Periods (PBP) and Internal rates of Return (IRR) or Benefit-Cost Ratios. Recognizing and quantifying environmental costs and benefits is invaluable and necessary for calculating the profitability of environment-related projects. Without these calculations, management may arrive at a false and environment- degrading conclusion.

3 Refer International Federation of Accountants, Environmental Management Accounting, New York, 2005.

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Tools for Cost Analysis

Cost Analysis includes Life Cycle Assessment (LCA), Activity Based Costing (ABC) andMaterial Flow Cost Accounting.

(a) Life Cycle Assessment (LCA)

Environment professionals have acknowledged that the production activities may affect supplies of natural resources and the environment quality; the adverse environmental impacts may occur at each stage in product life cycle. A means to examine the environmental impacts of a product or activity across its entire life cycle from raw materials until disposal is called Life Cycle Analysis (LCA). LCA is a systematic process for evaluating the life cycle costs of a product or service by identifying environmental consequences and assigning measures of monetary value to those consequences. The LCA includes identifying and quantifying energy and materials used and wastes released to the environment, assessing their environmental impact, and evaluating opportunities for improvement. The LCA will generate data on environmental releases and their effects which in turn enable entities to identify pollution prevention opportunities.

(b) Activity Based Costing (ABC)

The Activity Based Costing enables firms to allocate all cost, including environmental cost, to the Cost Centers and Cost Drivers based on based on the activities (Newell et al.,, 1994). Five main allocation is considered in the ABC and they include volume of emissions or waste, toxicity of emission and waste treated, environmental impact added (volume x input per unit of volume), volume of the emissions treated and relative costs for treating different kinds of emissions. The ABC will create more accurate cost information not only for better product pricing but also for reducing entire cost and supporting pollution prevention projects.

(c) Flow Cost Accounting (FCA)

Material Flow Analysis is basically intended to define the material and energy flows moving through a value creating system (such as business) over a certain period. Incorporating environmental costing perspective, the flow cost accounting includes evaluation of cleaner production potential at the plant level, preliminary estimate of waste generation costs and in-depth analysis of selected assessment of quantification of the volume and composition of various waste and energy streams and emissions as well as a detailed understanding of the causes of these waste and energy streams and emissions.

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Conclusion

The companies are well aware of the facts that environmental issues will affect the business and industry in the near future. They are fully convinced of the need for environmental information. Information on environmental performance of organizations might be available to some extent, but, decision-makers are seldom able to link environmental information to economic variables and are crucially lacking environmental cost information. As a consequence, decision makers fail to recognize the economic value of natural resources as assets, and the business and financial value of good environmental performance. The accounting profession and the companies has yet to respond to these issues and learnt a lot in dealing with the environmental matters in the books of accounts.

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