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School of Business and Computer Science Limited

ACCA PM – Performance Management

Lecture 6 : Environmental Accounting

Introduction

Environmental issues are becoming increasingly important in the business world.

Businesses are responsible for the environmental impact of their operations and are
becoming increasingly aware of problems such as carbon emissions.

The growth of environmental issues and regulations has also brought greater focus on
how businesses manage and account for environmental costs.

Importance of Environmental Cost to a Business:

(1) Identifying environmental costs associated with individual products and services can
assist with pricing decisions.

(2) It ensures compliance with regulatory standards.

(3) There is potential for cost savings.

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Principles of environmental costing

1. Increasingly, management accountants need to be aware of the environmental costs associated with
business activities.

2. In the past, environmental costs such as energy costs were treated as production overheads and
effectively hidden from management scrutiny.

3. Society has become more environmentally aware with 'carbon footprint' becoming a
recognised term. A carbon footprint measures the total greenhouse gas emissions caused directly and
indirectly by a person, organisation, event or product.

Managing environmental costs

Many benefits accrue from a clear understanding and effective management of the
environment-related costs of business activities.

(a) Environmental costs are becoming huge for some companies. Once identified,
environmental costs can be controlled and reduced.

(b) There is increasing worldwide regulation and a need for regulatory reporting of
environmental costs.

(c) Ethical issues – businesses should be aware of how their production methods will
affect the environment (eg carbon emissions).

(d) Improved brand image – 'green' ways of doing business can be a selling point.

(e) Associating environmental costs with individual products will lead to more accurate
pricing and improved profitability.

Defining environmental costs

Definitions of environmental costs vary widely. This can make it difficult to identify the
costs involved and therefore control them. They may be hidden inside 'general
overheads'.

Hansen and Mendoza (1999) suggested that environmental costs could be classified
as:
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(a) Environmental prevention costs: the costs of activities undertaken to prevent the
production of waste eg environmental training.

(b) Environmental detection costs: costs incurred to ensure that the organisation
complies with regulations and voluntary standards eg record keeping and recording.

(c) Environmental internal failure costs: costs incurred from performing activities that
have produced contaminants and waste that have not been discharged into the
environment eg waste disposal costs.

(d) Environmental external failure costs: costs incurred on activities performed after
discharging waste into the environment.

Much business activity takes place at the cost of the environment, and some of these costs are felt by
society as a whole. Externalised costs are those for which wider society has to 'pay' at least an element –
eg global warming.

Environmental Concern and Performance

Martin Bennett and Peter James looked at ways in which a Company’s concern for
the environment can impact on its performance.

(1) Short term savings through waste minimization and energy efficiency schemes can
be substantial.

(2) Increased Cost of Capital because investors and lenders demand higher risk
premium for companies with poor environmental performance.

(3) Energy and Environmental taxes are incurred such as UK’s landfill tax on waste
disposal.

(4) Pressure Group Campaigns can cause damage to reputation or additional costs.

(5) Environmental legislation may cause the ‘sunsetting’ of products and opportunities
for ‘sunrise replacements’.

(6) The cost of processing input which becomes waste is equivalent to 5-10% of some
Organizations revenue.

Achieving Business and Environmental Benefits

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Martin Bennett and Peter James suggests six (6) main ways in which business and
environmental benefits can be achieved.

(1) Integrating the Environment into capital expenditure decisions. Example

considering environmental opposition to projects which could affect cash flows.

(2) Understanding and Managing Environmental Costs. Environmental costs are

often ‘hidden’ in overheads and environmental and energy costs are often not allocated
to the relevant budgets.

(3) Introducing Waste Minimization Schemes. Such schemes may result in the
reduction or avoidance of pollution control expenditure.

(4) Understanding and Managing Life Cycle Costs. For many products, the greatest
environmental impact occurs upstream e.g. raw materials or downstream from
production e.g. energy to operate equipment. Organizations need to identify, control and
make provision for environmental life cycle costs and work with suppliers and customers
to identify environmental cost reduction opportunities.

(5) Measuring Environmental Performance. Business is under increasing pressure to

measure all aspects of environmental performance, both for statutory disclosure
reasons and due to demands for more environmental data from customers.

(6) Involving Management Accountants in a Strategic Approach to Environment-

related management accounting and performance evaluation.
A ‘green accounting team’ incorporating the key functions should analyze the strategic
picture and identify opportunities for practical initiatives. It should analyze the short,
medium and long term impact of possible changes in the following:
(i) Government policies e.g. transport
(ii) Legislation and regulation
(iii) Supply conditions e.g. fewer landfill sites
(iv) Market conditions e.g. changing customer views
(v) Social Attitudes e.g. factory farming
(vi) Competitor Strategies

Possible action includes the following:

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(i) Designating an ‘environmental champion’ within the strategic planning or

accounting function to ensure that environmental considerations are fully considered

(ii) Assessing whether new data sources are needed to collect more and better data.

(iii) Making comparisons between sites/offices to highlight poor performance and

generate peer pressure for action.
(iv) Developing checklists for internal auditors

Such analysis and action should help organizations to better understand present and
future environmental costs and benefits.

Environmental Costs

External Environmental Costs Internal Environmental Costs

Costs an organization causes but which Costs that an organization incurs

are suffered by others e.g. the public. to prevent environmental damage.
Example: Example:
(1) Pollution from toxic air emissions (1) Air filters and water treatment
(2) Oil spills equipment
(2) Costs of detecting
environmental damage or
emissions
(3) Costs of correcting
Environmental damage
(4) Costs of disposing any waste
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The US Environmental Protection Agency makes a distinction

between four types of cost.

(1) Conventional Costs, such as raw material and energy costs, have an impact on the
environment.

(2) Potentially hidden costs are relevant costs that are captured within accounting
systems but may be ‘hidden’ within general overheads.

(3) Contingent costs are costs that will be incurred at a future date as a result of
discharging waste into the environment such as clean-up costs.

(4) Image and relationship costs are costs incurred to preserve the reputation of the
business; e.g. the costs of preparing environmental reports to ensure compliance with
regulatory standards.

Controlling Environmental Costs

Environmental costs can be controlled through Environmental Management Systems.

Function Description
(1) Environmental review A first review of environmental impacts of materials,
and policy development issues and products and of business issues arising, as
well as the development of a tailored in-house policy or
measures to ensure adherence to external standards.
(2) Objectives and target Objectives and targets should be set unambiguous and
development achievable. Targets should be quantified within a
specified time period e.g. reduce carbon emissions by X
% within a specified time period.
(3) Life cycle assessment This aims to identify all interactions between a product
and its environment during its lifetime, including energy
and material usage and environmental releases.
 Raw material used have to be traced back to the
biosphere and the company recognizes impact
on habitat, gas balance, the energy used in the
extraction and transportation and the energy
used to produce the means of extraction

 For intermediate stages, emissions, discharges

and co-products.

 At the consumer purchase stage, the impact of

manufacture and disposal of packaging, transport
to shops and ultimately impacts of consumers
using and disposing of the product.
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(4) Establishment and Key features of environmental management systems

maintenance of includes information systems, budgeting, forecasting
environmental and management accounting systems, structure of
management systems responsibilities, establishment of an environmentally
friendly culture, considering impact on human resource
issues such as education and performance appraisal.
(5) Regulatory Compliance Making sure that current legal requirements are being
fulfilled and keeping up to date with practical
implications of likely changes in legislation.
(6) Environmental Impact A regular review of interactions with the environment,
assessment the degree of impact and also the impact of forthcoming
major investments.
(7) Eco-label applications Eco-labeling allows organizations to publicly identify
products and services that meet the highest
environmental standards. To be awarded an eco-label
requires the product to be the result of a reliable quality
management system.
(8) Waste Minimization Whether waste can be minimized or eliminated,
possibility of recycling or selling waste
(9) Pollution Prevention Deciding what to target
Programmes
(10) Research, How to bring desirable into product development,
development and bearing in mind product development may take several
investment in cleaner years, and opinion and legal requirements may change
technologies during that period. Desirable features may include
minimum resource usage, waste, emissions, packaging
and transport, recycling, disassembly and longer
product life.
(11) Environmental Consideration of the benefits and costs of reporting, how
performance and issues to report and what to include (policies, plans, financial
reporting data, activities undertaken, sustainability)

ISO 14000

ISO 14000 was first published in 1996 and based on earlier quality management
standards. It provides a general framework on which a number of specific standards
have been based. ISO 14001 prescribes that an environmental management system
must comprise:

 An environmental policy statement

 An assessment of environmental aspects and legal and voluntary obligations
 A management system
 Internal audits and reports to senior management
 A public declaration that ISO 14001 is being complied with
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Critics of ISO 14001 claim that its emphasis on management systems rather than
performance is misplaced, and it does not include rigorous verification and disclosure
requirements.

Accounting for Environmental Costs

The United Nations Division for Sustainable Development (UNDSD, 2003) identified a
number of management accounting techniques to account for Environmental Costs
which are as follows:

(1) Input/output Analysis

(2) Flow cost accounting
(3) Activity based costing
(4) Life cycle costing

(1) Input/outflow analysis

This technique records material inflows and balances this with outflows on the basis that
what comes in, must go out. So, if 100 kg of materials have been bought and only 80 kg
of materials have been produced, for example, then the 20 kg difference must be
accounted for in some way. It may be, for example, that 10% of it has been sold as
scrap and 10% of it is waste. By accounting for outputs in this way, both in terms of
physical quantities and, at the end of the process, in monetary terms too, businesses
are forced to focus on environmental costs.

(2) Flow cost accounting

This technique uses not only material flows but also the organisational structure. It
makes material flows transparent by looking at the physical quantities involved, their
costs and their value. It divides the material flows into three categories:
material, system and delivery, and disposal. The values and costs of each of these
three flows are then calculated. The aim of flow cost accounting is to reduce the
quantity of materials which, as well as having a positive effect on the environment,
should have a positive effect on a business’s total costs in the long run.
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(3) Activity-based costing

ABC allocates internal costs to cost centres and cost drivers on the basis of the
activities which give rise to the costs. In an environmental accounting context, it
distinguishes between environment-related costs, which can be attributed to joint cost
centres, and environment-driven costs, which tend to be hidden in general overheads.

In order to fully integrate environmental costs into their management accounting,

organisations can apply activity based costing principles to environmental costs.

Environmental costs would be grouped together into environmental cost pools, and
each pool would be associated with an environmental cost driver.

Individual products that passed through the most polluting processes would therefore
absorb more environmental costs than cleaner or more 'green' products.

As for ABC in general, this will lead to:

(a) Increased awareness of how environmental costs behave
(b) Better product pricing
(c) Better production decisions

Life cycle costing

Within the context of environmental accounting, life cycle costing is a technique which
requires the full environmental consequences, and therefore costs, arising from
production of a product to be taken account of across its whole life cycle,
‘from cradle to grave’.

Environmental costs are considered from the design stage of a new product right up to the end of life costs
such as decommissioning and removal.

The consideration of future disposal or remediation costs at the design stage may influence the design of
the product itself, saving on future costs.