F5 ENVIRONMENTAL MANAGEMENT ACCOUNTING

DEFINING ENVIRONMENTAL COSTS

Many organisations vary in their definition of environmental costs. It is neither possible nor desirable to consider all of the great range of definitions adopted. A useful cost categorisation, however, is that provided by the US Environmental Protection Agency in 1998. They stated that the definition of environmental costs depended on how an organisation intended on using the information. They made a distinction between four types of costs:

·           conventional costs: raw material and energy costs having environmental relevance

·           potentially hidden costs: costs captured by accounting systems but then losing their identity in ‘general overheads’

·           contingent costs: costs to be incurred at a future date, eg clean up costs

·           image and relationship costs: costs that, by their nature, are intangible, for example, the costs of preparing environmental reports.

The UNDSD, on the other hand, described environmental costs as comprising of:

·           costs incurred to protect the environment, eg measures taken to prevent pollution and

·           costs of wasted material, capital and labour, ie inefficiencies in the production process.

Neither of these definitions contradict each other; they just look at the costs from slightly different angles. As a Paper F5 student, you should be aware that definitions of environmental costs vary greatly, with some being very narrow and some being far wider.

IDENTIFYING ENVIRONMENTAL COSTS

Much of the information that is needed to prepare environmental management accounts could actually be found in a business’ general ledger. A close review of it should reveal the costs of materials, utilities and waste disposal, at the least. The main problem is, however, that most of the costs will have to be found within the category of ‘general overheads’ if they are to be accurately identified. Identifying them could be a lengthy process, particularly in a large organisation. The fact that environmental costs are often ‘hidden’ in this way makes it difficult for management to identify opportunities to cut environmental costs and yet it is crucial that they do so in a world which is becoming increasingly regulated and where scarce resources are becoming scarcer.

It is equally important to allocate environmental costs to the processes or products which give rise to them. Only by doing this can an organisation make well-informed business decisions.

For example, a pharmaceutical company may be deciding whether to continue with the production of one of its drugs. In order to incorporate environmental aspects into its decision, it needs to know exactly how many products are input into the process compared to its outputs; how much waste is created during the process; how much labour and fuel is used in making the drug; how much packaging the drug uses and what percentage of that is recyclable etc etc. Only by identifying these costs and allocating them to the product can an informed decision be made about the environmental effects of continued production.

In 2003, the UNDSD identified four management accounting techniques for the identification and allocation of environmental costs: input/outflow analysis, flow cost accounting, activity based costing and lifecycle costing. These are referred to later under ‘different methods of accounting for environmental costs’.

CONTROLLING ENVIRONMENTAL COSTS

It is only after environmental costs have been defined, identified and allocated that a business can begin the task of trying to control them.

As we have already discussed, environmental costs will vary greatly from business to business and, to be honest, a lot of the environmental costs that a large, highly industrialised business will incur will be difficult for the average person to understand, since that person won’t have a detailed knowledge of the industry concerned.

I will therefore use some basic examples of easy-to-understand environmental costs when considering how an organisation may go about controlling such costs. Let us consider an organisation whose main environmental costs are as follows:

·           waste and effluent disposal

·           water consumption

·           energy

·           transport and travel

·           consumables and raw materials.

Each of these costs is considered in turn below.

Waste

There are lots of environmental costs associated with waste. For example, the costs of unused raw materials and disposal; taxes for landfill; fines for compliance failures such as pollution. It is possible to identify how much material is wasted in production by using the ‘mass balance’ approach, whereby the weight of materials bought is compared to the product yield. From this process, potential cost savings may be identified. In addition to these monetary costs to the organisation, waste has environmental costs in terms of lost land resources (because waste has been buried) and the generation of greenhouse gases in the form of methane.

Water

You have probably never thought about it but businesses actually pay for water twice – first, to buy it and second, to dispose of it. If savings are to be made in terms of reduced water bills, it is important for organisations to identify where water is used and how consumption can be decreased.

Energy

Often, energy costs can be reduced significantly at very little cost. Environmental management accounts may help to identify inefficiencies and wasteful practices and, therefore, opportunities for cost savings.

Transport and travel

Again, environmental management accounting can often help to identify savings in terms of business travel and transport of goods and materials. At a simple level, a business can invest in more fuel-efficient vehicles, for example.

Consumables and raw materials

These costs are usually easy to identify and discussions with senior managers may help to identify where savings can be made. For example, toner cartridges for printers could be refilled rather than replaced.

This should produce a saving both in terms of the financial cost for the organisation and a waste saving for the environment (toner cartridges are difficult to dispose of and less waste is created this way).

ACCOUNTING FOR ENVIRONMENTAL COSTS

In the context of Paper F5, when the syllabus requires you to describe the different methods of accounting for environmental costs, it aims to cover two areas:

·           Internal reporting of environmental costs, which has already been discussed in the introduction.

·           Management accounting techniques for the identification and allocation of environmental costs: the most appropriate ones for the Paper F5 syllabus are those identified by the UNDSD, namely input/outflow analysis, flow cost accounting, activity-based costing and lifecycle costing.

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 100kg of materials have been bought and only 80kg of materials have been produced, for example, then the 20kg difference must be accounted for in some way. It may be, for example, that 10% of it has been sold as scrap and 90% 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.

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’ total costs in the long run.

ACTIVITY-BASED COSTING

ABC allocates internal costs to cost centres and cost drivers on the basis of the activities that 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 on general overheads.

LIFECYCLE COSTING

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

SUMMARY

I hope you now have a clearer idea about exactly what environmental management accounting is and why it’s important. While I have tried to give some simple, practical examples and explanations, a certain amount of jargon is unavoidable in this subject area. Enjoy your further reading.

Written by a member of the Paper F5 examining team