The aim of this article is to give a general introduction on the area of environmental management accounting.
Many of you reading this article still will not be entirely clear on what environmental management accounting is. You will not be alone! There is no single textbook definition for it, although there are many long-winded, jargon ridden ones available. Before we get into the unavoidable jargon, the easiest way to approach it in the first place is to step back and ask ourselves what management accounting itself is. Management accounts give us an analysis of the performance of a business and are ideally prepared on a timely basis so that we get up-to-date management information. They break down each of our different business segments (in a larger business) in a high level of detail. This information is then used to assess how the business’ historic performance has been and, moving forward, how it can be improved in the future.
Environmental management accounting is simply a specialised part of the management accounts that focuses on things such as the cost of energy and water and the disposal of waste and effluent. It is important to note at this point that the focus of environmental management accounting is not all on purely financial costs. It includes consideration of matters such as the costs vs benefits of buying from suppliers who are more environmentally aware, or the effect on the public image of the company from failure to comply with environmental regulations.
In order to be fully versed on what environmental management accounting is really seen by the profession as encompassing today, it is necessary to consider a couple of the most widely accepted definitions of it.
In 1998, the International Federation of Accountants (IFAC) originally defined environmental management accounting as:
‘The management of environmental and economic performance, through the development and implementation of appropriate environment-related accounting systems and practices. While this may include reporting and auditing in some companies, environmental management accounting typically involves lifecycle costing, full cost accounting, benefits assessment, and strategic planning for environmental management.’
Then, in 2001, The United Nations Division for Sustainable Development (UNDSD) emphasised their belief that environmental management accounting systems generate information for internal decision making rather than external decision making. This is in line with the statement at the beginning of this article that EMA is a subset of environmental accounting as a whole.
The UNDSD make what became a widely accepted distinction between two types of information: physical information and monetary information. Hence, they broadly defined EMA to be the identification, collection, analysis and use of two types of information for internal decision making:
This definition was then adopted by an international consensus group of over 30 nations and thus eventually adopted by IFAC in its 2005 international guidance document on ‘environmental management accounting’.
There are three main reasons why the management of environmental costs is becoming increasingly important in organisations.
First, society as a whole has become more environmentally aware, with people becoming increasingly aware about the ‘carbon footprint’ and recycling taking place now in many countries. A ‘carbon footprint’ (as defined by the Carbon Trust) measures the total greenhouse gas emissions caused directly and indirectly by a person, organisation, event or product. Companies are finding that they can increase their appeal to customers by portraying themselves as environmentally responsible.
Second, environmental costs are becoming huge for some companies, particularly those operating in highly industrialised sectors such as oil production. In some cases, these costs can amount to more than 20% of operating costs. Such significant costs need to be managed.
Third, regulation is increasing worldwide at a rapid pace, with penalties for non-compliance also increasing accordingly. In the largest ever seizure related to an environmental conviction in the UK, a plant hire firm, John Craxford Plant Hire Ltd, had to not only pay £85,000 in costs and fines but also got £1.2m of its assets seized. This was because it had illegally buried waste and also breached its waste and pollution permits. And it is not just the companies that need to worry. Officers of the company and even junior employees could find themselves facing criminal prosecution for knowingly breaching environmental regulations.
But the management of environmental costs can be a difficult process. This is because first, just as EMA is difficult to define, so too are the actual costs involved. Second, having defined them, some of the costs are difficult to separate out and identify. Third, the costs can need to be controlled but this can only be done if they have been correctly identified in the first place. Each of these issues is dealt with in turn below.
Hansen and Mendoza (1999) stated that environmental costs are incurred because of poor quality controls. Therefore, they advocate the use of a periodical environmental cost report that is produced in the format of a cost of quality report, with each category of cost being expressed as a percentage of sales revenues or operating costs so that comparisons can be made between different periods and/or organisations. The categories of costs would be as follows:
It is clear from the suggested format of this quality type report that Hansen and Mendoza’s definition of ‘environmental cost’ is relatively narrow.
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:
The UNDSD, on the other hand, described environmental costs as comprising of:
Neither of these definitions contradict each other; they just look at the costs from slightly different angles. For ProDipSust, you should be aware that definitions of environmental costs vary greatly, with some being very narrow and some being far wider.
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. 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, activity-based costing and lifecycle costing. These are referred to later under the section ‘accounting for 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 has already been 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.
This article 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:
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).
Environmental management accounting uses some standard accountancy techniques to identify, analyse, manage and hopefully reduce environmental costs in a way that provides mutual benefit to the company and the environment, although sometimes it is only possible to provide benefit to one of these parties.
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.
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’. It will enable an organisation to determine the profitability of a product or activity after taking into account not just production costs but also design, development and decommissioning costs.
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.
For example, activity-based costing may be used to ascertain more accurately the costs of washing towels at a gym. The energy used to power the washing machine is an environmental cost; the cost driver is ‘washing.’
Once the costs have been identified and information accumulated on how many customers are using the gym, it may be established that some customers are using more than one towel on a single visit to the gym. The gym could drive forward change by informing customers that they need to pay for a second towel if they need one. Given that this approach will be seen as ‘environmentally friendly,’ most customers would not argue with its introduction. Nor would most of them want to pay for the cost of a second towel. The costs to be saved by the company from this new policy would include both the energy savings from having to run fewer washing machines all the time and the staff costs of those people collecting the towels and operating the machines. Presumably, since the towels are being washed less frequently, they will need to be replaced by new ones less often as well.
In addition to these savings to the company, however, are the all-important savings to the environment since less power and cotton (or whatever materials the towels are made from) is now being used, and the scarce resources of our planet are therefore being conserved. Lastly, the gym is also seen as an environmentally friendly organisation and this, in turn, may attract more customers and increase revenues.
Adapted from an article written by a member of the Performance Management examining team