Environmental accounting – an activity based costing (ABC) approach

27th November 2006

Conventional management accounting has been criticised for ignoring the separate identification, classification, measurement and reporting of environmental information, especially direct and indirect environmental costs. Here, environmental costs such as energy, water and waste disposal are often not traced to specific production processes and are "lumped in" with general business overheads and allocated to cost objects.

More companies are now identifying and measuring direct environmental costs by revising allocation bases so as to separate out indirect environmental costs using activity based costing, (ABC). Environmental cost accounting can be seen in part as a specific application of ABC, which focuses on the environment as a key cost driver. Environmental management accounting's emphasis on end of life costs and on other costs which are either upstream or downstream from the organisation itself compliments the growing emphasis on product life costing in management accounting generally. ABC, when applied to environmental costs, distinguishes between environment related costs normally attributed to joint environmental cost centres (e.g. incinerators or sewage plants) and environment driven costs, which can be direct, indirect and contingent, and which are hidden in the general overhead.

Using ABC, environmental costs are removed from overhead costs and traced to products and services by identifying the resources, activities and the attendant costs and quantities used to produce the output. This reduces the potential for cross subsidization of dirty or environmentally damaging products, processes, sites and departments. ABC can be employed to chart the use and allocation of material, financial and energy resources on the basis of process and product lifecycles. It should include the allocation of usual production costs such as pollution control and the use of raw materials and energy, as well as hidden and less tangible costs and benefits, (capital costs such as emissions monitoring equipment, and expenses such as monitoring and testing procedures), plus liability costs. Removing environmental costs from overhead costs and accurately allocating them to specific products results in far fewer distortions in product costing.

Table 1 below illustrates an Environmental Costing Framework based upon Activity Based Costing / Management.

Table adapted from "An Introduction to Scope & Definition of System Boundaries", (no author given) found on the web at www.umich.edu/nppcpub/resources .  (Table 9. Reaction Costing Framework Based on ABC/M and TCA Principles (14)).

Activity based costing also applies to the end of a product's life cycle. This is particularly important in Europe where environmental legislation is increasingly forcing companies to be responsible for the 'take back' and disposal of products at their end of life, and to remediate land used for production facilities. Companies wishing to minimise product take back, recycling and site clean up costs will need to recognise and consider environmental costs during product and process design stages where they have the greatest influence. A comprehensive ABC model will help identify all the activities and the total resource costs related to preventing and remediating expected environmental damage. Current environmental costs must be correctly attributed to both existing products and past products. A failure to recognise in today's production costs the costs of future disposal, recycling and remediation will underestimate the total costs of producing today's products. Activity based costing can also be used to create activity based energy consumption models. Here energy consumption is translated into a cost driver. In a similar way, waste indices and indicators can be developed, becoming waste drivers where costs can be assigned to specific waste generation and waste disposal.

Comprehensive analysis of environmentally related activities is also a key requirement in order to assess levels of environmental hazard and toxicity and their associated costs. Such analysis identifies and assigns key cost drivers and product consumption patterns thus permitting a good attribution of environmental costs to individual products. To the extent that some environmental costs are traced to specific processes, all the products converted by these processes will be assigned a share of the process-specific environmental costs. Thus an ABC model of environmental expenses can inform product design and process selection decisions in order to reduce total life-cycle costs of products: including materials acquisition, materials conversion, materials disposal and recycling.¹ In addition, ABC can be applied to environmental costs so as to quantify the cost saving effects of environmental measures.

Activity based costing is only one of the means by which environmental management accounting is introduced into business. ABC initiatives do not automatically reveal environment driven costs – substantial inputs by environmental managers are required in order to ensure the costs of all environmentally related activities are included. Using ABC to identify and allocate environmental costs requires the clear definition, monitoring and reporting of such costs. Tracking systems for environmental wastes and toxicities of wastes from manufacturing systems is necessary in order to most accurately assign such costs. This in turn provides data for the estimation of potential liabilities, costs of disposal and other life cycle costs. One of the main advantages of using ABC to assess environmental costs lies in its use as a means to integrate environmental cost accounting into the strategic management process – thus linking environmental issues into management objectives and activities. In addition, in using ABC, environmental costs can be more accurately integrated within manufacturing planning, control and other information systems. This provides an extensive consideration of the environmental effects throughout the product life-cycle. It also ensures that intangible and uncertain environmental factors can be brought into any decision-making framework, even while debate continues over which environmental costs are the most relevant or material to the organisation. From a management accounting perspective, the next step beyond activity based costing of environmental impacts is strategic cost management. Here cost data is used to develop superior strategies in order to gain sustainable competitive advantage.

The inclusion of internal environmental costs in its accounting assists a company in maximising its current profitability. Inclusion also helps ensure that the company recognises and accounts for its external environmental costs, especially where it is likely it will be required to internalise these costs in the near future.