COST ACCOUNTANCY

06 April 2011

Full Cost Accounting

A Course Module on Incorporating Environmental and Social Costs into Traditional Business Accounting Systems

Overview:

This module describes methods for incorporating environmental information into accounting management information systems to allow financial decision makers to include environmental criteria in their decisions. The module is subdivided to permit a progression of detail concerning accounting systems and their role in encouraging the design and development, marketing, and use of more environmentally-conscious products, services, and manufacturing processes.

The module is suitable for use as part of an engineering or business environmental management course, at either the undergraduate or graduate level, through the selection of various components of the module. Thus for example, in an MBA course, the early material on types of accounting systems would be unnecessary, or in an engineering environmental management course, more emphasis could be placed on the managerial/cost accounting section than on the national accounting section.

The module is subdivided as follows:

1) Introduction

§ What is accounting?

§ Relevance of accounting and capital budgeting to environmental management and engineering issues

§ Types of accounting systems

§ Shortcomings of accounting systems as environmental information systems

§ Full cost accounting

2) Incorporating social and environmental costs into accounting systems:

§ National accounts

§ Financial accounts3

§ Cost accounting systems and capital budgeting

3) Valuing the environment

4) The ultimate goal – full cost pricing

5) Dif iculties associated with full cost accounting

6) Additional teaching resources available

§ Case studies

§ Readings

Appendix 1: Example short class projects and assignments

Appendix 2: Case study of environmental cost accounting for scrap at an automobile manufacturing facility- Instructor’s version and student version.

Appendix 3: Example of a pollution prevention investment analysis4

1.0 Introduction

1.1 What is accounting?

Accounting is the collection and aggregation of information for decision makers – including managers, investors, regulators, lenders, and the public. Accounting systems affect behavior and management and have affects across departments, organizations, and even countries. Information contained within an accounting system has the power to influence actions. Accounting information systems are particularly strong behavioral drivers within the context of a corporation

- where profits and the bottom line are daily concerns. In order for environmental concerns to be important criteria in everyday business management decisions, they need to be encapsulated within the accounting systems of the organization.

In this educational module we will discuss efforts to include environmental and other social information into accounting systems. We provide an overview of the three main types of accounting systems used by developed nations and discuss their shortcomings in terms of environmental information content. Although we will discuss the three types of systems, we will focus the bulk of the discussion on managerial or cost accounting systems - the day to day accounting information systems used by decision makers in enterprises. Example overheads for lectures are included in Appendix I.

1.2 Relevance of accounting and capital budgeting to environmental

management and engineering design issues

Accounting systems inform and motivate behavior, thus any information included therein has the

potential to influence behavior. Including environmental information in accounting systems is a

prerequisite to linking sound environmental management and the principles of sustainable

development with everyday business and personal decisions.5

Historically, the environmental effects of doing business have been excluded from financial

information systems unless they directly affect the entity’s profitability or future - for example

fines or accidents. Environmental effects, which are not regulated or scrutinized by the

government, are often ignored because they may be considered to be:

§ Unimportant (for example, there appear to be unlimited resources)

§ Not pertinent to the core business function or the bottom line

§ Part of the price of progress

§ Difficult to estimate and to assign financial values

More recently, there has been a shift by corporations and governments towards viewing the

environment as a perishable resource which needs to be managed for prolonged use - be that use

commercial or social. There has also been a realization that damaging the environmental is costly

- to individuals, corporations, and society. These costs need to be avoided. Managing and

avoiding environmental costs requires recognizing that these costs exist, ensuring that these costs

are recognized by the parties responsible for the costs, and providing incentives to reduce these

costs.

Most environmental effects are the result of design and engineering decisions. For example, a

product which contains toxic materials has the potential to have a high environmental cost.

However, these environmental costs may not have been apparent to the product designer.

Manufacturing processes which generate large amounts of waste will result in high disposal costs,

in addition to the costs of inefficient resource utilization and the costs associated with handling

and managing materials which do not ultimately become marketable product. The process

engineer may be aware of the waste handling costs, but is unlike to fully realize additional costs

associated with waste.6

While many decision makers are not environmental experts, all are probably familiar with

financial systems of some form or another and most face cost constraints. The consumer in the

supermarket has a finite amount to spend, the manager has spending limits. The aim of full cost

accounting is to encapsulate environmental effects within the financial measures used to make

decisions.

1.3 Types of accounting systems

There are three main types of accounting systems - each with a different purpose and involving

data gathering at different levels of aggregation:

National Accounting Systems

National accounts are national income and production accounts, such as the Gross National

Product (GNP) and Gross Domestic Product (GDP) which aim to measure and track an

economy’s contribution to the well-being of its inhabitants. National income accounts show the

national demand or goods and services and are used to track and measure economic growth.

Conventional economic thinking has assumed that the increases in goods and services produced

domestically (GDP) and national income (GNP) are adequate yardsticks of economic health. For

example, the World Bank uses per capita GNP as a major criterion for classifying national

economies.

An international Standard System of National Accounts (SNA) and procedural rules for

calculating GNP were agreed upon in 1968 and are codified in the “blue book” produced by the

UN Statistical Office.

Specific definitions of a number of national accounting measures are shown in Table 1.

Table 1. Defining national economic performance (Adapted from Duthrie, 1993)

Gross Domestic Product This is the total production of a country measured as: i) the monetary

value of final goods and services; ii) the expenditures on goods and

services produced; or iii) the income received for goods and services.7

value of final goods and services; ii) the expenditures on goods and

services produced; or iii) the income received for goods and services.

Gross National Product This is the total income of a country including GDP PLUS payments,

profits, interest etc. flowing in from abroad, minus profits, interest,

payments etc. flowing out to other countries.

Per Capita GDP or GNP GDP or GNP divided by the population. This is a crude estimate of

the average standard of living.

Net National Product GNP minus an allowance for depreciation of capital.

Net Income NNP minus any indirect taxes paid by producers to the government.

Financial Accounting Systems

Financial accounts, such as balance sheets and income statements are used to keep track of

business incomes and outflows. These financial reports are for use by persons outside the firm -

for example, lenders or investors. There are relevant to the enterprise as a whole and are generally

subject to strict government rules.

The most common financial accounting reports are for external use by are the financial statements

in a firm’s annual report to shareholders. In the United States and most developed countries,

these reports conform to generally accepted accounting principles developed predominantly by

the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission

(SEC).

The overall objectives of a firm’s financial accounting statements are: (Stickney et al, 1991):

1) To provide information useful for making rational investment and credit decisions.

2) To allow investors and creditors to assess the amount, timing, and uncertainty of cash flows.

3) To provide information about the economic resources of a firm and the claims on those

resources.

4) To provide information about a firm’s operating performance during a period.

5) To provide information on how a firm obtains and uses money and other financial resources.

6) To provide information on how management has discharged its stewardship responsibility to

owners and the public.8

The main types of financial accounting statements are presented in Table 2.

Table 2. Principal Financial Accounting Statements.

Balance Sheet Balance Sheets present a snapshot of the investing and financing

activities of a firm at a particular moment in time (usually the last day

of the firm’s fiscal year). The balance sheet presents a summary of the

firm’s assets, liabilities and shareholder’s equity. In a balance sheet

the sum of the assets must equal the sum of the liabilities and

shareholder’s equity. There are strict guidelines governing the

estimation of assets and liabilities.

Income Statement The Income Statement presents the results of the operating activities

of a company for a specific period of time - usually the fiscal year.

The statement summarized the revenues and expenses and reveals the

net income or earnings of the firm during the period of time covered.

Cash Flow Statement The Cash Flow Statement shows the net cash flows related to

operating, investing, and financing activities for a specific period of

time - usually the firm’s fiscal year.

Management or Cost Accounting Systems and Capital Budgeting

Management or cost accounting systems are part of an enterprise’s information system and refer

to the internal cost tracking and allocation systems to track costs and expenditures. These are

internal rather than external accounting systems. There are no fixed rules governing how an entity

should keep track of cash flows internally, although there are many formal methods available for

users. Capital budgeting is basically a form of predictive cost accounting over a set time frame

which is used to analyze the costs of alternative projects or expenditures over the specified

period of time.

Managerial or cost accounting measures are the predominant financial drivers in day to day

business decision making affecting every aspect of the firm’s activities. Good cost accounting is

vital to understanding the profitability of current activities and to predicting the profitability of

future activities. There are many examples of firms who discovered non-profitable services or9

products once thorough cost accounting procedures were implemented. The bulk of this module

will focus on these types of accounting information systems.

The main objectives of managerial/cost accounting are (Hilton, 1988):

1) Providing managers with information for decision making and planning.

2) Assisting managers in directing and controlling operations.

3) Motivating managers towards the organization’s goals.

4) Measuring the performance of managers and sub-units within the organization.

Basic cost classifications are demonstrated in Table 3. - Note, these classifications are not

exclusive, for example a cost may be fixed and indirect, or variable and direct for example.

Table 3. General Cost classifications

Variable Costs Variable costs change in total in proportion to the

level of activity. For example if a carmakers

production increases by 5%, its tire costs will

increase by about 5%.

Fixed Costs A fixed cost remains unchanged in total as the level

of activity varies. For example, the property tax on

a rental apartment is the same regardless of the

number of building occupants.

Direct Costs A direct cost is the cost of direct labor and material

used in making the product or delivering the

service.

Indirect Costs/Overhead Costs Indirect costs are costs of an activity which are not

easily associated with the production of specific

goods or services.

Opportunity Costs The benefit that is sacrificed when the choice of one

action precludes an alternative course of action.

Sunk Costs Costs that have been incurred in the past and cannot

be changed by current actions.

1.4 Shortcomings of accounting systems as environmental information systems

National Accounting Systems10

It is possible for a country to act in such a way as to deplete its forests, exhaust its mineral

resources, pollute its waters, and deplete its fisheries and wildlife without affecting measured

GDP or GNP. In fact, activities such as mining or environmental cleanup, will actually

contribute positively to a countries national account measures. Conversely, a country could

vastly improve the quality or fertility of its land and natural resources and these improvements

would not be reflected as increases in GDP/GNP.

National accounts are actually inadequate measures of a country’s long-term economic welfare as

they do not take into account activities, such as resource depletion, which will ultimately affect

economic growth. The accounting systems also ignore or mislabel many of the costs and benefits

associated with natural resources and environmental quality. The costs of reducing the adverse

effects of environmental degradation are treated as ordinary investment and consumption

activities. Damages caused by pollution usually are included only to the extent that they

influence productivity. Environmental services provided by the natural environment (waste

disposal, pollution clean-up and dispersion etc.) are not accounted for at all.

Financial Accounting Systems

Corporate financial statements also exclude estimates of social costs beyond those directly

impacting the bottom line. However, there are guidelines on the reporting of environmental

liabilities - these pertain to likely remediation and liability issues, rather than long-term social

issues. These liabilities are often reported in the statement footnotes since their magnitude is

unknown.

Managerial/Cost Accounting Systems

Most corporate managerial accounting systems do not track costs closely. Easily identifiable

costs, such as labor or raw materials, are often finely tracked and allocated to particular product11

or process lines, but many costs - such as administration costs and environment, health, and

safety costs, are considered to be indirect or overhead costs and are allocated broadly across

product and process lines. Placing a cost in an overhead account allows it to be shared across

activities, but generally removes cost responsibility from any one particular product line or

manager. If no one is responsible for a cost, it is likely to be ignored, or in the worst case, may

increase as a result of efforts to reduce other costs.

1.5 What is Full Cost Accounting?

Full cost accounting describes how goods and services should be priced to reflect their true costs

(including environmental and other social costs). Depending on the type of accounting system

involved it can thus relate to national, financial, or managerial/cost accounting. With full cost

accounting, natural resources would be factored into calculations of a country’s GDP; natural

resources would be redefined as assets on company ledgers; and environmental costs would be

built into a product’s cost.

To confuse issues slightly, within each type of accounting system, the term full cost accounting

may be used to refer to either the full private (or bottom line) costs to an enterprise of an

activity, or more correctly, the full social costs to society of the activity including externalities

(such as health impacts resulting from ozone depletion). Externalities are costs not borne by the

responsible entity, for example, the ecological impacts of climate change resulting from

automobile emissions are not included in the price consumers pay for petroleum. In its correct

formulation, full cost accounting should refer to all social costs. However, this is difficult in

practice and many attempts at full cost accounting (particularly in managerial accounting efforts)

have stopped at the level of incorporation of private costs. Figure 1 demonstrates the difference

between current accounting systems, full “private” accounting systems, and full ‘social”

accounting systems.12

Figure 1a) Typical accounting framework: dark shaded area shows direct private costs allocated to products or

activities, light shaded are shows indirect private costs (including some environmental costs) allocated to overhead

accounts. Unshaded area shows social costs resulting from corporate activities but not charged to the company.

Figure 1b) Modified full cost accounting framework: dark shaded area donotes all private costs allocated to

products or activities. Unshaded area shows social costs resulting from corporate activities but not charged to the

company.

Figure 1c) Full social accounting framework: dark shaded area denotes all costs (both private and social) allocated

to products or activities.

Social Costs/Externalities

Indirect Private Costs

Social Costs/Externalities

Indirect Private Costs

Direct Private Costs

Social Costs/Externalities

Indirect Private Costs

Direct Private Costs

Direct Private Costs13

2.0 Incorporating social and environmental costs into accounting

systems:

National Accounts

As discussed earlier, national accounts do not record changes in environmental quality and most

natural resources and ignore or mislabel many of the costs and benefits associated with natural

resources and the environment. Amending the accounts to correct these problems requires:

1) Expanding the set of goods treated as national assets to include uncounted environmental and

natural resources - this is called expanding asset account boundaries. This would also involve

computing values for depletion and degradation of natural assets.

Some economists have attempted to calculate Net Domestic Product (NDP) measures by

subtracting the values resulting from the depreciation of natural assets, and the depletion and

degradation of natural resources from GDP measures. For example, the GDP measures for a

country in Indonesia were adjusted for resource depletion and consumption by Repetto for the

World Resources Institute in 1989. This study showed that the conventionally measured GDP

overstated the true growth of net income. While the GDP increased by about 7.7% annually, the

NDP figures rose by only 3.9% annually. This means that half of the recorded growth during the

period was generated by drawing down natural resources rather than by sustainable productivity

increases.

2) Expanding the set of goods and services included in measures on national income to include

services flowing from the environment or natural resources - this is called expanding the

production boundaries. Such services include the provision of recreation , biodiversity, and

aesthetic benefits.14

3) Reclassifying some of the economic activities measured in the accounts by identifying

activities that protect against environmental degradation and recognizing the contribution of the

waste disposal services of the environment - this is called reorganizing the production

boundaries.

A number of nations, including the United States, have begun to develop environmental national

accounts. For example, in France, “National Heritage Accounts” are produced by the National

Institute of Statistical Studies in Paris. These accounts attempt to integrate economic, ecological,

and socio-cultural functions of the environment. Raw physical data is collected on water, air,

soil, flora and fauna, and ‘others’. This information is aggregated into “state of the environment”

reports, and various forecasting and simulation models and a modified GDP is calculated. This

modified GDP is not very comparable with the official GDP however.

Cost Accounting Systems and Capital Budgeting/Investment Analysis

(Much of this section is derived from EPA, 1995)

Environmental costs are one of the many types of costs incurred during the operation of an

enterprise. Environmental costs need management attention because:

1) Many environmental costs can be reduced through changes in business activities and

decisions, e.g. waste minimization activities.

2) Environmental costs are often allocated to overhead accounts rather than to specific activities

and thus get overlooked.

3) Better management of environmental costs can result in improved environmental performance

and health and safety measures.

4) Understanding the source and amount of environmental costs encourages more accurate

costing and pricing of goods and services, and allows unprofitable activities to be highlighted.15

5) Understanding environmental costs can help companies determine the advantages of

developing environmentally-conscious goods and services - these will often ‘cost’ less,

especially on a life cycle basis.

6) Detailed accounting of environmental costs can help support the development and

management of a corporate environmental management system.

The term environmental costs can be used to describe private environmental costs - the costs

that directly impact a firm’s bottom line, and public or social environmental costs - the costs to

society as a whole. To date, attempts to focus on better tracking and allocation of environmental

costs within management accounting frameworks have predominantly focused on private costs

and we will deal with these in detail. However, attempts are underway in some companies to

begin to estimate and include social or “full” costs in their internal management information

systems.

The EPA has developed a system of examining costs in order to focus management attention on

environmental issues. These are also summarized in Table 1.

Tier 0. Usual or Conventional Capital and Operating Costs (equipment, materials, labor

etc.)

Usual costs are costs that are directly associated with the project. Included would be capital

expenditures, such as the costs of buildings, equipment, materials, utilities, installations costs,

etc. Also included are operating and maintenance expenses such as, materials, labor, insurance,

training, and permitting.

Tier 1. Hidden Costs (monitoring, paperwork, reporting requirements, etc.)

There area number of environmental costs that may not be accounted for as such. These include

upfront environmental costs, regulatory or voluntary environmental costs, and backend16

environmental costs (see Table 1). Upfront costs are incurred prior to the operation of the

process or facility and related to the siting of facilities, qualification of suppliers, evaluation of

alternative pollution control equipment etc. Regulatory and voluntary environmental costs

include items such as environmental insurance, permitting costs, environmental monitoring and

testing, recordkeeping, voluntary audits, remediation, recycling activities etc. These costs are

often assigned to overhead accounts rather than allocated to departments of products directly.

Backend environmental costs are usually also ignored in current decision making as they are not

incurred at the present time. Such costs include the future costs of decommissioning a

laboratory, or product takeback requirements.

Tier 2. Contingent Costs (penalties, fines, future liabilities)

Contingent costs are costs that may or may not be incurred at some point in the future. They

can only be estimated in probabilistic terms - their expected value, or the probability of their

occurrence. Examples are personal injury claims related to product use, future remediation costs,

fines or penalties etc.

Tier 3. Less tangible Costs (corporate image, community relations, consumer response

etc.

These are the difficult to estimate costs associated with maintaining corporate image, good

relationships with investors, employees, and customers etc. These costs would include the costs

of environmental outreach activities (annual community cleanup days or treeplanting days for

example), and publication of environmental reports etc.

All of the costs outlined above are private costs borne by the company. This analysis does not

include the social costs or externalities not directly borne by the company.17

Once environmental costs have been identified and quantified or estimated, they need to be

allocated to the originating activities. By allocating theses costs, a company will motivate

managers and decision makers to find creative pollution prevention alternatives which will lower

these costs. However, good allocation of these costs will probably involve overhauling or

augmenting the current cost accounting system. Activity-based costing, a managerial accounting

technique which attempts to allocate all or almost all a firm’s costs is well suited to efforts to

implement full cost accounting efforts within a firm, as once the costs have been identified,

allocation does not require a new type of accounting framework. A theoretical example of better

environmental cost allocation is shown in Figure 3. In this scenario, toxic waste from product B

is being incorrectly charged to widget A increasing the apparent cost of production of product A

while reducing the apparent cost of production of product B. Better cost allocation reveals the

true private costs of product B and may result in efforts to reduce these wastes. Additional

examples of tracking and allocating environmental are provided in EPA, 1993, NPPC,

1994, and EPA, 1995. Similar cost analyses can be used in capital budgeting or investment

analysis. By including the tier 1-tier 3 costs where possible, expected environmental costs and

savings can estimated, to result in a more complete understanding of the costs and benefits

associated with particular projects or investments. Appendix 2 demonstrates the potential

environmental cost savings associated with scrap reduction at an automobile

manufacturing facility. Appendix 3 reproduces sections of EPA, 1993 which details an

investment analysis for a pollution prevention project .18

Table 1. Examples of environmental costs incurred by firms (adapted from EPA, 1995).

Potentially Hidden

Costs

Regulatory Upfront Voluntary

Notification Site Studies Community Relations

Reporting Site preparation Monitoring/testing

Monitoring/testing Permitting Training

Studies/Modeling R&D Audits

Remediation Engineering/Procurement Qualifing Suppliers

Recordkeeping Installation Reports (e.g. Env. Reports)

Plans Insurance

Training Conventional Costs Planning

Inspections Capital Equipment Feasibility Studies

Manifesting Materials Remediation

Labelling Labor Recycling

Prepardness Supplies Environmental studies

Protective Equipment Utilities R&D

Medical Surveillance Structures Habitat/Ecosystem

Protection

Env. Insurance Salvage Value Landscaping

Financial Assurance Financial Support

Pollution Control Back-end

Spill Response Closure/Decommissioning

Stormwater Management Disposal of Inventory

Waste Management Post-closure Care

Taxes/Fees Site Survey

Contingent Costs

Future Compliance Costs Remediation Legal Expenses

Penalties/Fines Property Damage Natural Resource Damages

Response to Future

Releases

Personal Injury Damage Economic Loss Damages

Image and

Relationship Costs

Corporate Image Relationship with Staff Relationship with Lenders

Relationship with

Customers

Relationship with Suppliers Relationship with

community

Relationships with

Investors

Relationship with regulators

Relationships with Insurers19

Figure 2. Demonstration of incorrect cost allocation (adapted from EPA, 1995)

Under the traditional cost accounting system, the toxic waste generated only by Product B is

allocated to both products. Better environmental cost accounting would result in the toxic waste

charges being taken out of the overhead account and allocated directly to Product B (see shaded

arrow).

3.0 Valuing the Environment

Once we move beyond the concept of private costs to the quantification and allocation of full

social costs, we are faced with a dilemma - how do you assign costs to social and environmental

intangibles such as a pretty view, untouched ecosystem, species existence and genetic diversity?

Some environmental impacts can be estimated or measured through estimates of human healthrelated costs or impacts on the economy. However, many are difficult to determine - such as the

costs of species extinction or ecosystem loss. Recognizing these externalities makes long-term

sense for corporations and governments - today’s external costs become tomorrow’s internal

costs as a result of regulation and legislation. In fact, instances where there is a large discrepancy

between internal and external costs are probably good indicators of areas where regulation will

appear.

Product A

Salaries A + B

Product B

Overhead

Paint Cost

A + B

Labor,

Materials A

Labor,

Materials B

Rent Toxic Waste

Cost from B20

Before it is possible to implement full social cost accounting at either the managerial, financial, or

national level it is necessary to have agreed upon estimates of the costs and benefits of

environmental resources. The main methods used to date to assign costs to environmental

damage are as follows:

3.1) Market Prices

Direct measurement of the market prices for various natural resources such as timber and

fisheries can be used to estimate the economic damage resulting from damage or depletion of these

resources.

3.2) The Hedonic Price Approach

The hedonic approach attempts to identify how much of a given difference in property or land

price is due to differences in environmental quality and to infer how much people are willing to

pay for improvements in quality. Identification of property price differences are done through

multiple regression which takes into account other reasons for price differences, such as

accessibility, proximity to amenities, the amount of property available, etc. For example, Pearce

and Markandya (1988) show that pollution appears to significantly affect property values once

other variables are taken into account.

3.3) Contingent Valuation

Contingent valuation usually involves directly asking people what they are willing to pay for a

particular benefit (in this case environmental benefit), or what they would be willing to accept in

compensation to tolerate the loss of the particular benefit. The aim of the questions is to find out

what prices would be revealed if markets for the asset existed.21

3.4 The User Cost Approach

This method relies on attempting to estimate the total costs associated with an activity. For

example, the true cost of visiting a park or other environmental attraction includes the lost income

associated with not working, the additional cost of food etc.

Less direct approaches to estimating environmental costs also exist. In general these take the

form of estimating dose-response relationships such as the effect of pollution on health or on

physical assets such as buildings.

4) The Ultimate Goal - Full Cost Pricing

Full cost pricing implies that all the private and social costs associated with a product or activity

(and determined using full cost accounting) are included in the price of the activity. This is quite

different to our earlier discussions where the attempt was to determine and allocate all costs to

aid in internal decision making. Full cost pricing would extend this concept to the consumer. For

example, if all the environmental costs associated with cup manufacturing were included in the

price of paper and plastic cups, one would expect the least environmentally damaging to have the

lowest price. Thus the consumer can make an environmental choice based on price –or can

choose the more environmentally-damaging alternative at a higher price, knowing that the

additional environmental costs have been paid for.22

It is important to remember that currently we (society) do pay the full social cost of activities

and products – however, much of the costs are paid to government agencies or less directly, in

the form of increased health costs or reduced living quality. Full cost pricing attempts to ensure

that the costs are paid by the users rather than by society at large.

5) Difficulties Associated with Full Cost Accounting

Obviously full cost accounting is not straightforward. There are many barriers that need to be

overcome before it becomes a mainstream practice.

Generic problems associated with FCA include the difficulties of estimating the costs of

environmental damage. As shown earlier, there is no easy way to calculate many environmental

and social costs, and in many instances it can become a question of personal values.

Additionally, detailed full cost accounting would require an understanding of the life cycle

environmental impacts of a product, process, or activity. Life cycle assessment (LCA) is the

tool being developed to provide information on life cycle impacts, however, at present, there is

no accepted methodology for LCA and the topic is a subject of controversy.

Specific difficulties associated with developing full cost National and financial accounts include:

§ Comparing present and historical measures. National and financial accounts are used to

do historical analyses. Changing the rules would make such comparisons difficult, if not

impossible.

§ How to do international comparisons. Comparing accounts internationally would also be

problematic if different countries arrive at different methods for full cost accounting.

Specific difficulties associated with full cost accounting and capital budgeting include:23

§ Consistency among companies. There are no rules regarding how an entity is to do its

internal cost accounting and cost accounting data is not audited. Generating consistent

methodologies will be difficult.

§ Translating costs into prices. As described above, the ultimate goal is to have a society

where there are no social costs – all costs are included in price. This is not

straightforward in a competitive global market. There is an incentive to “cheat” and

exclude some environmental or social costs as excluding costs will lead to lower prices and

competitive advantage.

§ The lack of internal incentives. There needs to be a strong motivation to change

accounting and financial practices. In a world where budgetary constraints exist there are

incentives to reduce, rather than increase, costs.

6.0 Additional Information Sources and Bibliography – many of

these publications include examples:

Pearce, D.W. and Markandya, The benefits of Environmental Policy, OECD, Paris, 1988.

P.E. Bailey, Full Cost Accounting for Life Cycle Costs - A Guide for Engineers and Financial

Analysts, Environmental Finance, 13-29, Spring, 1991.

Congressional Budget Office, “Greening the National Accounts”, CBO, Washington, D.C. 77pp,

1994

David Duthrie, How to Grow a Green Economy, New Scientist, January 1993, 39-43.

EPA, 1992, Total Cost Assessment: Accelerating Industrial Pollution Prevention through

Innovative project Financial Analysis. Free Publication, EPA/741/R-92/002, EPA, May 1992.

EPA, 1993, A Primer for Financial Analysis of Pollution Prevention Projects. Free Publication,

EPA/600/R-93/059, EPA, April, 1993.

NPPC, 1994, Homework/Exam Problem: Overhead Allocation for Pollution Prevention, William

Lannen, Pollution Prevention in Accounting Example, National Pollution Prevention Center for

Higher Education, Ann Arbor, MI, August, 1994.24

EPA, 1995, An Introduction to Environmental Accounting as a Business Management Tool:

Key Concepts and Terms. Free Publication, EPA 742-R-95-001, EPA, June 1995.

EPA, 1995(b)Environmental Accounting Resource List, Free Publication, EPA742-B-95-001,

February 1995.25

Appendix 1: Example class projects and Assignments

Many of the publication above include examples of accounting problems. Additional suggested

projects and exercises include:

1) Take a simple product that is relatively inexpensive, for example, a pen or a sheet of paper.

Do a preliminary life cycle assessment by listing the various activities involved in the

manufacture of the product and estimating the environmental consequences of these activities.

List the environmental consequences that are regulated and likely to be addressed by the

company. List the environmental consequences that are likely to be excluded from the

company’s accounts and product prices.

2) List as many environmental and social consequences of car ownership as possible. Similar

lists can be developed for other activities or products, e.g. TV usage, tourism, etc. How

many of these do you think are private versus social?

3) Develop your own contingent evaluation questionnaire pertaining to an area of interest. The

questionnaire should contain questions designed to elicit the values the reader places on

certain items or issues. Divide your audience into two groups. Provide one group with the

questionnaire only. Provide the other group with some reading material about the topic/area,

and then ask them to fill in the questionnaire. Compare the results of the two groups.

4) Do a similar exercise to 2), however in this case, give the first group a questionnaire which

frames the questions in terms of willingness to pay; give the second group a questionnaire

which frames the questions in terms of willingness to accept. Compare the answers of the

two groups.26

Appendix 2

Developed By Rebecca Cassler and Cheryl Horney, Carnegie Mellon University

INSTRUCTOR’S VERSION

True Costs of Plastic Scrap: An Environmental Cost Accounting Case Study

Overview for Instructor: This example goes through a step-by-step analysis of determining the

full “private” costs of scrap in an automobile parts facility. Part 1 describes a simple mass

balance that leads to an initial scrap cost estimation. Part 2 investigates the income from scrap

sales and the disposal costs of scrap. Part 3 includes a detailed analysis of scrap effects in the

manufacturing facility including materials, labor, parts loss and electricity costs. Part 4 illustrates

the financial usefulness of environmental cost accounting and asks for discussion. Understanding

the full costs of scrap will provide incentives for scrap reduction: decreasing impacts on the

environment and improving the bottom line.

Part 1:

An automobile manufacturer makes the plastic interiors of cars in an injection molding facility. In

one year the facility buys 21,600,000 pounds of polycarbonate plastic for $1.39 per pound. The

polycarbonate is molded into: 1,360,000 mainframe parts totaling 18,300,000 pounds and

1,360,000 add-on parts totaling 2,720,000 pounds. The balance of the polycarbonate is scrap.

Questions:

a) Approximately how much material is scrapped?

b) What percent of the total purchased plastic does this represent?

c) What is the cost of scrap?

Mainframe Parts

Plastic In Add-on Parts

Scrap

Answers:

a) Pounds of Scrap: 21,600,000 – 18,300,000 – 2,720,000 = 580,000lbs

b) Percent Scrap: 580,000/21,600,000 = 3%

c) 580,000 lbs * $1.39/lb ~ $806,000

Molding27

Part 2:

Although a significant amount of scrap is directly recycled back into manufacturing processes, a

large amount of scrap must be taken off site that was not considered above:

§ Approximately 346,400lbs of polycarbonate are recovered from molding the mainframes'

component carriers and another 193,600lbs are recovered from add-on parts molding.

This scrap is sold for $0.31/lb.

§ Purges from the molding machine total 21,600lbs and are landfilled at a cost of $0.025/lb.

§ Another 691,000lbs of scrap representing 51,400 parts are recovered from subassembly,

painting and final and sold at $1.47/part.

Question:

a) What is the net income (revenues – costs) from the scrap?

Answer:

a) Scrap Income: (346,400+193,600)(.31) – 21,600(.025) + 51,400(1.47) = $242,418

Material Cost of Scrap: (540,000+21,600+691,000)(1.39) = $1,741,114

Net Income from Scrap: $242,418 - $1,741,114 = -$1,498,696 (about -$1.5 million)

Part 3:

The automobile manufacturer is evaluating the injection molding facility through full cost

accounting to determine the true cost of scrap. The materials cost of the scrap was easily

calculated from a mass balance as shown above. However, scrap is produced at five main points

in the manufacturing process: mainframe molding, molding of add-on parts [component carriers],

subassembly, painting and final assembly. To recover the scrap, there are associated costs

throughout manufacturing such as: labor, regrind/rework, loss of parts and additional electricity

usage.

To process scrap, there are two full-time blending/regrind skilled personnel in the facility. Their

salaries, including overtime and benefits, total $130,000/year/person. In addition to those two

laborers, employees regrind and rework approximately 24,000 scrap parts from subassembly,

painting and final assembly. For each of these scrapped parts, initial materials cost $18.70/part,

regrind labor costs $2.70/part, and the facility sells the reground scrap for $4.20/part. From other

parts of the facility, there are approximately 220,000 lbs of scrap that can immediately be

Blending &

Regrind

Mainframe

Molding

Add-on

Parts

Molding

Sub-Assembly

Painting

Final

Assembly

Plastic In28

recycled into manufacturing and approximately 160,000 lbs that are reground and sold. This

reground material can be sold for $0.30/lb and was initially purchased for $1.39/lb.

In addition to the materials and labor costs of the scrap, the facility is also losing revenue from

overall parts loss. The 24,000 parts are composed of 14,800 parts from subassembly, 5,900

parts from painting and 3,300 parts from final assembly. The values of parts (i.e. the value

added from labor, materials, etc.) after each of the processes are: $4.80/part for subassembly,

$8.00/part for painting and $35.40/part for final assembly. These prices are representative of the

approximate production costs for each part after each process.

To replace these parts that are eventually scrapped, a significant amount of overtime labor is also

needed. Labor is broken down into three categories: direct, indirect, and skilled. For mainframe

molding, molding of add-on parts [component carriers], subassembly, painting and final

assembly, there are all three different types of laborers. Mainframe manufacturing handles an

extra 54,000 parts that result in $56,000 of overtime labor. Add-on parts require a total of

$70,000 of overtime labor. Subassembly, painting and final assembly use the $87,000, $9,500 and

$41,000 of overtime respectively.

Additional electricity usage is required to manufacture the scrapped parts. To make additional

mainframes, 225 hours of work using 201kilowatts of energy are needed. Add-on parts require

153kW for 165 hours. Painting and final assembly use 383kW for 25 hours and 30kW for 15

hours respectively. One kiloWatt-hour costs $0.05.

Question:

What is the total cost of this scrap rate using full cost accounting? The table below can help

organize and estimate the various scrap costs.

Scrap Activity Scrap Costs per Year

Regrind Laborers

Regrind/Rework Costs

Parts Loss

Overtime Labor

Additional Electricity

Materials Cost (from Part 2)

Total29

Answer:

Regrind Laborers

• 2 laborers * $130,000/laborer = $260,000

Regrind/Rework Costs

• Scrap from Subassembly, Painting and Final Assembly:

24,000 parts * ($18.70 + $2.70 - $4.20) = $418,000

• Molding Scrap that must be reground and sold:

160,000 lbs * ($1.39 - $0.30) = $174,400

Total Regrind/Rework Costs: $418,000 + $174,400 = $592,400 ~ $592,000

Parts Loss

• Subassembly Parts: 14,800 parts * $4.80/part = $71,040

• Painting Parts: 5,900 parts * $8.00/part = $47,200

• Final Assembly: 3,300 parts * $35.40/part = $116,820

Total Parts Loss: $71,040 + $47,200 + $116,820 = $235,060 ~ $235,000

Overtime Labor

• Sum of mainframe, add-on, subassembly, painting and final assembly:

$56,0000 + $70,000 + $87,000 + $9,500 + $41,000 = $263,500 ~ $264,000

Additional Electricity

• Mainframes: 225 hr * 201 kW * $0.05/kW-hr = $2,261

• Add-On Parts: 165 hr * 153 kW * $0.05/kW-hr = $1,262

• Painting: 25 hr * 383 kW * $0.05/kW-hr = $489

• Final Assembly: 15 hr * 30kW * $0.05/kW-hr = $23

Total Electricity Costs: $2261 + $1262 + $489 + $23 = $4035 = $4000

Scrap Activity Scrap Costs per Year ($)

Regrind Laborers 260,000

Regrind/Rework Costs 592,000

Parts Loss 235,000

Overtime Labor 264,000

Additional Electricity 4,000

Materials Cost (from Part 2) 1,500,000

Total 2,855,00030

Part 4:

This problem has estimated the materials costs of scrap from a simple mass balance calculation

(Part 2) and taken a closer look at the specific costs of scrap that were not outwardly obvious

(Part 3). Knowing this information, what is the difference in the estimations of scrap costs from

the 3 parts above? Did the full cost accounting evaluation provide incentive for the manufacturer

to be more concerned about scrap? What are the potential insights and other uses of full cost

accounting analyses? Discuss.

Answer:

Difference in Scrap Cost Estimations:

Part 3 – Part 2: $2,855,000 – $1,500,000 = $1,300,000

Part 3 – Part 1: $2,855,000 - $800,000 = $2,000,00031

STUDENT VERSION

Developed By Rebecca Cassler and Cheryl Horney, Carnegie Mellon University

True Costs of Plastic Scrap: An Environmental Cost Accounting Case Study

Part 1:

An automobile manufacturer makes the plastic interiors of cars in an injection molding facility. In

one year the facility buys 21,600,000 pounds of polycarbonate plastic for $1.39 per pound. The

polycarbonate is molded into: 1,360,000 mainframe parts totaling 18,300,000 pounds and

1,360,000 add-on parts totaling 2,720,000 pounds. The balance of the polycarbonate is scrap.

Questions:

a) Approximately how much material is scrapped?

b) What percent of the total purchased plastic does this represent?

c) What is the cost of scrap?

Mainframe Parts

Plastic In Add-on Parts

Scrap

Part 2:

Although a significant amount of scrap is directly recycled back into manufacturing processes, a

large amount of scrap must be taken off site that was not considered above:

§ Approximately 346,400lbs of polycarbonate are recovered from molding the mainframes'

component carriers and another 193,600lbs are recovered from add-on parts molding.

This scrap is sold for $0.31/lb.

§ Purges from the molding machine total 21,600lbs and are landfilled at a cost of $0.025/lb.

§ Another 691,000lbs of scrap representing 51,400 parts are recovered from subassembly,

painting and final and sold at $1.47/part.

Questions:

a) What is the net income (revenues – costs) from the scrap?

Molding32

Part 3:

The automobile manufacturer is evaluating the injection molding facility through full cost

accounting to determine the true cost of scrap. The materials cost of the scrap was easily

calculated from a mass balance as shown above. However, scrap is produced at five main points

in the manufacturing process: mainframe molding, molding of add-on parts [component carriers],

subassembly, painting and final assembly. To recover the scrap, there are associated costs

throughout manufacturing such as: labor, regrind/rework, loss of parts and additional electricity

usage.

To process scrap, there are two full-time blending/regrind skilled personnel in the facility. Their

salaries, including overtime and benefits, total $130,000/year/person. In addition to those two

laborers, employees regrind and rework approximately 24,000 scrap parts from subassembly,

painting and final assembly. For each of these scrapped parts, initial materials cost $18.70/part,

regrind labor costs $2.70/part, and the facility sells the reground scrap for $4.20/part. From other

parts of the facility, there are approximately 220,000lbs of scrap that can immediately be