Management Accounting: The Hidden Driver for Clean Production

by Burton Hamner

copyright 1998

bhamner@cleanerproduction.com

It may come as a surprise to most people, but the person in an industrial company who is most likely to make clean production and pollution prevention succeed is the accountant. The logic is clear: CEOs and company owners will lead the company towards environmental sustainability only if they think it is in the best financial interests of the company. They will invest in clean technology and pollution prevention only if they have an accurate financial picture of the current costs of generating waste and pollution and can clearly see how pollution prevention will minimize those costs. Accountants are the ones who tell the boss what the costs are.

So what is the surprise? Because experience in thousands of companies shows that accountants almost never have an accurate financial picture of the current cash costs of pollution. They always underestimate these costs, usually by a lot. Many of the costs of generating pollution are hidden in overhead; accounting ledgers don't recognize the costs or the specific polluting processes which generate them. Nonetheless the costs are numerous and much higher than expected by almost all CEOs.

The cost of capital is a major expense hidden in almost all accounting systems. If a million dollars is spent on managing wastes each year, and a company expects an internal rate of return of 20% on its investments, then waste is costing the company $200,000 per year in lost profits which would have been generated if the million dollars was invested in profitable enterprise.

In addition to these daily cash costs are potential costs such as fines for non-compliance, lawsuits, public relations, clean-up costs for environmental damage, and lost sales due to bad publicity. Many US companies have paid hundreds of millions of dollars to clean up pollution and land contamination generated years ago, when there were no environmental laws to worry about. Although long-term liability is still not a feature of Asian and other developing country environmental laws, it is coming. A major issue is the sale of contaminated industrial land. When land is contaminated, and buyers learn to investigate this issue, they may decide not to purchase land which is or is suspected of being contaminated. This decreases the market value of property and reduces the asset value of the landholder. Such losses of property value have driven most Western banks to require environmental investigations of contamination on any transaction of real property or which is secured by real property. Accountants responsible for reporting the value of corporate assets should realize that pollution of corporate property is a hidden threat that can suddenly materialize on the balance sheet as a known and significant liability which must be reported under public accounting rules.

Another key issue is that the costs of generating waste and pollution are going up and will keep going up. In many countries there is legislation in place now that will require significant investments in pollution control in the future, if actions are not taken to minimize wastes now through clean technology and pollution prevention. This means that accountants cannot just identify this year's cost of pollution. They also need to identify the rate of increase of the various cost factors, and the time and amount of future major cash outlays for pollution management. Considering the delay between the initial passing of environmental legislation and the actual enforcement of resulting regulations, and the effects of existing legislation on certain costs such as regulated chemicals, accountants should be using at least a three-year rolling forecast of environmental costs.

CASH COSTS OF GENERATING POLLUTION AND WASTE =

   [2x(PxQ) + (QxM_T) + D(C)]

+ [Q x (L+S) + (d+se+st)]

+ [D(ce) + L + ND + (QxPr) + m] x (1+IRR) x (1+R)^t

+ [D(ce) + Qx(de)]

+ [ml + i + f]

Inefficient Use of Raw Materials, Leading to Waste = 2x(PxQ) + (QxM_T) + D(C)

• Purchase price (P) of the quantity (Q) of raw materials which are wasted = (PxQ)
• Replacement cost of raw materials which are wasted (you have to buy it again!) = (PxQ)
• Costs of processing materials (M) up to the time they become waste at time T = QxM_T
• Depreciation (D) of extra production capacity (C) needed to accommodate inefficiency and hence waste generation, which leads to the need for bigger buildings and more land

Waste Handling Prior to Treatment or Disposal = Qx(L+S) + (d+se+st)

• Labor (L), supplies (S) = Qx(L+S)
• Depreciation (D) of cost of drains (dr), safety equipment (se), storage (st) = D(dr+se+st)

Waste Treatment = D(ce) + L + ND + (QxPr) + m

• Depreciation of capital equipment (ce) = D(ce)
• Taxes on or rent of and or space for treatment systems (L)
• Non-depreciable system costs ND including regulatory analysis, system design, installation, testing
• Waste processing costs (Pr) including electricity, labor, maintenance, supplies, chemicals, sampling = QxPr
• Waste system management (m) including inspection, sampling, record-keeping, reporting, emergency response

Waste Disposal = D(ce) + Qx(de)

• Depreciation of capital equipment (ce) for vehicles or land disposal sites = D(ce)
• Disposal expenses (de) including labor, containers, transportation, disposal fees = Qx(de)

Other = ml + i + f

• Management labor (ml) to make sure all the above items are done properly
• Higher insurance premiums (i) due to use of hazardous materials and generation of hazardous wastes
• Legal and consulting fees (f) associated with pollution management

 

It does not stop there. The Capital Opportunity Cost = Return on investment that would have been obtained if all the money spent managing waste was instead invested in productive activities. The company's standard Internal Rate of Return required for projects is a good benchmark. If it is 20%, then the total cash cost must be multiplied by 1.20 to account for the profits that were lost because money was spent on waste instead of investment. And the costs go up every year with inflation. So Inflation of Costs = (1+R)^t, where R is rate of inflation over number of years t. Thus the total annual cost of waste and pollution, including the capital opportunity cost, should be multiplied by the inflation factor to give a picture of the costs for the foreseeable future.

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The total current costs of environmental protection are much higher than executives think. A study done by the US Environmental Protection Agency at the Amoco Oil Company's Yorktown Refinery showed that, at the beginning of the study, the refinery managers thought that environmental costs were about three percent of total operating costs. When an intensive analysis of the refinery's costs was completed it revealed that environmental costs were actually 22 percent of total operating costs. Needless to say the refinery management was highly motivated to implement clean technologies when they realized the magnitude of the costs of not implementing them.

The issue of proper management accounting for waste and pollution costs is so important that the US EPA has established a national network on environmental accounting and capital budgeting in its Design for Environment Program. The World Resources Institute, in cooperation with industry leaders and management accounting professors, produced a book called Green Ledgers which provides case studies demonstrating conclusively that existing accounting systems in many companies do not recognize the cash costs of pollution and that the decisions of executives about implementing clean technology are biased against clean production because they do not have the full financial picture. The US Institute of Management Accountants has become very active in this new issue. A number of business school researchers are investigating models for better accounting for environmental costs. The mission is clear: If executives don't know how much they are spending on pollution now, they can't know how much they can invest in order to prevent it.

A recent experience with a Philippine meat processing plant illustrates how costs can be hidden. I visited the plant, where I was informed that the new wastewater treatment system had cost the company 10 million pesos (US $1.00 = 26 pesos). In the plant, it was noted that about 50% of the discharge to the treatment system was cooling water which was hot but not contaminated. When they were asked why they didn't invest in a cooling tower to recycle the cooling water, the company management stated that since they got the water from a ground well and was basically free, the cooling tower was not cost effective.

I asked the managers to determine how much water really did cost the company. When the costs of electricity for pumping, well maintenance, down-time for pump maintenance, treating the well water to food grade use (chorination, hardness adjustment, triple filtering, filter media replacement, capital and utilities for the treatment system) were calculated it was discovered that it cost the company almost 5 million pesos a year just to get the water into the production lines. Then, of course, there is the cost of having a much bigger treatment plant to handle the cooling water.

The company management later stated that, had they known how much the water really cost them, they would have invested in a cooling tower which would have reduced total water use by 50%, thereby reducing the cost of processing incoming water, as well as the size and cost of the wastewater treatment system. The company subsequently initiated a corporate-wide training program on pollution cost analysis, total quality environmental management and pollution prevention in order to reduce the current and future costs of pollution control.

Perhaps one of the most damaging hidden costs of pollution is treating environmental costs as overhead. When the costs are treated as overhead, all departments in the company pay a share of overhead based on some allocation formula. But in reality, not all departments create the waste and pollution. It may be only one or two production departments out of a dozen that create 90% of the pollution. When the costs of pollution are spread around equally as overhead, two bad things happen: the _dirty_ departments appear to cost less than they should, and the _clean_ departments appear cost more than they should. This can actually subsidize pollution. Dirty production units appears to be less expensive than they actually are, so companies continue to operate them as is. By charging environmental costs back to the responsible departments, they have a budgetary incentive to minimize pollution. In at least one case I know of, a company dropped a particular product because it turned out to be losing money when the full environmental costs of its production were allocated back to it.

The methods for better cost allocation are not new or particularly complicated; they are the subject of Activity-Based Costing, which is a well-established area of management accounting and which leading companies worldwide are exploring. ABC basically means identifying all the activities associated with a particular production step, measuring the costs of the activity, and charging all those costs to the step. There is very little overhead in a full ABC system because most of the costs are assigned to specific activities. Anyone interested in promoting clean production and pollution prevention should become familiar with Activity-Based Accounting. Many books on the subject are readily available, as are a number of articles in the pollution prevention literature.

There is one final twist to the accounting issue. When considering the costs of investment, most larger companies consider long-term cash flows to determine the internal rate of return or net present value of the investment. A hurdle rate or discount rate is established to accommodate the effects of inflation on decreasing the future value of cash flows, and the rate also reflects the perceived risk of the investment as well as inflation. We expect a higher rate of return, and impose a higher discount rate, on risky investments. But pollution prevention and clean production actually reduce risks of future environmental costs. So a pollution prevention or clean production investment should be subject to a lower hurdle rate or discount rate than an investment in pollution control or continuing the existing polluting processes. How much lower? This is a difficult decision, but it is very clear that if a company is to invest in a risk-reducing project it should use a lower hurdle rates than it uses to evaluate the future financial feasibility of existing high-risk processes.

What can we do to help promote better environmental management accounting? There are two simple answers. The first is to become familiar with the existing resource materials on the subject and participate in the networks of professionals exploring the issue. It is not hard to become literate in the subject. The second answer is to get the accountants out of their offices and on to the factory floor where they can see that pollution is not an overhead cost, it is a process-specific waste production cost. Once they are aware of the reality, then they can be helped to identify the total process-specific costs that lead to total environmental costs, and can allocate the pollution costs accordingly.

CEOs that are considering whether to invest in clean production and pollution prevention should try the bucket and scale approach to the cost equation. The bucket is all the real costs in the company, with the most obvious costs at the top and the least obvious at the bottom. The scale is the balance between the current cost of continuing to generate waste and pollution, and the alternative cost of preventing it. In the beginning, the prevention alternative side of the scale is down as its costs are known, but all the costs have not been added to the current waste generation side. First, the boss should dig the direct cash costs of annual waste and pollution off the top of the bucket, and put those on the current costs side of the scale. If the prevention alternative does not cost less, the CEO should dig a little deeper and put the predicable future cash costs of waste generation on the current side of the scale. If prevention still does not cost less, then some more digging should be done to add unpredictable costs such as penalties, lawsuits, or public relations damage control. Finally, if the prevention alternative still does not cost less than current waste and pollution, then intangible but real "costs" such as lost productivity due to chemical exposure and poor health, poor governmental and public relations, and lower morale from working in a dirty company should be thrown onto the scale on the side of current waste and pollution costs. If after all this the cost of prevention still weighs more, then it can be be rejected. But in most cases, the cost of generating waste and pollution will start to outweigh the costs of preventing it before the CEO has hit the bottom of the company cost bucket.

There is really no more important issue in promoting clean production and pollution prevention than money. And accounting is the way that top management understands money. By working with accountants and promoting full-cost accounting and activity-based costing, the logical financial reasons (should they actually exist) to implement clean production become apparent. There is no better motivator than profit, and it is both a shame and an opportunity that so much potential profit through clean production is hidden by inadequate accounting for the costs of generating waste and pollution.