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economic impacts.

Current costs related to current operations How to account for current social, environmental, and economic costs related to current operations is less controversial; these costs should be reflected in operating activities, processes, and products. However, the difficulty for many organizations has been to separately identify and account for those costs as social, environmental, and economic costs. In some companies, social, environmental, and economic costs related to production are accounted for as manufacturing overhead costs and are arbitrarily allocated to activities, processes, and products using a cost driver that does not reflect the relationship between the cost incurred and the activity, process, or product. Still other social, environmental, and economic costs are accounted for as administrative overhead costs, and are never allocated to activities, processes, or products. This makes it difficult to understand the social, environmental, and economic cost impacts of operational decisions, which again impedes effective decision-making. Tools such as life-cycle costing, activity-based costing, and full social and environmental cost accounting can help managers to better capture and assign these costs.

Future costs related to current operations It can be difficult to accurately predict the future social, environmental, and economic benefits, costs, and liabilities related to past or even to current production. Estimating future impacts depends on many factors that may be unclear today, including changing social and legal structures. It is unlikely that Philip Morris understood, 40 years ago, that changes in the social and legal climate in the US would result in extensive product liability costs for cigarettes. Recognizing potential future liabilities may cause a company to modify its strategy, product or production processes, or its accounting and management decisions.

The difficulty of predicting changes that may occur in the social and legal climate, along with the inability to reasonably estimate and measure the economic impact of those changes, is one reason why many future costs are not accounted for in the formal accounting system. However, there are some future costs that can be reasonably understood and should feature in the decision- making process, such as post-consumer use and recycling costs, disposal costs, facility decommissioning costs, natural resource restoration costs, and risk and legal liability costs. Other costs that are less predictable, such as those related to changing social and legal structures or reputational costs and the changing costs of technology, also need to be factored into the decision- making process.

Many managers find that practices such as life-cycle analysis and full social and environmental cost accounting are useful in helping them to identify and evaluate the longer-term impacts of current decisions. Other approaches identified in this book provide ways to measure and integrate social, environmental, and economic costs and benefits into operational and capital investment decisions.

Costing systems Identifying the full range of corporate sustainability impacts is an important step toward better management decision-making. Once identified, the impact of these costs on the company’s activities, processes, products, and services can be analyzed using available tools. A number of companies have begun the transition to improved social and environmental cost accounting in two

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ways: by clarifying their understanding of internal social and environmental costs through ABC (activity-based costing), and by placing a value on significant external costs, through LCC (life- cycle costing) or other approaches. Other companies have chosen to use FCA (full cost accounting) to include a broader set of external costs along with future costs into management decision-making.

Activity-based costing Two often-stated reasons for unreliable accounting data are the tendency to allocate social, environmental, and economic costs to overhead and the tendency to combine social, environmental, and economic costs in cost pools with nonenvironmental costs. This hampers management’s ability to assess social, environmental, and economic costs and make informed decisions. For example, AMP Ltd., an Australian-based global financial services organization, analyzed its environmental accounting and identified areas where costs were being inaccurately aggregated. Costs for waste collection and disposal and wastewater were included in the rent expense paid for buildings. The aggregation of these services made it difficult to identify opportunities to reduce waste and its associated costs. The company conducted a waste audit of one of its offices and identified that general and kitchen waste could be reduced by 65–80% through recycling.9

Increasingly, companies have seen the benefit of methods such as ABC to identify, measure, and track social, environmental, and economic costs and to assign them to activities, processes, products, services, customers, and channels. While traditional cost accounting assumes that producing products and services causes costs, ABC assumes that activities performed for products, services, and customers cause the costs. ABC first assigns costs to the activities performed by the organization (direct labor, employee training, regulatory compliance), and then attributes these costs to products, customers, and services based on a cause-and-effect relationship.

Better cost management requires the accumulation of social, environmental, and economic costs and tracing those costs to the activities that cause them. Carefully identifying all social, environmental, and economic costs has often produced totals that are four to five times the estimated amounts. These costs often hidden in manufacturing overhead include: permits, penalties and fines, water and air treatment costs, energy costs, waste treatment and disposal, training, inspections, and protective equipment. Also frequently overlooked are social, environmental, and economic costs that are buried in administrative overhead, such as record-keeping costs, community relations costs, site studies, legal costs, and audits. By attributing social, environmental, and economic costs to the activities that generate them, managers and employees can be motivated to find alternatives that lower those costs and increase profitability.

An ABC methodology provides detailed activity-cost and related information, and is especially useful for an organization that has many social, environmental, and economic costs embedded in its manufacturing and administrative overhead cost structures, and that also has some degree of either process or product variation. An ABC analysis provides a better understanding of a company’s costs, links social, environmental, and economic costs to management objectives and activities, improves decision-making, and supports full cost accounting as well as LCC.10

Life-cycle costing LCA (life-cycle assessment) is a design discipline used to minimize the environmental impacts of

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products, technologies, materials, processes, industrial systems, activities, or services. LCC, an extension of the basic LCA, attempts to identify all the costs—internal and external—associated with a product, process, or activity throughout all stages of its life. Life-cycle cost has been defined as the amortized annual cost of a product, including capital costs, and disposal costs discounted over the lifetime of a product.11 With regard to social and environmental costs, LCC consists of monetizing social and environmental impacts throughout a product’s life-cycle. It requires the measurement of present and future costs and benefits of a company’s products, services, and activities and can be an important part of the implementation of a sustainability strategy.

Canon assesses the CO2 emissions of its products over their entire life-cycle (Fig. 4.1) and implements concrete plans based on findings. Entire life-cycle CO2 emissions in 2012 were approximately 4,890,000 tons, an approximately 14% decrease over 2011.12

FIGURE 4.1 Canon evaluates life-cycle CO2 emissions of its products

Source: Canon (2013) Sustainability Report

Full cost accounting Some companies use FCA to include a broader set of external costs along with future costs into management decision-making. FCA allocates all direct and indirect costs to a product or product line for inventory valuation, profitability analysis, and pricing decisions. In other words, LCC translates social and environmental performance into financial currency, and FCA integrates these values into the framework of accounting. For example, Baxter International calculates and reports its positive and negative sustainability impacts as subsets of traditional accounts, allowing sustainability items to be easily identified.13 The combination enables managers to integrate sustainability impacts into decisions such as product costing, product pricing, capital investments, product design, and performance evaluations.

An FCA framework allows for consideration of external or societal costs and benefits (e.g. costs to human health and the natural environment) along with internal or private costs and benefits in the decision-making process. This requires a company to integrate present and future social, environmental, and economic impacts into its process and product costing system, including costs related to contingent liabilities and image and relationship costs and benefits.

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FCA adapts existing management decision support systems to accommodate the new information generated through LCC. An important element of FCA is the consideration of future social, environmental, and economic costs and allocation of these costs to products. Then, present and future environmental costs should be integrated into the product costing system.

Full cost accounting versus full cost pricing A common misconception is that FCA implies the expression of full costs in prices as well. It is important to separate the decision to adopt FCA methods (or any of the other methods discussed here) from the decision to incorporate these costs into product pricing. Corporations should adopt FCA so that they will better understand both the present and future costs of current production and can use that information to guide decisions throughout the value chain. Whether to make this new information transparent in product pricing is another issue. Prices may continue to be determined by the market, but an assessment of the company’s profitability must use more complete information about present and future social, environmental, and economic costs.

Summary of costing systems Companies are increasingly trying to improve their costing of social, environmental, and economic impacts. In 2003, Canon introduced a program in which each department bears the financial burden of its own waste processing. Prior to this program, the general affairs division handled all the costs of waste disposal. In the new program, waste, including papers and plastics, generated by each workplace is collected at a recycling center where the department, type of waste, and amount are recorded. Each department is then assessed a waste-processing fee for the waste produced.14 Using a full environmental costing system is beneficial because:

• Many environmental costs can be eliminated by simple changes

• Some environmental costs add no value to the process or product and usually constitute cost savings

• Understanding the environmental costs can lead to better pricing and creation of value of goods and services15

Part of the reason that more companies have not adopted FCA is the difficulty in valuing social, environmental, and economic impacts.16 However, an estimation of these impacts (discussed in Chapters 6 and 7) can help companies internalize external costs. As companies improve the costing of social, environmental, and economic impacts, they gain a clearer understanding of the complete costs of products, services, processes, and other activities. This should lead to a better understanding and improved management of both sustainability and financial performance.

Risk assessment Today, risks are both larger and more varied than previously thought and have been seen in companies and countries that thought they were shielded.17 With globalization increasing rapidly, a common challenge is how to integrate social, environmental, and political risks such as political instability, political corruption, business corruption, child labor practices, anti-corporate sentiment, terrorism, and environmental pollution into management decisions.

Some businesses are prone to social, environmental, and political risks because of the location

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