Integrating Environmental Factors into Life Cycle Costing - Coursework Example

Integrating Environmental Factors into Life Cycle Costing Integrating Environmental Factors into Life Cycle Costing Life cycle costing has gained prominence over the past few years. Life cycle costing encourages the expansion of accounting boundaries from dealing with only the present to adopting a more strategic look at the accounting needs of a firm (Schaltegger & Burritt, 2000). As will be noted in the paper, the benefits of life cycle costing are numerous. Among these benefits is the fact that life cycle costing can help to shed light on the environmental costs caused by a product over its entire life cycle. This helps to make managerial decisions such as decisions on pricing more effective. This paper takes a look at traditional life cycle costing approaches and an evaluation is made as to the extent to which they have integrated environmental factors. The paper ends by stipulating how environmental issues and their costs can be incorporated into life cycle costing. Life cycle costing refers to the sum totalling of all the costs incurred during the lifetime of an item i.e. the total procurement and ownership costs (Dhillon, 1989). The procurement cost refers to the acquisition or the investment costs whereas the ownership costs can be termed as costs involving maintenance as well as other costs connected to owning a product (Dhillon, 1989). Thus, according to Schaltegger and Burrit (2000), “the basic idea behind life-cycle costing is to identify, track and account for costs relating to the whole life-cycle of a product” (p. 124). In today’s market place, where organizations are constantly facing multiple challenges of competition, rapid technological advances and changing consumer tastes and preferences, it has become critical to cut back on costs incurred so as to maximise the benefits. Organizations are relentlessly searching for new ways to reduce both their fixed and variable costs so as to increase their profit margins. Life cycle costing plays an important role in regulating both fixed and variable costs. It has wide applicability such as in “comparing competing projects, long range planning and budgeting, selecting among competing bidders, controlling an ongoing project, comparing logistics concepts, and deciding the replacement of aging equipment” (Dhillon, 1989, p. 30). Dhillon notes that the significance of conducting life cycle costing stems from the fact that at times the costs of operating/ owning a product may be more than the initial cost of the investment. Thus, life cycle costing helps to determine how costs will be spread out to allow the firm to break even and more importantly achieve profitability. Several models have been used by managers to carry out life cycle costing. These models “contribute to cost reduction by identifying high cost contributors” (Kumaran et al., 2001, p. 262). The same authors identify 8 models that are used by managers in present day. However, the authors note that none of these models takes into account the environmental cost implications on the value of the product/ service. This shows that these models fall short of serving their purpose by capturing some costs while leaving others out. Some of these models include: economic input-output LCA model, activity-based costing model, total cost assessment model, design to cost model etc. Attention is however shifting to the contribution of eco-costs to the total cost of the product through its lifecycle. As such, a new approach to lifecycle costing is required. Notably, the life cycle costing models may vary from one organization to the other. Dhillon (1989) observes that factors such as the nature of the problem, existence of many different cost data collection systems, many different types of equipments and the inclination of the users may pose challenges to the feasibility of a having a standard costing system. Nonetheless, traditional life cycle costing has failed to address the environmental costs in their frameworks. Indeed, Dunk (2002) notes that environmental costs are usually missing in the final financial statements/ reports with the disclosure of social responsibility activities of a firm being largely voluntary. Kumaran et al., (2001) recommend the revision of such models in order to fully integrate such issues into financial decision processes. Several benefits are to be accrued from the inclusion of environmental costs into costing models. Dunk (2002) points out that due to the fact that “firms are increasingly held liable for environmental costs, environmental management often results in cost reduction” (p. 720). Dunk also asserts that environmental reporting also gives management information on which to base their decisions such as decisions on pricing. According to Dunk (2002), firms are also likely to benefit from improved quality performance of their products by incorporating environmental costs. This is likely to give the organization a competitive edge in the long run. Doost and Letmathe (2000) observe that while some organizations simply react to the environmental regulations, through compliance, there is “considerable potential for more success in achieving the traditional company objectives such as maximizing profits or higher level of market share” (p. 425). This should provide the management with the motivation to protect the environment based on the perceived benefits to be gained. This approach would yield more fruit since the efforts of incorporating environmental costs in financial decisions will be intrinsically motivated as opposed to reliance on legal imposition of environmental regulations. However, Doost and Letmathe (2000) point out that the management will only do this if they think/ perceive that the benefits of including the environmental costs far outweigh the costs involved. Bebbington (as cited in Dunk, 2002) underlines the important role that accounting can and should play in environmental issues by stating that “accounting plays a crucial role in managing the firm-environment relationship and, in particular, accounting should help orientate organizational actions to the biosphere” (p. 721).The process of incorporating environmental costs starts with “identifying environmental impacts of the organization, which is also a requirement of the ISO 14001 standard” (Doost & Letmathe, 2000, p. 126). Doost and Letmathe recommend that the costs and the environmental impacts should be documented and categorised as either low or high significance. Only the highly significant economic impacts should be considered. The next step is to find out which flows of materials and energy are causing the significant environmental impacts. The idea here is to attribute the environmental impacts to specific processes or materials. For instance Doost and Letmathe (2000) give an example of how “chlorofluorocarbons contribute to the green house effect and to the depletion of the ozone layer” (p. 426). Environmental costs are arrived at by coming up with the quantities of the materials and energy. The measured quantities should be compared to the standard quantities. The standard quantities act as a bench mark upon which any deviations from the norm are observed and recorded. Finally the “environmental costs have to be assigned correctly to their causing objects like input, processes and products” (Doost & Letmathe, 2000, p. 426). This is because all environmental impacts can be traced back to either input, process or product related factors. Understanding this distinction helps to allocate costs to the right causes, thus aiding in managing such costs. Input-related environmental impacts are caused directly by the use of an input irrespective of the process to which the input is put to. Process-caused environmental impacts on the other hand are as a result of combining several inputs through a process. On the other hand, product-caused environmental impacts are as a result of a product and not a single input or process (Doost & Letmathe, 2000). Kumaran et al. (2001) take a similar approach to incorporating environmental costs in life cycle costing analysis. They propose the life cycle environmental cost analysis or LCECA model which aims at including eco-costs into the overall cost of products. The note that eco-costs are the indirect and direct costs of the environmental impacts brought about by the product or service in its entire life cycle (p. 268). This model borrows a lot from the LCCA method highlighted by Fabrycky and Blanchard (1991). The new model includes a new grouping of eco-costs such as costs of effluent control, cost of waste/effluent treatment, cost of implementation of EMS, rates for waste disposal, costs of eco-taxes, costs of rehabilitation (in case there are environmental hazards), costs of energy; and cost savings on reuse and recycling strategies. According to Kumaran et al. (2001), the eco-costs mentioned above are deciphered and identified from the product. “The costs are then added to the other major costs such as research and development costs, production costs, operation and maintenance costs and disposal costs” (p. 270). The approach recommended by Kumaran et al., therefore combines the eco-costs to the other costing methods such as activity based costing models. This helps to give a more comprehensive view of the costs involved in the different product life cycle stages. As such, the LCECA model recommended by Kumaran et al. is consistent with other models of life cycle costing but has the added benefit of incorporating environmental costs. This makes it more reliable. Environmental costs can also be enforced through the use of audits. Audits comprise both external and internal audits. External audits are done to review the management system by an independent external auditor or registrar (Doost & Letmathe, 2000, p. 429). The most common external audits are the ISO audits such as ISO 14001 which reviews the quality management or environmental management system. The significance of these values cannot be undermined. Kumaran et al. (2001) reckon that such international standards are slowly being viewed as mandatory requirements for operating in the domestic and international markets. In a bid to attract such certifications, an increasing number of companies are striving to improve their environmental accounting system. This is especially true for the ISO 14001 standard which is “dedicated to continual improvement as the overall goal of environmental management systems. To accomplish this, the organization has to define concrete objectives, targets and measures to achieve them” (Doost & Letmathe, 2000, p. 429). Similarly, internal audits can be carried out against certain set standards. Internal audits are typically performed by an internal audit department. They can be used to ascertain compliance with the management’s set goals. In summary, the environmental costs cannot be ignored in the modern day economy. With industrialization comes the associated cost of diminishing natural resources. Indiscriminate pollution without regard to the environmental concerns for the present and future generations is not sustainable in the long run. The situation can only be controlled if environmental costs are included in the generation of accounting information. This is because it is on the basis of accounting information that decisions are made by an organization’s management. Inclusion of environmental costs of a product through its life cycle therefore means that decisions will be made which are of mutual benefit to the organization and most importantly to the environment. References Dhillon, B. S. (1989). Life cycle costing: Techniques, models, and applications. Gordon and Breach Science. Retrieved 15th April, 2010, from http://books.google.co.ke/books?id=eP4Sq3KUBkYC&printsec=frontcover&dq=life+cycle+costing+methods&cd=1#v=onepage&q=life%20cycle%20costing%20methods&f=false Doost, R., K. & Letmathe, P. (2000). Environmental Cost Accounting and Auditing. Managerial Auditing Journal, 15 (8). Retrieved on 15th April, 2010, from http://www.emerald-library.com Dunk, A., S. (2002). Product quality, Environmental accounting and Quality performance. Accounting, auditing and Accountability Journal, 15 (5), 719-732. Retrieved 15th April, 2010, from http://www.emeraldinsight.com/0951-3574.htm Kumaran, D., S. Ong, S. K., Reginald B. H., & Tan. (2001). Environmental life cycle cost analysis of products. Environmental Management and Health, 12 (3), 260-276. Retrieved on 15th April, 2010, from http://www.emerald-library.com/ft Schaltegger, S. & Burritt, R. (2000). Contemporary Environmental Accounting: Issues, Concepts and Practice. Greenfield Publishing. Retrieved on 15th April, 2010, from http://books.google.co.ke/books?id=8ujaV8YcLioC&pg=RA1-PA124&dq=life+cycle+costing-+environmental+issues&cd=2#v=onepage&q&f=false Read More