Summary by Summary by Zuwena De Freitas
Master of Accountancy Program
University of South Florida, Summer 2002
The purpose of this paper is to show how environmental costs can be analyzed using the same framework for analyzing quality costs. By using the concept of Total Quality Management (TQM) in the environmental arena, companies may be able to shift expenditures away from remediation toward efforts to prevent environmental problems from ever occurring.
More and more companies are realizing the need to focus on long-term environmental cost savings. Short-term cost reductions often lead to much higher expenditures and liabilities over the long run such as environmental cleanup cost required by the federal, state or local environmental legislation. As estimates of the nationwide cost of the cleanup now reach $750 billion it becomes apparent that simply reacting to environmental problems is not cost-effective.
The quality perspective
TQM has taught managers to recognize the full extent of quality costs and to recognize that poor quality has its own cost. Managers realized that quality control is not about inspecting quality into products but about prevention. The same cost categories that have been used to analyze quality cost are introduced in this paper to analyze environmental costs. These costs categories are as follows: Prevention costs, Appraisal costs, Internal failure costs, and External failure costs:
Prevention costs: Expenditure made now to reduce future outlays.
Prevention costs represents a company’s active efforts to solve problems before they occur and turn them into opportunities. Prevention is an investment. Companies can experience a long-term competitive advantage when environmental engineering efforts are undertaken to reduce and eventually eliminate pollutants. Coors is a good example of this. Coors’ initially controversial program of switching to aluminum cans eventually gave it a competitive edge. As William Coors said, "Using fewer resources means lower cost in the long run, even if the upfront cost is high."
Many expenditures for prevention are tied to the development and acquisition of long-term assets and are the most successful when carried out during the design phase for new products and technologies. From 70-80 percent of a product’s cost are often locked in at this point and managers should analyze the possible cause-and-effect relationships between their decisions and future environmental impacts.
Appraisal costs: Expenditures made to monitor how a company’s activities affect the environment.
Due to regulatory pressures to reduce air, land and water emission appraisal has become critical. Appraisal costs include:
Charges for the depreciation of test equipment
Costs of supplies used in test and inspections
Costs of obtaining outside laboratory endorsements
These activities can be compared to the appraisal or inspection costs that companies incur in TQM programs. In TQM, much of the appraisal effort focuses on inspecting the inputs and production processes. For environmental effects, efforts focus on monitoring the production processes and by-products. By engaging in monitoring activities companies will be bale to discover problems early and corrective actions can be taken quickly and economically.
Internal failure costs: Expenditures made to correct environmental breakdowns discovered in appraisal efforts.
This type of environmental cost is comparable to the internal failure costs in TQM but there are several important differences.
One major difference has to do with how internal failure costs arise. Under TQM, these costs arise from a company’s efforts to meet customer specifications and include rework and scrap cost. With environmental expenditures, these costs are linked more to the production processes. The type of risk and the level of exposure related to internal failure costs constitute another difference. Environmental expenditures relate to a broad range of production processes, which means that companies will encounter significant internal failure costs. For example, improper workers’ exposure to hazardous chemicals and failure to comply with regulations from the Occupational Safety and Health Administration (OSHA) immediately expose the company to significant liabilities.
External failure costs: Expenditures incurred when the resolution or remediation efforts fall outside the control of a company’s management.
These are the most significant costs and begin when the remediation efforts fall outside the control of a company’s management. It is then up to regulatory agencies or litigation to dictate the specific corrective measures to be taken. With TQM, external failure costs begin with the sale or delivery of a flawed product to a customer.
Inland Steel is an example of a U.S corporation that has received civil penalties of $54.5 million and was handed cleanup costs from a 1990 pollution lawsuit stemming from operation at its East Chicago Steel mill. External environmental costs under both TQM and in the environmental area include these types of corporate liability for damage and remediation activities but they may also include possible lost sales because of poor reputation.
Cost categories and strategies
By classifying environmental expenditures in the different cost categories, a number of approaches for controlling expenditures become apparent. Companies must focus their effort on prevention and appraisal as more control can be exercised over these two costs. As management exercises more and more control over these two costs, the up-front costs increase while failure cost (internal and external) decrease. The goal is to find the level of control that leads to the lowest total costs.
When failure costs increase for example, the optimal solution involves tighter control. This implies that more resources should be pumped into prevention and appraisal programs.
If prevention and appraisal costs decline, the optimal solution will again involve tighter control. This is true because companies can afford to expand more effort to gain control over effects on the environment and this does not necessarily have to mean more dollars.
There are reasons to believe that these types of changes may occur. First, the decrease in the cost of information and production can lead to costs savings for companies. Gains from synergy are also possible considering design integration and production engineering by many advance manufacturing companies. Finally, increased social pressure may drive up the costs of using inputs that generate undesirable by-products and waste. Based on these reasons, prevention may well lower the total environmental costs that a company will face.
The TQM framework for analyzing quality costs may be equally useful for analyzing environmental expenditures. Companies will be able to adopt production technologies that eliminate the hazard waste itself as opposed to paying for expensive hazardous waste removal. This should lead, in the long run, to an overall reduction in cleanup costs and a lower exposure to contingent liabilities for environmental problems.
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