Environmental management accounting : a means of ensuring business integration of environmental strategies?

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University of Amsterdam

Faculty of Economics and Business

Master Thesis

Environmental Management Accounting:

A Means of Ensuring Business Integration of

Environmental Strategies?

- - - CONFIDENTIAL- - -

Name: Wiebke Held

Student No.: 6259383

Program: M.Sc. Business Studies, Strategy University of Amsterdam

1st Supervisor: René Bohnsack 2nd Supervisor: Mark van der Veen

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ABSTRACT

Organizations are experiencing more and more pressure from stakeholders and government regulations regarding their environmental performance. It has become too costly not to take the natural environment into account since stricter laws and higher fines have been imposed. Yet, many firms struggle to successfully implement an environmental strategy, thus academic literature on environmental management accounting has been emerging for the past decade. Reporting systems have long been used in organizations in order to monitor the success of strategies and therefore helping to implement these. However, empirical research on the relationship of environmental management accounting and business integration of environmental strategies is very limited, since it is a new managerial technology and has not been widely used. In order to study this relationship, the author uses a case study approach. The case study subject is an international German textile manufacturer. Three initiatives, which target environmental savings, have been chosen from its environmental strategy in order to examine if environmental management accounting can support the business integration of these initiatives. The analysis of five in-depth interviews, two visits at the premises and secondary data, partly confidential, yield valuable inside into the research topic. Among others, the results show that especially the reporting systems of all three focal targets can be enhanced through EMA helping to achieve the targets and thus lead to business integration. Moreover, it is shown that EMA can also have a positive impact if implemented at the supplier level, not only helping the focal organization but also its whole value chain.

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Preface

Having been able to write this master thesis about environmental management accounting means a lot to me, since I have always had a strong interest into sustainable corporate development. Finishing my master studies at the University of Amsterdam in this field has been a great pleasure for me.

I would like to thank company X, all interviewees and especially the Head of Environmental Services for the cooperation, ideas and support. Moreover, I would like to thank my supervisor, René Bohnsack, for his continuous support, guidance, ideas and feedback. Accordingly, I would also like to thank my second supervisor, Mark van der Veen, for his efforts. Special thanks go to my parents and friends, who have been incredibly supportive, helpful and patient during the entire writing process.

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Index of Figures

Figure 1 – Integrative Framework of Environmental Accounting ...17

Figure 2 – Simplified material flow model...20

Figure 3 – Material flow model with material values...21

Figure 4 – Integrated framework of Strategy, business model and tactics ...36

Figure 5 – Theoretical framework ...38

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Index of Tables

Table 1 – EMA Framework ...19

Table 2 – Physical Materials Accounting: Input and Output Types...22

Table 3 – Environmental costs hidden in overhead accounts...26

Table 4 – Environmental costs attributed to cost centers and products...26

Table 5 – Environmental-related Cost Categories for EMA ...28

Table 6 – List of interviewees...41

Table 7 – List of Sources ...42

Table 8 – Selected targets for analysis...43

Table 9 – Aggregated target results of 24 reporters from 2008 until 2010 ...51

Table 10 – Results Green Company initiative ...54

Table 11 – Results Complexity Reduction ...59

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Index of Abbreviations

ABC Activity-Based Costing

CPA Cleaner Production Assessment EA Ecological Accounting

EDCA Environmentally Differentiated Conventional Accounting EMA Environmental Management Accounting

EMEA External Monetary Environmental Accounting EPEA External Physical Environmental Accounting EPI Environmental Performance Indicator

ERP Enterprise Resource Planning KPI Key Performance Indicator

MEMA Monetary Environmental Management Accounting MFCA Material Flow Cost Accounting

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1 Introduction

In recent decades, environmental issues have become a major concern when discussing the problems of industrialization and economic growth (Xiaomei, 2004). Soil, water and air pollution resulting in global warming, chemical waste and deforestation are only a few examples that are associated with the growing economy. Economic, environmental and social well-being is significantly influenced by organizations. In order to ensure the long-term sustainable development of the economy and society, corporate sustainability is necessary (Schaltegger, Bennett and Burritt, 2006). Consequently, it has become increasingly important to nations, politics as well as the world economy and every firm operating in it (WBCSD, 2001; IFAC, 2005). Firms that do not pay any attention to environmental management put their existence and the environment at risk (Hunt & Auster, 1990; Marcus & Fremeth, 2009). Therefore, governments have yet been involved in developing regulatory and voluntary standards to promote and establish sustainable development throughout organizations, thereby increasing the awareness for environmental management. For companies, this means to proactively manage environmental impacts they have on the natural environment, in order to not compromise the needs of future generations (UNCED, 1987).

Due to the increasing costs of neglecting environmental protection, also business performance is connected to means of environmental protection and its management (Schaltegger & Burritt, 2000). Thus, many companies formulate environmental strategies to manage environmental issues. Well-formulated environmental strategies can enhance a company’s competitive position and lead to better quality, reduced costs, improved environmental image and new market opportunities (Maxwell, Rothenberg, Briscoe & Marcus, 1997; Flint & Golicic, 2009). However, developing an environmental strategy is a challenging undertaking due to rising cost associated with environmental liabilities and increasing complexity in environmental issues, especially for multinational companies (Epstein & Roy, 2007). The real challenge lies in moving from value statements and formalities of the strategy documents to the implementation at business unit, plant and project levels (Maxwell et al., 1997).

In order to formulate and integrate corporate aims and strategies management control systems are usually implemented (Anthony, 1965). Further, it has long been

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11 acknowledged by strategy researchers such as Rumelt (1972), Miles, Snow, Meyer and Coleman (1978) and Porter (1980) that different control systems are used and needed in order to implement different corporate strategies. Considering the difficulties of environmental strategy implementation, literature on environmental accounting has been emerging for the last decade. It generally suggests that companies have to fully account for the environmental costs and liabilities, but also the benefits, resulting from their operations in order to successfully manage environmental issues (Schaltegger & Burritt, 2000).

The present thesis deals with Environmental Management Accounting (EMA), which focuses on the link between internal information used for management decision-making and the successful implementation of environmental strategies. Compared to conventional accounting systems, in which most environmental costs disappear in overhead accounts, EMA takes environmental impacts resulting from business operation directly into account (Schaltegger & Burritt, 2000). An important value proposition of EMA is its impact on the integration of environmental programs and strategies (Bennett, Rikhardsson and Schaltegger, 2003). Environmental issues have become increasingly complex and can have a detrimental impact on a company if it is not sufficiently prepared (Schaltegger and Burritt, 2000). As stated by Maxwell et al. (1997), increasing complexity can make it difficult to develop and integrate an environmental strategy. Bennett et al. (2003) even go as far as saying that without a link to financial consequences no environmental program or strategy will be influential and successful.

However, Fereirra, Moulang and Hendro (2010) state that empirical research on EMA is very limited. Bouma and van der Veen (2004) add that it mostly focuses on the implementation of EMA tools rather than on the effectiveness of EMA in facilitating the realization of environmental objectives. Moreover, Bouma and van der Veen (2004) state that in order to evaluate environmental investments, most of the management accounting tools have been developed by government organizations and have only been adopted to some extent in the business world. Therefore, the question remains to what extent EMA actually facilitates the integration of environmental objectives and thus helps to achieve environmental strategies.

For that reason, the research question guiding the present thesis can be stated as: How can EMA support business integration of environmental strategies? The objective of this thesis is to empirically investigate the link between EMA and the

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12 business integration of environmental strategies. After this introduction, the thesis is divided into six parts. The second part will outline the theoretical background relevant to this research. The theory of Environmental Management Accounting will be of special importance, since it presents the necessary EMA framework. With the help of Business Model theory the link between EMA and environmental strategy integration will be explained as well as a theoretical framework for this thesis will be developed. The third section will present the research design as well as the case study subject, a German textile manufacturer. It will contain information about the set up of the case study as well as the methodology and data analysis. In section four, the data analysis and results will be presented. In section five, the results will be linked and discussed in regard to the presented theory. Moreover, this section will contain implications for theory and practice. Finally, section six will conclude the findings of this research.

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2 Theory

This chapter provides an overview of the relevant theory in order to assess the question of how Environmental Management Accounting can help to ensure business integration of environmental strategies. At first, environmental strategy will be defined. After that, EMA theory will be discussed. It is the main focus of this thesis and therefore the largest part of the literature review. Moreover, business model theory is discussed in order to assess the integration of environmental strategies. Finally, a theoretical framework is suggested.

2.1 Environmental Strategy

Strategy is a multi faceted concept. Usually several options need to be explored and tested before making choices (Johnson, Whittington & Scholes, 2011). Chandler defines strategy as “the determination of the long-run goals and objectives of an enterprise and the adoption of courses of action and the allocation of resources necessary for carrying out these goals” (1963, p. 13). Seeing it from a value perspective, Porter claims that “[c]ompetitive strategy is about being different. It means deliberately choosing a different set of activities to deliver a unique mix of value” (1996, p. 60). Generally it can be stated that strategy is “the long-term direction of an organisation” (Johnson et al., 2011, p. 3). There are three levels of strategy inside an organization. The corporate-level strategy deals with the overall scope of the organization as well as how value is added to the business. Business-level strategy, on the other hand, is concerned with the individual businesses and how they should compete in their markets. Operational strategies deal with delivering corporate- and business-level strategies regarding resources, processes and people (Johnson et al., 2011).

Environmental strategies typically are generic and at the corporate-level. Their development is in response to specific environmental effects (Roome, 1992; Kolk & Pinkse, 2005). Kolk and Pinkse (2005) state that the formulation of these strategies usually depends on the risks and opportunities an organization perceives in regard to environmental protection as well as the types of environmental regulations relevant for the business. The reasons for companies to start developing environmental strategies lie in the shift from only complying with regulations concerning the environment and climate change to proactive environmental management (Hoffman,

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14 2000). Today’s business world is much more complex than regulatory compliance. With the rising awareness of environmental protection, pressure is not only coming from government regulations anymore but also from investors, local communities, consumers, labor unions and the media, to only name a few. These powerful stakeholders transform environmentalism from something external to something internal and make it a central objective of the organization (Maxwell et al., 1998; Hoffman, 2000). Judge and Douglas (1998) as well as Klassen and McLaughlin (1996) found a link between environmental performance and an organization’s financial performance. This correlation also supports the argument that mere waste and efficiency savings resulting from regulatory compliance is not enough anymore (Sharma & Vredenburg, 1998). Firms need to proactively manage environmental issues, as environmentalism and organizational strategy become increasingly intertwined. In the overlap of environmental protection and corporate affairs the strategic aspect emerges, which demands organizations to allocate resources to environmental initiatives in order to accomplish their economic objectives (Hoffman, 2000).

2.2 Environmental Management Accounting

In this section, first EMA is explained as a value creating activity. After that, the EMA framework is discussed. Then Physical Environmental Management Accounting is explained followed by Monetary Environmental Management Accounting. In the last part of this section, current research on the implementation of EMA is outlined.

2.2.1 EMA as a Value Creating Activity

In economics, capacity and resource restraints are issues every company has to face. Therefore, the activities performed by a company have to be justified by being value-adding. In order to do so, most companies of a certain size use management accounting systems including management accountants and tools (Bennett et al., 2003). Management accounting can be defined as “the identification, measurement, accumulation, analysis, preparation, interpretation, and communication of information that assist executives in fulfilling organizational objectives” (Horngren and Foster, 1987, p. 2). For the purpose of this thesis, management accounting will be called

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15 conventional management accounting hereafter in order to distinguish it from environmental management accounting (EMA).

Conventional management accounting has several value-adding functions for companies, such as strategic and operational planning, performance measurement and feedback about results. However, providing the basis for decision-making by obtaining information about how to achieve desired or targeted goals is arguably the most important function (Schaltegger and Burritt, 2000). Bennett, Bouma and Wolters (2002, p. 1) define EMA as “the generation, analysis and use of financial and non-financial information in order to optimize corporate environmental and economic performance and to achieve sustainable business”. Conventional management accounting as well as EMA data is mostly intended for internal use (Schaltegger and Burritt, 2000) and is not regulated by law (Jasch, 2004). The difference between conventional management accounting and EMA becomes clear when looking at the focus and purpose of the two systems. Conventional management accounting actively influences the organizational reality through the language it creates. It traditionally focuses mainly on monetary measures creating a certain vocabulary and definitions of concepts, e.g. the annual reporting cycle, which are usually accepted without being scrutinized by the users of the information system. Furthermore, since conventional information systems are not regulated by law companies can decide on which issues the conventional management accounting system is focused on. Thus, the organizational behavior is actively influenced by the accounting system in place (Bennett et al., 2003).

In contrast, EMA focuses not only on monetary measures but also on physical measures. Often accounting departments see the environmental departments in responsibility for environmental issues, although some environmental issues, such as materials and energy efficiency or full cost of waste, are already included in the conventional accounting system. However, they often remain hidden in overhead accounts, so that conventional management accounting systems are not able to provide exact information on how much the natural environment is impacted and harmed by an organization’s operations (Schaltegger & Burritt, 2000). Through EMA, conventional management accounting systems can be improved in order to account for environmental costs and impacts.

Another value proposition of EMA is the creation of a language including terminology and communication schemes, which can be used by managers in order to

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16 make well-informed decisions and promote awareness for environmental issues throughout the organization (Schaltegger and Burritt, 2000). Moreover, with the help of data collected in EMA, companies are able to establish eco-efficiency indicators in order to monitor their environmental performance (Schaltegger & Burritt, 2000; WBCSD, 2000; IFAC, 2005; Jasch, 2009). By assessing and allocating environmental costs, EMA enables managers to improve the quality of their decision-making through which it presents enhanced value to the company (Jasch, 2004). Resulting from enhanced information availability and improved decision-making, EMA most fundamentally proposes value by improving the natural environment itself. Rikhardsson, Bennett, Bouma and Schaltegger (2005) describe EMA as a new managerial technology. By integrating knowledge, methodology and practice and applying these in order to combine environmental management and economic results, EMA helps the company to become more resource efficient (Rikhardsson et al., 2005). This leads to reducing the negative impacts a company has on the natural environment and improving its economic performance (Bennett et al., 2003).

2.2.2 EMA Framework

As in conventional management accounting, environmental accounting can be distinguished according to two criteria; monetary vs. physical units and internal vs. external accounting (Schaltegger & Burritt, 2000; Burritt, Hahn & Schaltegger, 2002). In order to fully assess the EMA framework, first environmental accounting as a whole is explained. After that, the EMA framework is specifically addressed.

In earlier academic literature of environmental accounting, Schaltegger and Burritt (2000) introduce a framework that has tight methodological links to conventional accounting. They distinguish between Environmentally Differentiated Conventional Accounting (EDCA) and Ecological Accounting (EA), the former being measured in monetary and the latter in physical units. EDCA, being defined as a part of the conventional accounting system that is already in place in an organization, encompasses management accounting, financial accounting and other accounting systems. On the other hand, EA, being seen as an extension of the conventional accounting system, encompasses internal, external and other ecological accounting. This structure has two explicit strengths. It clearly distinguishes between environmentally induced impacts, which are measured in monetary units, and the impacts of corporate activities on the natural environment, which are expressed in

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17 physical units. This clear distinction is important, since information expressed in monetary or physical units is often collected from different sources and are measured differently in terms of quality and quantity. Moreover, different information is needed for different stakeholders and purposes. Therefore, a clear-cut differentiation is necessary in order to emphasize that the accounting system deals with two different kinds of information (Burritt et al., 2002).

However, there are also disadvantages of this early framework. Management accounting only considers monetary units. Yet information measured in physical units often builds the basis for monetary measures. Therefore, it is important to integrate monetary and physical aspects and provide an integrated structure (Burritt et al., 2002). Nevertheless, a clear differentiation between monetary and physical as well as internal and external information is still necessary in order to keep consistency and completeness in regard to the accounting system.

Figure 1 – Integrative framework of environmental accounting (Source: Burritt et al., 2002)

Burritt et al. (2002) introduce an integrated framework, which connects monetary and physical aspects but at the same time provides a clear-cut distinction

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18 between these two types of measures. Additionally, it provides an overarching structure interconnecting all parts of environmental accounting (see Figure 1). In their framework, they define environmental accounting as consisting of monetary environmental accounting and physical environmental accounting (see Figure 1, horizontal dimension). Furthermore, they distinguish between external and internal environmental accounting. Having set up the core elements of the framework, Burritt et al. (2002) position the elements of environmental accounting according to the criteria (monetary vs. physical units; internal vs. external) in the framework. For the purpose of this research, only the grey highlighting (Figure 1) showing the position of EMA in the integrated framework is further explained. As can be seen in Figure 1, EMA is defined as internal environmental accounting including both Monetary Environmental Management (MEMA) and Physical Environmental Management Accounting (PEMA).

MEMA is based on conventional management accounting methods, which are enhanced and modified in order to account for environmental issues of corporate activities. It is concerned with environmentally induced impacts on the corporation, which are measured in monetary units, such as for example fines that are imposed for disobeying environmental laws and regulations or capital invested in order to improve the natural environment. Moreover, it acts as control and accountability instrument as well as builds the foundation for management decision-making regarding how to achieve desired or targeted goals. Also strategic and operational planning is influenced by MEMA. Like MEMA, PEMA is also an internal management information tool. However, information is measured in physical units, for example kilograms. It deals with physical material quantities used or emitted by a company. In order to measure the environmental impact the company has through its material use environmental impact information is collected and organized by PEMA (Burritt et al., 2002).

In addition to the integrated framework, Burritt et al. (2002) indicate three further dimensions that have to be considered as an important part of EMA; time frame, length of time frame and routineness of information. The time frame dimension indicates whether the focal EMA tool addresses the past, present or future time, whereas the length of the time frame dimension determines the short or long term orientation of an EMA tool. The routineness of information dimension indicates whether information is gathered ad hoc or routinely. In Table 1 all dimensions of the

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19 EMA framework are included. With the help of the five dimensions any specific EMA tool can be allocated in the EMA framework, as the numbered boxes in Table 1 show. Each of the boxes contains some examples of important EMA tools. The location in the table is indicating where amongst these five dimensions the EMA tool is to be positioned. In sections 2.2.3 and 2.2.4 physical and monetary EMA tools will be discussed in more detail.

Table 1 – EMA framework (Source: Burritt et al., 2002)

2.2.3 Physical Environmental Management Accounting

In the first part of this chapter, the most relevant PEMA tool is discussed. Then different types of physical accounting information important under PEMA are described.

2.2.3.1 PEMA Tools

According to Jasch (2009), information measured in physical units is at the heart of the EMA system. Further, Bennett et al. (2002) point out that EMA has historically placed more emphasis on PEMA, since the use of water and energy has a direct impact on the natural environment and measuring those impacts in terms of waste and emissions is of high value to the organization. Especially in manufacturing companies, material purchasing costs are of high significance and can be a significant cost driver in companies (German Federal Environment Ministry, 2003; IFAC, 2005).

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20 Also Wagner (2003) states that PEMA tools have been circling around in the business world for quite a while. Thus, physical EMA data is essential and builds the basis for the development of environmental-related costs assessments.

The main focus of PEMA is tracking and tracing an organization’s physical inputs and outputs to make sure that no significant amounts of energy, water or other materials stay unreported (Wagner, 2003). This is very important in order to correctly assess and be able to report material-aspects of environmental performance (IFAC, 2005). However, the required information is not always easily available in conventional accounting systems, as it is not recorded specifically with the focus on PEMA. Generally, the information can be collected best in production or operation departments (IFAC, 2005). Often it is not cross-checked with the accounting department, though, which can lead to distorted calculations (Jasch, 2009).

In order to track and trace all physical input and outputs, a material flow model needs to be created (Figure 2). It gives an overview of material flows in the company (German Federal Environmental Ministry, 2003).

Figure 2 – Simplified material flow model (Source: German Federal Environmental Ministry, 2003)

To achieve a complete and integrated depiction of a company’s material use, however, material flows need to be tracked, traced and quantified throughout the

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21 different material management steps, such as materials procurement, delivery, inventory, internal distribution, use, product shipping as well as waste collection, recycling, treatment and disposal. In order to do so, a material flow balance, sometimes also referred to as mass balance or input-output balance, should be conducted. It accounts for all energy, water materials and waste that go in and out of an organization. The general idea behind a material flow balance is that all inputs have to become outputs eventually, whether in the form of product outputs or non-product outputs (waste). If the material flow model is then combined with the material flow balance, a material flow model with material values can be created (Figure 3). This combined approach is called materials flow accounting (IFAC, 2005).

Figure 3 – Material flow model with material values (Source: German Federal Environmental Ministry, 2003)

Material flow balances can be conducted at different levels, such as a whole organization, particular sites, or even just one focal waste stream, process line or product line (IFAC, 2005). This is particularly important for organizations that find it interesting or necessary to extend their materials flow cost accounting beyond their own operations and include physical data from suppliers or other elements of the supply chain, since several different material flow balances can be combined and not

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22 always the whole organization of a supplier has to be taken into account (Schaltegger & Burritt, 2000).

The physical accounting data collected through materials flow accounting builds the basis for creating environmental performance indicators (EPIs). EPIs help to assess the environmental-related aspects of a company’s environmental performance. On the one hand, they can indicate an absolute value, such as the total amount of fresh water used per year. On the other hand, also relative indicators can be used as an EPI representing an organization’s environmental performance relative to its size, production output or number of employees. Relative EPIs are particularly useful since a company’s size, production output or number of employees can significantly vary from year to year. Just like material flow balances, EPIs can also be calculated at many levels and thus serve the interests of various stakeholders (IFAC, 2005).

2.2.3.2 Types of Physical Accounting Information

According to IFAC (2005), there are three different categories of types of physical accounting information; material inputs, product outputs and non-product outputs (waste and emissions). Table 2 shows all input and output types according to these three categories. For the purpose of this research, the categories of IFAC (2005) are adopted, because they are in line with the standard practice of material flow balancing and the general structure of ISO 14031. However, the categories are not prescriptive and may be adjusted to the needs of specific sectors or individual organizations (IFAC, 2005). In the following, each input and output type is explained in more detail.

Table 2 – Physical materials accounting: Input and output types (Source: IFAC, 2005)

Material Inputs Product Outputs

(including Packaging) Non-‐Product Outputs (Waste and Emissions)

Raw and Auxiliary Materials Products Solid Waste Packaging Materials By-‐products Hazardous Waste

Merchandise Wastewater

Operating Materials Air Emissions

Water

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23 Material Inputs are characterized as any energy, water or other materials that come into an organization. Within this category, Raw and Auxiliary Materials are materials, which eventually become part of a company’s final physical product or by-product. Whereas raw materials are characterized as the major product components, auxiliary materials are defined as minor product components. Packaging materials are used for the shipping of final physical products. Packaging materials are usually purchased ready-to use, however sometimes also need to be processed before they can be used. Items that are purchased and resold as products undergoing no or only little processing are called Merchandise. This type of material inputs tends to have fewer impacts and costs related to the environment, since they do not undergo processing. Operating Materials are material inputs that do not become part of any final physical product, for example office supplies or building cleaning supplies. Since operating materials do not become part of the final physical product, they inevitably become a non-product output when leaving the organization. Water includes all water from all sources used by an organization, such as rainwater, groundwater and surface water. Finally, Energy includes all types of energy used by an organization, such as electricity, gas, coal, fuel oil, district heating and cooling, biomass and solar, wind and water energy. Water and Energy are defined separately from other input materials, because from an environmental perspective they are specifically important (IFAC, 2005).

The second category, Product Outputs, includes all products, by-products and packaging, which are passed on to the customer. Within this category, Products are characterized as any physical product including its packaging. By-products, on the other hand, are defined as minor products that are incidentally produced during the manufacturing process of the primary product. Often, boundaries between products, products and waste are not clearly defined. This is especially the case between by-products and waste (IFAC, 2005).

Non-Product Outputs form the third category of Input and Output Types. It includes all non-product outputs, which are defined as output that is not a product output. Non-product outputs can be generated during the manufacturing process in the form of waste and emissions due to inefficient operating practices or poor product design for example. Raw and Auxiliary Materials, Packaging Material, Merchandise and occasionally water contribute to non-product outputs generation. Within this category, Solid Waste is defined as nearly non-hazardous waste in solid form, for

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24 example paper, plastic or food. Hazardous waste, however, is defined as more dangerous waste in solid, liquid or mixed forms, such as batteries, paint or wastewater treatment sludge, respectively. Water that is contaminated in some form is defined as Wastewater. High biochemical oxygen demand, suspended solids, nutrients, excess heat and toxic materials are only some examples of water contamination. Finally, Air Emissions are defined as air streams with precarious degree of pollutants, such as carbon monoxide or sulfur dioxide (IFAC, 2005).

2.2.4 Monetary Environmental Management Accounting

In the first part of this chapter, the most relevant MEMA tools are discussed. Then different types of monetary accounting information and cost categories important under MEMA are described.

2.2.4.1 MEMA Tools

Wagner (2003) points out that only in the last few years academics as well as organizations realized that the physical environmental accounting data also needs to be transferred into monetary terms in order to speak the same language as and reach the company’s decision-makers. According to Wagner (2003) input-output-costing, waste costing, material-only-costing, pollution prevention costing or activity-based costing are the most common terms to describe MEMA. Schaltegger and Burritt (2000) describe three MEMA accounting methods; full cost accounting, direct costing and activity-based costing. They point out, that activity-based costing (ABC) is the most favorable of these three methods, because it integrates environmental cost accounting with strategic management processes and is linked to management objectives and activities. A limitation of activity based costing is that it is mainly used in the United States and not in Europe and is costly to implement (Wagner, 2003). However, it is the only approach that fully traces environmentally induced costs to the products responsible for those costs. Also Jasch (2009) focuses solely on ABC, arguing that ABC is “the correct allocation of costs to processes and products, through this reducing the amount of costs hidden in overhead cost categories” (p.113) and thus improving conventional cost accounting approaches. Therefore, in the following this research focuses solely on ABC.

In ABC, costs should whenever possible be allocated to the corresponding cost carriers (products) or cost centers. By this means, environmentally induced costs

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25 can be made fully visible and managers can base their decisions on more detailed information. Improved understanding of business process constitutes the strength of ABC (Schaltegger & Burrit, 2000). It shows where in the production process value is added or where value is destroyed. By tracing significant material flows, costs can be assigned to the cost centers causing these costs (Jasch, 2009). To understand the full scope of ABC, Table 3 shows an example of a conventional accounting approach assigning energy, waste and emissions treatment and depreciation costs to an overhead account. By doing so, costs are equally divided between both products, A and B. Considering also the material costs and working hours input, products A and B cause the same total product costs.

Table 4, shows the same cost calculation for product A and B, however, ABC is used. By allocating energy, waste and emissions treatment and depreciation costs directly to the respective products, the total product costs for product A and B change significantly. Table 4 indicates that product A with total product costs of 149 is “cleaner” than product B with product costs of 171. It is also revealed in which cost centers product B causes more costs (energy and waste and emissions treatment), thus showing potential improvement opportunities for this product in regard to environmental friendliness.

Through this example it becomes clear that costs hidden in overhead accounts cause distorted calculation and provide superficial information. By using ABC, more detailed information on environment related cost centers can be provided, thus supplying management with more detailed information and thereby enhancing management decision-making regarding to environmental issues (Jasch, 2009).

However, caution is needed when choosing the allocation key to assign costs to a unit of waste for example. Jasch (2009) suggest volume of emissions or waste treated, relative costs of treating different kinds of waste or emissions, or alternatively direct costs of material inputs, treatments or projects as possible allocation keys. Schaltegger and Burritt (2000) add the toxicity of emissions and waste treated to this list. Since allocation keys are based on management and accounting knowledge as well as judgment of a particular business sector or situation the organization is facing, allocation keys may be varying from company to company (Schaltegger & Burritt, 2000).

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Table 3 – Environmental costs hidden in overhead accounts (Source: Jasch, 2009)

Table 4 – Environmental costs attributed to cost centers and products (Source: Jasch, 2009)

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27 As with physical accounting data, monetary accounting data can also be compiled at different levels depending on the intended use of the information (Jasch, 2009). On this basis, also EPIs can be established in order to assess a company’s environmental-related costs. The IFAC (2005) especially emphasizes that “cost data can help translate environmental performance into the ‘cost and savings’ language that business managers understand” (p. 41).

2.2.4.2 Types of Monetary Accounting Information

Since law does not regulate EMA, there are various EMA approaches and methodologies, often tailor-made for the specific needs of a specific company (Schaltegger & Burritt, 2000). One main problem of applying MEMA is the definition of environmental costs, which varies with each of the different MEMA approaches and methodologies (Jasch, 2004). Environmental costs can be defined as internal and external costs, which also relate to costs resulting from environmental damage and protection (Jasch, 2009). However, the focus of EMA lies on internal corporate environmental costs opposed to external costs incurred from corporate activities, which are not internalized through regulations, for example (Jasch, 2009). For the purpose of this research, the six environment-related cost categories developed by the International Federation of Accountants (IFAC) regarding MEMA are adopted. These cost categories are considerably representative of international MEMA practice and provide a common basis for discussion. However, they are by no means prescriptive (IFAC, 2005). In the following, the six cost categories, shown in Table 5, are described in detail.

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Table 5 – Environmental-related cost categories for EMA (Source: IFAC, 2005)

1. Material Costs of Production Output

Includes the purchase costs of natural resources such as water and other materials that are converted into products, by-‐products and packaging.

2. Materials Costs of Non-‐product Outputs

Includes the purchase (and sometimes processing) costs of energy, water and other materials that become Non-‐Product Output (Waste and Emissions).

3. Waste and Emission Control Costs

Includes costs for: handling, treatment and disposal of Waste and Emissions; remediation

and compensation costs related to environmental damage; and any control-‐related regulatory compliance cost

4. Prevention and Other Environmental Management Costs

Includes the costs of preventive environmental management activities such as cleaner production projects. Also includes costs for other environmental management activities such as environmental planning and systems, environmental measurement, environmental communication and any other relevant activities.

5. Research and Development

Includes the costs for Research and Development projects related to environmental issues.

6. Less Tangible Costs

Includes both internal and external costs related to less tangible issues. Examples include

liability, future regulations, productivity, company image, stakeholder relations and externalities.

The first cost category, Materials Costs of Production Output, especially applies to manufacturing firms. Most material inputs are turned into physical products (including by-products and packaging) eventually. When leaving the manufacturer, these products have environmental impacts, for example emitting toxic materials in a landfill after disposal. Moreover, the material inputs have been extracted from the environment at some point, which has an impact on the ecosystem. The product’s environmental impact during its life cycle (materials extraction, manufacturing, customer use and disposal) often outweighs the impact of materials that leave the company as waste and emissions during the manufacturing process (IFAC, 2005). Therefore, purchase costs of material inputs that are converted into products, by-products and packaging are included in this category. The data derived from this category is useful for a company in order to manage materials-related environmental impacts of its products effectively (Jasch, 2009).

In the second category Materials Costs of Non-Product Outputs are considered. They include all material inputs that are not converted into physical

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29 products, by-products or packaging. Although companies try to minimize non-product outputs, there still can be a significant amount of material inputs leaving the company as non-product output (waste and emissions). Data collected in this cost category can help companies to reduce their non-non product outputs, for example the information reveals that more efficient manufacturing equipment can reduce the non-product outputs (IFAC, 2005).

In the third category, Waste and Emission Control Costs, the handling, treating and disposing costs of the waste and emissions are considered. Moreover, costs occurring from environmental damage such as remediation, cleaning or compensation settlements as well as regulatory compliance costs related to waste and emission controls fall in this category (IFAC, 2005).

Under category four come Prevention and Other Environmental Management Costs, such as green purchasing, supply chain environmental management, extended producer responsibility, etc. Costs for environmental planning systems, environmental measurement (for example, monitoring and performance auditing), environmental communication (for example, government lobbying and environmental reporting) and other relevant issues (for example supporting environmental project in the social community) are also part of this category (IFAC, 2005).

Research and Development Costs are summarized in category five. For example, developing and testing new equipment to achieve higher materials use efficiency can be considered as environmental-related research and development costs. The sixth and last category, Less Tangible Costs, encompasses both, internal and external, difficult-to-quantify (intangible) costs. These costs can seldom be traced from an organization’s information system, however, be of great significance (IFAC, 2005). Liability, company image and stakeholder relations are examples of potential intangible costs, which can be especially considered for investment appraisal (Jasch, 2009).

2.2.5 Combining Monetary and Physical Information

An EMA system has to be clearly differentiated between MEMA and PEMA, but at the same time physical and monetary accounting data have to be integrated to a certain extent as well (Burritt et al., 2002; IFAC, 2005; Jasch, 2009). Bartolomeo et al. (2000) emphasize that the very identification of costs does not influence management behavior related to environmental issues. Only if the costs are allocated

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30 to the corresponding cost object, management is influenced. One way to do so is described by Jasch (2009) as Material Flow Cost Accounting (MFCA). This approach combines Materials Flow Accounting (described in 2.2.3.1) and ABC (described in 2.2.4.1) by integrating the two types of generated accounting information in order to achieve a comprehensive environmental information system. It is the most recent and state of the art EMA approach (Jasch, 2009).

MFCA measures the material flows and stocks in monetary and physical units on company, production process or product level. It is also based on materials flow charts but in addition is allocating costs to the material flows simultaneously. However, these material flow charts can be very complicated and challenging to conduct (Wagner, 2003). Contrary to ABC, MFCA uses only three cost categories; Material Costs, System Costs and Delivery or Disposal Costs. Material costs are the collection of physical quantities of materials involved linked to the material purchase prices. Furthermore, outputs are differentiated between positive (products) and negative (waste and emissions) product outputs. System costs are defined as all costs occurring during materials handling inside an organization (for example personnel costs or depreciation). In MFCA, each material flow that occurs inside the organization has to carry its system costs. Delivery or disposal costs are assigned to all outputs and encompass the costs for making sure that each product leaves the company, that is transport costs for positive product output and disposal costs for negative product outputs (German Federal Environment Ministry, 2003; Jasch, 2009). According to Wagner (2003) MFCA is starting at the end of pipe (delivery costs) and tracing the materials flow back to the beginning of the pipe, the materials purchasing (material costs). In the next step, materials are traced in both directions, from start to end of the pipe and vice versa. Once the material flows are depicted in charts, it is looked for the corresponding data in the Enterprise Resource Planning (ERP) system of the company. Often, certain flows are not included in these systems and in the accounting process.

Wagner (2003) further points out that in MFCA, many business and technical functions come together. One big problem is that ERP systems, like SAP for example, often do not provide much information about material flows. Thus data is collected by hand from several sources. This process is very inefficient in the long run. Therefore ERP systems need to be modified in order to provide material flow information automatically and it must be easily accessible. In principle, today’s EPR systems are

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31 capable of doing this, however they are customized with different objectives (Wagner, 2003). Moreover, almost all departments are involved when tracking and tracing material flows, however people from different departments speak different business languages, which often leads to misunderstandings or even to a total lack of communication. Usually management has an economic focus and speaks a monetary language having good knowledge about accounting and marketing, whereas employees involved in the production processes are speaking a technical language and have a high degree of flow transparency in physical terms. The environmental department often speaks in terms of pollution reduction or legal compliance, but have very little information on cost or technical interdependencies. Material flow charts can help to create a common language by visualizing the material flows throughout the entire company as well as the interdependencies of departments. Thus, material flow charts are an integrative measure (Wagner, 2003).

The MFCA approach also allows creating cross-cutting EPIs, which are called eco-efficiency indicators (IFAC, 2005). According to WBCSD (2000) eco-efficiency combines physical and monetary EMA data in order “to relate product or service value to environmental influence” (p. 8). To calculate eco-efficiency, the following equation can be used, whereby “product or service value” is measured in terms of turnover or profit and “environmental influence” is measured in terms of energy, materials and water consumption as well as waste and emission volumes:

Eco-efficiency is enhanced when “providing more value per unit of environmental influence or unit of resources consumed” (WBCSD, 2000, p. 8). One advantage of eco-efficiency is its flexibility, since there are numerous ways to calculate eco-efficiency using the general equation stated above (Schaltegger & Burritt, 2000; WBCSD, 2000). Furthermore, it is a means of measuring the combined economic and ecological performance over a given period of time in regard to the management of a given organization (Schaltegger & Burritt, 2000).

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2.2.6 Implementation of EMA

This section intends to give a brief overview of current research results of studies dealing with the implementation of EMA. Since EMA has to be tailored to the special needs of companies (Wagner, 2003), the examples given in this section cannot be generalized, however they might give a good idea about where to start and what to focus on.

Worldwide, more and more companies are certified according to the ISO 14001 environmental management system standard (Wagner, 2003). According to Environment, Health and Safety Online (2010) the number of ISO 14001 certified companies accounted for 14,000 in 2010. The ISO 14001 requires the implementation of an Environmental Management System (EMS) that enables a company to (ISO 14000 essentials, n.d.):

• Identify and control the environmental impact of its activities, products and services

• Improve its environmental performance continually

• Implement a systematic approach to setting environmental objectives and targets, to achieving these and demonstrating that they have been achieved

In the EMS it can be distinguished between organizational aspects, aspects of technology and aspects of information. The information side of an EMS requires companies to do documentation of their EMS, for example internal and external reporting and decision-making tools. This is where EMA touches upon the ISO 14001 standard and the relationship between environmental accounting and environmental management systems can be understood (Wagner, 2003).

A study implementing EMA, cleaner production assessment (CPA) (cf. Schaltegger, Bennett, Burritt & Jasch, 2009) and EMS simultaneously showed that when assessing and reviewing the company’s environmental impacts, most likely financial implications play a big part and are chosen to be tackled first, since measures that result in higher savings are the first ones to be implemented. EMA helps to clarify the environmental cost structure of a process or product and supports the setting of priorities, targets and objectives within the EMS. Thus, EMA is a good foundation for the ISO 14001 standard and vice versa (Csutora & De Palma, 2009).

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33 Moreover, during the designing of an EMA information system, a CPA can provide a great amount of relevant data. This is especially the case in companies in which the accounting system does not provide information on material flows (De Palma & Csutora, 2003). Furthermore, the EMA information system seemed to give more bargaining power to the environmental managers at the organization’s decision-making level. Although the EMA application is mostly driven by the environmental department, it proved to be crucial for the success of the implementation that the accounting department is a part of the EMA project team (Csutora & De Palma, 2009). Moreover, the study showed that an incremental implementation of EMA makes more sense in industries where one technology or process resembles one product, for example in the chemicals industry. However, when a number of products are manufactured in the same technological process (for example the paper industry), EMA should be applied at a full-scale level, because technologies and products are linked to a large extend. One advantage of the incremental implementation is that it provides a good balance between EMA benefits and administration costs, since the higher the environmental costs, the higher the potential EMA benefits that can be realized by controlling these costs. When environmental costs are low, the administrative burden could undermine the benefits of EMA (Csutora & De Palma, 2009).

Another long-term study on the implementation of EMA in large Finnish companies revealed several success factors. After nine years only one company had still an EMA system in place and was the only one to consider possible eco-efficiency and strategic positioning benefits of EMA in addition to compliance gains, which was most prevalent in all other companies (Kumupulainen & Pohjola, 2009). Moreover, the following success factors could be identified (Kumupulainen & Pohjola, 2009, p.489):

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34 • An innovative attitude and persistent key personnel

• Transparent goal setting, internally and externally

• A gradual EMA development process with early realization of the first financial savings

• Management support and sufficient resources

• Broad involvement of personnel: accounting, all functions/locations included in the EMA system, cooperation with external partners and stakeholders (and possibly also external support and financing) • Value-chain and long term thinking

• Benchmarking of other companies and EMA/environmental management guidelines

• Anticipating future requirements (e.g. legislation, disclosure, needs of the green market)

Opposing, also several critical failure factors emerged (Kumupulainen & Pohjola, 2009, p. 489):

• Lack of management support and insufficient resources allocated • Too narrow project group in EMA design and development

• Unclear or missing quantification of added value and problems with technical implementation

2.3 Business Model Theory

In order to understand how EMA could act as a driver for business integration of environmental strategies, this thesis is also focusing on the emerging literature stream of business model theory. Teece (2010) states that only for the last decade or so business model theory has been explicitly come to public consideration. Although it reflects the most recent research in the field of business strategy, theorists have still not agreed on one single correct definition of business models. However, it is generally agreed on that business models are not the same as strategy, have something to do with the logic of a firm and how it operates as well as playing a big role in how a firm creates and captures value (Shafer, Smith & Linder, 2005; Morris,

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35 Schindehuette & Allen, 2005; Chesbrough, 2010; Casadesus-Masanell & Ricart, 2010).

For the purpose of this thesis, focus will be laid on the relationship of business models and strategy, since this research seeks to explain and develop a framework for business integration of environmental strategies with the help of EMA. Casadesus-Masanell and Ricart (2010) present a conceptual framework in which they separate and relate the concepts of strategy and business model. In order to understand the differences and links between those two concepts, the definitions according to Casadesus-Masanell and Ricart (2010) will be presented in the following section. After that, their integrated framework is presented from which the theoretical framework for this thesis will be derived in section 2.4.

2.3.1 Business Models, Strategy and Tactics

Casadesus-Masanell and Ricart (2010) define a business model to be “the logic of the firm, the way it operates and how it creates value for its stakeholders” (p.196). They further argue that business models consist of two parts; concrete management choices on how a given company has to operate and the consequences evoked by these choices. By choosing a particular business model, a certain set of tactics is made available to an organization. Tactics are defined as “residual choices open to a firm by virtue of the business model it chooses to employ” (Casadesus-Masanell & Ricart, 2010, p. 196). In other words, the choice of the business model determines which tactics, i.e. choices, are at a company’s disposal. Consequently, business models and tactics are closely interconnected. Also Shafer et al. (2005) point out that a business model is a set of choices. According to them, a business model tests and analyzes these choices to make sure they are mutually supportive and internally consistent.

Having established the relation of business models and tactics, now the relation between business models and strategy is explained. In order to do so, one must understand the definition of strategy first. Mintzberg (1994) defines strategy as a pattern, plan, position or perspective. Porter (1996) views strategy as “the creation of a unique and valuable position, involving a different set of activities” (p. 68). Casadesus-Masanell and Ricart (2010) point out that ‘creation’ implies the choice made by an organization to compete in a specific manner. Further they argue that the strategy is not the ‘unique and valuable position’ itself, but the creation of it, thus the

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36 unique and valuable position being a reflection of the strategy. Therefore, on the grounds of Porter, they define strategy as “the choice of business model through which the firm will compete in the marketplace” (p. 196). In other words, the strategy encompasses an organization’s contingent plan of which business model it will use.

2.3.2 Integrated Business Model Framework

Having defined the notions of business model, strategy and tactics, Casadesus-Masanell and Ricart (2010) develop an integrated framework (Figure 4). The framework describes strategy and business models as related, yet different concepts. Strategy is the contingent plan of which business model to use, whereby a specific set of tactics is enabled. In regard to strategy, a firm can take actions containing choices as to which policies, assets or governance structures can be used in order to constitute the business model. Consequently, strategy implicates designing business models as well as redesigning them if contingencies happen. The difference between strategy and business model is difficult to observe. Casadesus-Masanell and Ricart (2010) state that if there are no contingencies there is no benefit from separating the two concepts.

Figure 4 – Integrated framework of strategy, business model and tactics (Source: Casadesus-Masanell & Ricart, 2010)

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37 However, if contingencies occur, which is very likely in today’s volatile business world, there is need of modification of the business model. In this situation the difference between strategy and business model become particularly visible, since they no longer coincide. Thus, it becomes clear that a strategy is “much more than the mere selection of a business model; it is a contingent plan as to how the business model should be configured, depending on contingencies that might occur. [Moreover,] [a]n organization’s business model is the reflection of its realized strategy” (Masanell & Ricart, 2010, p. 205). Furthermore, Casadesus-Masanell and Ricart (2010) point out that, strategic choices, made at the strategy stage (see Figure 4) are more severe and require more commitment, whereas tactical choices are relatively easy to change, since they involve choices like prices, intensity of advertising or minor product modifications, for example. Strategic choices, on the other hand, include choices about policies, assets or governance structure, as has been mentioned before.

2.4 Theoretical Framework

Based on the theory discussion above, the following theoretical framework can be developed (Figure 5). In the first column, the main elements are presented. It shows the process of environmental strategy integration into the business model supported by EMA. In the second column, each step in the process is explained. In the third column, the respective academic literature stream supporting the framework as well as the corporate level at which the process takes place is indicated.

According to this framework, the environmental strategy is formulated at the CEO level. It responds to specific environmental effects, such as perceived risks and opportunities due to environmental protection, stakeholder pressure or regulations. In order to enforce and integrate the environmental strategy, EMA is implemented by Environmental Department in cooperation with the controlling function of the organization. Many environmental performance data is already present in most management accounting systems, however it is not looked for specifically. By adjusting the accounting system, environmental costs can be properly allocated and traced. Through the generation of EMA data, environmental impacts and costs can be detected and correctly traced on a product level, which allows a detailed and structured assessment of the organization’s environmental performance. Moreover, through analyzing EMA data the environmental performance can be monitored. By

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38 providing the environmental performance information at the department level, new tactics are made available, which result in enhanced decision-making. This leads to the optimization of environmental and economic performance, whereby targeted goals, formulated in the business model, are achieved. Thus the environmental strategy is integrated into the business model. Since the integration of the environmental strategy is an ongoing process, the achievement of the targeted goals results in a reassessment of the environmental strategy, keeping the integration process dynamic.