What it means
Ordinary accounting records what a business pays out, such as materials, wages and rent. It usually does not record the cost of the air pollution a factory emits or the water it uses up, because someone else bears that cost.
True cost economics tries to add those items to the picture. The costs are called externalities because they fall outside the market price.
A negative externality, such as carbon emissions, imposes a cost on third parties, while a positive externality, such as training that makes a whole sector more productive, creates a benefit for others. True cost approaches count both.
In practice, a company or analyst estimates the external effects in physical units, such as tonnes of carbon or litres of water, and then puts a dollar value on them using a price per unit. The assumed prices are judgements and can differ widely, so the method is as much about showing the scale of the effect as about finding one exact figure.
The idea is used in sustainability reporting, in food and farming studies, and in internal carbon pricing, where a company charges its own divisions for their emissions when it makes investment choices. Governments use similar thinking when they set taxes or rules on pollution.
The limits matter. Valuing nature and health in dollars is difficult, estimates are uncertain, and different assumptions can reverse a conclusion.
True cost figures are not part of standard financial statements, so they should be labelled clearly as management or sustainability information. A good report states every assumed price, so that readers can substitute their own and see how the answer changes.
It should also say which impacts were left out because they could not be measured.
In practice
Real-world examples.
Example
A food company compares two ways of growing wheat. The organic method costs $20 more per tonne, but the standard method has $35 per tonne of estimated pollution and soil damage, so the organic route is cheaper on a true cost basis.
Example
A manufacturer sets an internal carbon price of $50 per tonne. Its capital committee adds this charge to each proposal, and a proposal that looked cheap with a high emissions profile is dropped.
Example
A pension fund asks its asset managers to report the estimated external costs of the companies it holds. The report shows that one holding's pollution costs are equal to 40% of its annual profit, which prompts a discussion with the board of that company.
Formula
Calculation
True cost per unit = Market price per unit + External cost per unit
External cost per unit = Quantity of impact x Assumed value per unit of impact
A bakery sells a loaf for $4. Producing it creates 0.5 kilograms of carbon dioxide, valued at an assumed $0.20 per kilogram, and uses water with an assumed external cost of $0.30.
The external cost is 0.5 x 0.20 + 0.30 = 0.10 + 0.30 = $0.40. The true cost per loaf is 4.00 + 0.40 = $4.40, which is 10% higher than the market price. On 100,000 loaves a year, the hidden cost is 100,000 x 0.40 = $40,000.Case study
Seen in the real world.
Greenfold Textiles is an illustrative, fictional clothing maker with annual profit of $2,000,000. Its sustainability manager estimated that its dyeing process released pollutants into a river, with an assumed local clean-up cost of $600,000 a year, borne by the town.
Management added the figure to its internal reports. On a true cost basis, profit fell from $2,000,000 to $1,400,000, which led the board to approve a $1,500,000 water treatment system with a payback of about 3 years on the avoided clean-up costs.
The illustrative lesson is that the exercise changed a decision, not just a report. The system reduced the clean-up cost to $100,000 a year, and the town's council later cited the improvement when it renewed the factory's operating licence.
Watch out
Common mistakes.
- Treating true cost figures as precise, when they depend on assumed prices for pollution and other impacts.
- Counting only negative externalities, and ignoring benefits that the activity creates for others.
- Presenting the numbers as audited financial results, when they are management estimates outside standard accounting.
Questions
People also ask.
Is true cost economics the same as full cost accounting?
They are closely related, since both try to include environmental and social costs, but full cost accounting is often used for internal management decisions.
Who uses true cost figures?
Sustainability teams, investors, farmers, policy makers and companies that apply an internal carbon price to their own investment decisions.
Does a company have to pay the true cost?
Not unless a tax, regulation or court decision makes it do so, which is why governments sometimes price externalities directly.
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