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The High Cost of Low Prices
By Holly Testa, Director, Shareowner Engagement

When we go shopping, we check the price tag. Is the price too high, reasonable, or too good to be true? In an ideal world, the price would include the full cost of production, plus a fair profit for the company and its shareowners. In the real world, many of the products we buy are grossly underpriced, allowing some costs to be borne by uninvolved third parties, or by society at large.

Hidden costs lurk in many places—clothing, food, consumer electronics and, of course, energy. In the short run, consumers feel good about “screaming deals” and companies thrive because they can sell their wares below actual cost and still make a tidy profit. However, collectively, we are running up a huge “bill” in the form of environmental damage, health costs, an exhausted supply of natural capital, and increasing income disparity.  In the long run, someone has to pay.

Who Pays, and How?

Economists call these hidden costs “negative externalities”—defined simply as any cost not included in a price. Taxes, regulation, and litigation are mechanisms that can be used to take hidden costs into account (e.g. taxing cigarettes, implementing pollution restrictions, or filing a lawsuit seeking damages from an oil spill). However, a far more efficient, market-based way to deal with externalities is to “internalize” them—so that the price of a product or service reflects all costs. Of course, this is easier said than done.

Hidden costs are accrued over time, and the source and size is not always apparent. Early in our industrial development, it was all too easy to overlook these costs—resources were abundant, the benefits seemed to far outweigh the damage, and there was always a new frontier to exploit. But we are now running up against the limits of our planetary resources.

According to a report by KPMG, Expect the Unexpected: Building Business Value in a Changing World, 10 interacting “megaforces” are causing a rapid escalation of the environmental costs incurred by our economy. Environmental costs across 11 industries rose by 50% between 2002 and 2010-from an estimated $566 billion to $854 billion. These costs do not show up on financial statements. If companies were required to “internalize” just these identified impacts, average earnings could be cut by a staggering 40 percent.

As resources become scarce, pressure on companies to recognize their share of these costs will likely increase. This new accounting could cause a fundamental shift in how companies must operate in order to remain relevant. “The link between sustainability and financial results is becoming increasingly clear,” said John Vehimeyer, CEO of KPMG LLP. “Companies that recognize the external influences on their organizations and leverage them as opportunities are realizing a competitive advantage.”

Measuring What’s Hidden

Companies are finding ways to measure and manage the environmental and social impact of their products, and a few are sharing information with consumers. Patagonia has developed The Footprint Chronicles and Nike launched the Considered Design program. Both evaluate environmental and social impact information for the entire lifecycle of each product.

In the wake of these efforts, the apparel industry formed the Sustainable Apparel Coalition, which brings together apparel and footwear brands, retailers, manufacturers, industry experts and the EPA. The coalition is developing a standardized, industry-wide tool for measuring the environmental and social performance of apparel products and the supply chains that produce them. The outdoor industry has also come together to create a similar tool with their Eco Index, now in beta testing. Through these efforts, industries can develop metrics and share best practices to both identify hidden costs and to drive those costs down.

Posted: March 20, 2012