Intellectual Capital
There are a lot of stories showing that the right measurement is important, that market valuation is not a simple calculation of tangible assets, or that showing new measurements are used to give further insight in the organization. All this is related to the term intellectual capital, which has been defined in many ways. It is about those intangible assets that do not show up on financial statements but can be codified, valued and managed by the company. It might be knowledge of people that is important to a company. Or it can be said to be the combination of patents, processes, skills, about stakeholders of a company. Economists define it simply as Tobin’s-q.
The principles of intellectual capital
The concern with intellectual capital comes from different sources:
\- a more accurate valuation of intangible inputs increase market efficiency through more appropriate flows of capital
\- new measurements provide managers with a clearer picture
\- to guide future strategy like accounting systems do
Accuracy in valuations
Brand valuation, goodwill, human assets accounting are all subjects brought forward in the discussion about truly valueing a company. Still there is a difference between book and market value of companies.
Goodwill on the books is also only what was paid for another company above book value, calculated via “fair” value of the underlying assets. Intangible assets can be valued by accountants by finding out their market value. The difference between what the accountant then says the company is worth and what you pay is goodwill.
The difference between accounting data and share prices has increased over the last 30 years as more value is attached to intangible assets that cannot be monetized. Data from 1992 suggests that 40% of the value of a company is missing from the books, something that is subscribed to intellectual capital assets by some.
Tobin’s q is a measurement of that really in that it calculates the ratio between market and book value. But the market value is more about investor attitude towards the value of the firm than an objectifiable value. Bubbles on the stock market are still happening even though we know they exist and the collapse of confidence brought forward by investors. Once some speculators cash in, it might create a panic and the bubble bursts. This then turns out to be a self-reinforcing process. Can we remove that bubble with good intellectual capital accounting?
Internal efficiencies are another thing driving intellectual capital measurement. Companies want to be worth more or know what they are worth at least. Some studies seem to show that an increase in published R&D expenditure increases market value. Another link seems to be between expenditure on advertising and market value. These costs seem to lead to a reaction that would suggest and increase in assets instead of costs.
In that, companies need to manage all their assets including knowledge. The better you measure all your assets, the more easily you detect opportunities and all allocate resources better. This I actually buy into. You can also measure to read a goal, meaning that you look at where you stand and if your base is capable of supporting you in reaching your goal.
So what drives intellectual capital measurement:
\- Market inefficiencies
\- Internal inefficiencies
\- Measurement to reach goals
We can then group intellectual capital into some categories:
\- knowledge
\- information
\- communication
\- human resources
\- brands
\- copyright
\- patents
\- systems
Roos and Roos identify a three-stop process:
\- nurturing an intellectual capital language
\- identifying intellectual capital indicators
\- developing an intellectual capital report
You might not agree to all of this but one thing that is sire is that current performance measurement is sub-optimal to predict future financial performance. Strategic decisions need full information, which is not anything new really. The link of IC to market value should now be clear though.
The language of intellectual capital
The vocabulary is important to make the areas of focus and concern clear. The process to build the vocabulary should be continuous, being fitted and refitted to your necessary focus and concern. There are some intellectual capital methods that can be noted:
\- Kaplan and Norton’s Balanced Scorecard
\- Skandia’s Navigator
\- Karl Sveiby’s Intangible Asset Monitor
\- The IC Index
They often are similar in their categories of concern:
\- human capital
\- infrastructure
\- intellectual property
\- franchise value / customer capital
\- renewal and development
\- process
\- …
In the end the areas of concern need to be indicators of future performance. Financial measurement as sales show past performance. Customer loyalty or satisfaction might show future performance. An intellectual capital language is looking at future performance. There are several areas of concern that might be a good starting point:
\- Information sharing because good capacity means good ability to re-use
\- Networks, communication & and innovation (e.g. 3M)
\- Intellectual property
\- Brands
\- Talent/Human resources
These are again just examples though.
In summary, you need three steps.
1. Broadly define intellectual capital.
2. Identify subgrouped areas of concern.
3. Identify elements that contribute to future success.
It must be pointed out that even though you find a potential element it might not contribute to the company intellectual capital. In a sense you might have to move back from 3 to 2 for further discussion and re-evaluation. The process should never end.
Measureing Intellectual Capital
1. From the root up: Find your concerns and then ask those at the core how they should be measured.
2. Recap: a) Nurture IC language. b) Identify IC indicators. c) Develop IC Report
3. Intro to measures: Many measures will not be monetary but they might be.
4. Discounted Cash Flow: Patents and Copyrights are often valued like that, via future cash flows discounted by a discount factors, which can still be wrong though.
5. Monetary Measures: e.g. amount spent on training, R&D expenditure
6. Ratio Measures: This gives a relative performance indicator.
7. Absolute Numbers: Number of scientists for example. But there needs to be a sound justification for exactly that number.
8. Subjective: More used to augment a measure. Do you find working here a pleasant experience rated between 1 and 5 can best be used to support another measure but not as the only one.
9. As a new method: In the financial market you always compare, yet here you are only looking inside which might mean that it is respected too much outside the organization as a measure.
Examples of measurement methods
Skyrme argued that these systems are currently in a stage of evolution, being refined over time.
1. The balanced scorecard
It was introduced 1992 in an HBR article by Kaplan and Norton based on a year-long study at 12 companies. There are four perspectives: financial, customer, internal business, innovation and learning. They are often interlinked, influencing each other and need to be based on areas of focus and concern. The main idea is that you put control of vision and strategy while implementation is done by others. It focusses on the drivers or lead indicators of future performance. Some examples are on page 40 of the book or likely to be found all over the net.
2. The Skandia Navigator
Skandia, the swedish financial services company, is one of the leaders in IC measurement. If I remember correctly they are also on the forefront of a move to remove budgets totally. Anyway, they look at: financial, customer, human, process, and ‘renewal and development’. the human focus is at the center with the systems there to help managers figure out their appropriate measurements.
There are only very few measures in their system but they have been refined over a long period. Skandia believes the measurement system shows how Skandia can create financial capital from intellectual capital.
1. The intangible assets monitor
Karl Eric Sveiby developed it, designating four categories of concern:
2. Internal structure: patents, concepts, models, systems, …
3. External structure: relationships, brands, trademarks, reputation, …
4. “Individual” competence: employee ability to act, skills, education, experience, eq, …
Competence belongs to be individual he believes but the company cannot be conceived without people. Each of these categories is then measured to see whether it aids stability, efficiency, or growth and renewal.
1. The IC Index
Göran and Roos combine some larger focus areas into an “efficiency” index. Different areas of focus are combined to form an index. Some examples are on page 44.
Additional points
The report needs to include the following:
\- How did IC become important to use
\- How does it fit our objectives
\- Explanation of areas of concern
\- Measures in tables and charts
The reader of a company report needs to be introduced to the specific measures as they are very specific to the company. The idea is that if the measures are accurate (financial reporting is a science too), the market will reward it and become more efficient.
Then you also need to assess the need. It is certain that regulatory bodies like the SEC will require more IC accounting as standard account is only showing the past. Several studies show that the benefits outweigh the costs.
Steward actually believes that utilizing your intellectual capital means exploiting the “free-floating brainpower” of individuals.
Critique of ICM Programs
it is merely repackaging of managing people (Boudreau)
we already have benchmarking, competence models, business worth, … all the other reports that are similar.
can the data really correspond to the question? Sample bias, missing data, the difference between correlation and causation, playing the numbers, … all play a role.
Power (1994) raised the question whether any audit system is not flawed and only uses up valuable resources. This is because the data can easily be misinterpreted, because of the increase of likelihood of group think, becoming entrenched in the numbers and whether that what is audited is really important of whether something else is not simply missed.
Context of the auditor matters and might be unfit. What, how and if something is audited is influence by the receivers of the audit. There is likely one way. And who audits the auditors?
Potential for fraudulent behavior is big (playing the numbers).