The Most Valuable Resource: Measuring and Managing Intellectual Capital

In the second quarter of fiscal year 2000, Microsoft had a market value of over $600 billion, but the book value of their assets was approximately $45 billion – $22 billion of which were current assets. With less than $2 billion of physical assets, Microsoft is a paragon of the New Economy in which a company's value is found not in earthly measures like revenues, P/E ratios, or market shares, but in intellectual capital – organizational culture, customer loyalty, and brand equity. And Microsoft isn't alone: Over the past two decades, the difference between market and book values of U.S. companies has reached unprecedented levels.

This growing difference arises due to the nature of knowledge-based organizations and their dependence on intellectual capital, which have changed the way we view the value creation process. Traditional financial measures like return on capital and earnings per share – measures that constitute most corporate performance management systems – tell investors and management little about the true performance of the company. Because accounting practices have failed to keep pace with the growing importance of intellectual capital, many of these assets remain out of sight, out of mind– off balance sheets and unmonitored. Without tools to capture and measure intellectual capital, many firms wind up mismanaging their intellectual assets or, worse, destroying knowledge value – simply because managers misunderstand the nature of the company's resources.

MOST VALUABLE NONFINANCIAL METRICS TO INVESTORS:

Strategy Execution
Management Credibility
Quality of Strategy
Innovation
Ability to Attract Talented People
Market Share
Management Experience
Quality of Executive Compensation
Quality of Major Processes
Research Leadership

(Source: Ernst & Young, 1997)

Although intellectual assets may not be visible, they can be measured and managed. But if managers want to cultivate intellectual resources, they need to develop performance measures that link internal productivity to market value-added, earthly financials to airy measures of intellectual capital. The firms that develop integrated mechanisms to capture and manage these vital resources will be best prepared to generate sustained returns.

Accounting-based performance measurement systems dominate both external market-based evaluation of firms and the internal evaluations of managers and strategic business units. But these accounting tools simply don't capture the value of intellectual capital. Brand equity, research and development, and human capital – among other forms of intellectual capital – don't appear on balance sheets.

To compensate for these accounting shortcomings, a number of consultants and analysts have developed measures designed to better capture shareholder value. Market value-added and economic value-added, for example, are increasingly popular measures aimed at increasing the relevance of financial reports. Companies such as GE and Coca-Cola focus on market value-added as the prime performance indicator of their businesses.

Despite the trend toward calculating economic value-added, few methods are able to capture the full value of an organization's intellectual capital. To do that, firms need a measurement system framed around the resources that create value for the organization – a system that has at its core the intellectual assets needed to compete successfully in the global marketplace.

In recent years, the focus of the investment community has moved beyond fundamental financial ratios and toward nonfinancial indicators. More and more, investors consider financial measures to be the lagging indicators of performance and nonfinancial factors the leading indicators.

A recent Ernst & Young study of financial analysts identified the 10 most important nonfinancial measures to investors – metrics that can be integrated into management reporting and evaluation systems.

These measures reflect the view that resources, not products, constitute the primary source of competitive advantage. Specific resources include brands, skilled personnel, trade contracts, access to capital, and so on. Notably, none of these resources appears directly on financial statements.

But they do drive a firm's competitive advantage. As a result, companies need to identify and manage them. Accounting systems for intellectual resources should track the accumulation, maintenance, and availability of resources. Sophisticated tracking and monitoring should permit firms to control both the availability of resources and their strategic deployment.

Activity-based costing represents perhaps the most significant step toward resource-based performance measurement. In the past decade, ABC has revolutionized product costing by relating product cost to the resources – material, financial, human time – that go into that product. ABC allows companies to determine the relative cost and value of their products and then reengineer the underlying processes for greater efficiency.

Yet, activity-based costing and process reengineering are just the tip of the iceberg. They do a good job of capturing and measuring basic resources, such as product and period costs, but they miss the value of intellectual assets like research and development, information systems, and other specialized functions. A truly resource-based system must capture all resources and then help shape corporate strategies. Simply increasing the number and volume of scorekeeping measures doesn't represent a step forward; integrating these measures and improving upon them does.

One way to think about developing a system for tracking activities and inputs is to divide resources into four fundamental groups:

Financial resources
People and organization processes
Technology
Customer equity

Figure 1 represents an integrated model of financial and nonfinancial measures for each basic resource pool. By highlighting the strategic importance of nontraditional capital, this model lets managers focus on accumulating and managing the people and processes that drive the company's value and bottom line. Just as traditional accounting tools help managers accumulate and allocate financial resources, this model provides the conceptual framework for managing intellectual capital.

By defining success beyond financial performance, the model helps managers integrate processes and resources into the firm's overall success – an essential step toward competing in a knowledge-based economy.

Celemi, the Swedish consulting firm (www.celemi.com), exemplifies this integrated approach. Celemi developed the Intangible Assets Monitor as a tool to capture and report on its elusive strategic assets – reputation and customer relationships, consulting models, work systems, and management. For example, Celemi evaluates its customer assets according to each new client's ability to attract new business and enhance Celemi's image. Celemi looks for the right clients, not the most clients. The most valuable clients are those that expand the knowledge base of Celemi's employees by demanding new technology or innovative business solutions – all of which expand Celemi's intellectual capital.

Skandia, a Sweden-based insurance firm (www.skandia.com) has also expanded its business measurement process to include an integrated set of measures. The Business Navigator, as the model is known, classifies core business processes into five categories: (1)Financial Focus, (2) Customer Focus, (3) Process Focus, (4) Renewal and Development Focus, and (5) Human Focus. The metrics for these categories create a reporting process clearly tied to the company's strategic goals – generating value from customers, employees, and processes.

Skandia uses the Business Navigator for both internal and external reporting. Using the Navigator's measures, the company publishes a report on intellectual capital as a supplement to its annual report. Within each of the five categories, the company reports on its accumulation and use of intangible resources: The Financial Focus contains traditional return-based efficiency and effectiveness metrics. The Customer Focus includes metrics about customer satisfaction and unit growth. The Process Focus concentrates on efficiency and outputs/savings per employee. The Renewal and Development Focus highlights return business and seeds of future growth. The Human Focus values the importance of employee loyalty, skills, and competencies.

The real value of resource integration isn't as an accounting and reporting instrument but as a tool for managing the drivers of value. Accountants are paid to track the past, but managers are paid to build the future. It's relatively easy to chart out a one-time accounting plan to capture and measure a company's intellectual assets, but those measures become dated and irrelevant unless both the measures and the processes underlying them are updated and improved on.

Just as corporate strategists set goals and benchmarks for financial resources, they need to set goals and benchmarks for integrated resources. That means translating corporate strategy into measurable strategic plans for action. It means linking those plans to integrated metrics – and using the metrics to improve processes, resource allocation, and efficiency. It means updating outcomes and modifying the metrics as business processes change. It means linking strategic goals to individual performance and creating compensation and advancement structures that reward individuals' achievements.

Noah P. Barsky, CMA, CPA, Ph.D., is an assistant professor of accountancy in the College of Commerce & Finance at Villanova University, Villanova, PA. You can contact him by e-mail at noah.barsky@villanova.edu or by phone at (610) 519-6272.

Garry Marchant, Ph.D., is the Ernst & Young Professor of Accounting in the Department of Accounting and Finance at the University of Melbourne, Australia. You can reach Garry by e-mail at g.marchant@ecomfac.unimelb.edu.au.