Thursday, May 05, 2005

Billions in Bits (from my Borland blog)

As Borland’s SDO vision evolves, one of our stated areas of interest and investment is how to unlock the value of the business information embedded in our integrated ALM solution. Clearly this will involve features and functions of, and integration to, the emerging world of enterprise governance solutions such as Mercury ITG, Niku and others. Seeing this trend as the “next big thing” is perhaps bittersweet for thinkers like Paul Strassman whom have been highlighting the need for such approaches since the late 80’s. I have to admit I am a big fan of Strassman – and in this posting highlight some pointers to his work on this topic from the late 90’s. His multi-decade quest has been how to value the entrusted information capital that resides in our organizations.

To illustrate the massive impact of information capital to an organization’s value, look at the value of Google. Just shy of $3 billion in assets, it has a market capitalization of over $60 billion. In financial reporting, the gap between these two numbers is never formally recognized unless the assets are sold. Upon sale, the gap between asset value and sales price would be stuck into the accounting catch-all of “goodwill”. Though intangible, these assets hold real — and obviously significant value – to the marketplace. What are these hidden assets? Why does the stock market recognize $57 billion in intangible assets? Part of this number is the market’s present value for future earnings on existing and new revenue streams. However, that is still not all. Many economists are quite comfortable ascribing the remainder of the hidden assets as the value of Google’s intellectual capital.

Accepting that a significant component of a company’s economic value is the intangible asset of its staff’s current and future capabilities begs some significant questions about how companies and the people they employ are managed. I would like to highlight these questions and illustrate some key thoughts regarding the role of intellectual capital in companies; especially in the ever-burgeoning multi-billion dollar operating budget environment known as the “back-office”. First, I’ll say a little about what I call your corporate economy.

What is a Corporate Economy?
One of the traditional organizational breakdowns companies use is “front-office” and “back-office”. Another popular concept is “profit center” versus “cost center.” Unfortunately, these segmentations suffer from a number of issues. Within many organizations they have become politicized or become pejoratives. (How terrible to be one of the “costs” of the organization, but not part of the value!) Even worse, in light of emerging thoughts on the value of intellectual capital, these traditional distinctions may not be optimally useful in determining corporate strategy.

I think a useful dividing line is between staff that are intimately involved in customer transactions (transactional staff), and the staff that provides the services which enable those transactions (service teams). This categorization seems especially poignant in companies whose profitability stems from transactions of intangible products (interest rate swaps or foreign currency options, insurance policies, DNA sequences, information models of distribution networks, etc). With this as a definition of your corporate economy, there are three questions - when asked, and well answered - give structure to your corporate economy.

What is the nature of my relationship with my clients? This is answered in part by your business transaction systems which tell you what you sold, to whom, for how much. The emergence over the last decade of customer management systems indicates that the transaction systems are only part of the answer, and companies are searching for the other half of the answer.

What is the nature of my relationship with my competitors? To the extent I can legally know - what are they selling, to whom, for how much? But also, what are their product plans, business emphases, and keys for continued success. Software to help companies answer these questions is just beginning to emerge under the loose category of “competitive intelligence”.

And finally, what is the nature of my relationship to my internal service sector? What are the key activities of my “service teams” that support my “transactional staff”? Which services are most needed in order to produce more, higher quality, customer transactions? Today’s crop of Project Portfolio Management systems and Enterprise Corporate Governance systems are attempting to provide software systems to help answer the third of these questions. These systems are evolving to help business management know and evaluate its service sector, and equally as important, allow business management to evaluate its effectiveness in using the corporate service sector.

How is the value of intellectual capital defined?

Barron’s defines intellectual property as “a special type of intangible property, arising from the creative endeavors of the human mind.” If intellectual property is the end product, then it can be inferred that the “equipment” asset used to create the product is the human mind.

Paul A. Strassmann, a 40-year veteran of the information technology business in both the government and commercial sectors, defines information capital, or to use his trademarked term Knowledge Capital®, as forming when “employees think or talk about how they are delivering goods and services. This usually occurs when workers are engaged in overhead tasks, not when they’re actually delivering goods or services”. The delivery of goods and services is usually considered a “front office” (transactional staff) function; overhead tasks are usually considered the realm of the “back office” (service teams).

Looking at the Google example suggests that in a world divided into front and back offices, the excess market capitalization widely recognized as the intellectual capital value of the company, is wholly attributable to the “front office”. But could this be true? It is unlikely. Some value must occur in the “back office” to enable the transactional staff to be productive in generating revenue. Once the concession is made that a company’s service sector staff have an impact of millions to billions on corporate stock market capitalization, then it is time for a change.

The ability to leverage service sector intellectual capital takes the stage, displacing the overly simplistic cost management approach commonly and broadly applied to large segments of the company. Organizations that treat intellectual capital as “out of sight, out of mind” are left wondering how the competition seems to make great gains “out of nowhere” or “from nothing.”

How is intellectual capital measured?
It is widely understood that the cost of acquiring knowledge and the profit-generation potentials of such knowledge are unrelated. The value of intellectual property is in its use, not in its costs.
— Paul A. Strassmann

Intangibility is attributed as the reason intellectual capital is difficult to measure. Intellectual capital deviates from traditionally-noted sources of capital, because instead of being implemented to accomplish a defined task and then depreciated over time, it can expand its original role or be a form of innovation in new areas (for example, NASA innovations which work their way into consumer products). Knowledge assets, unlike what we traditionally consider capital, have infinite potential. Yet, as seen with many skill sets, particularly technological, intellectual capital can also depreciate – making it all the more important to understand, control, and capitalize on how your information resources are used. How and whether the potential is reached will increasingly be the advantage or downfall of any knowledge-driven company.

The Google example illustrates how intellectual capital assets are valued by traditional accounting with an organization’s other, more tangible assets. The consensus as to whether or not knowledge capital should be accounted for and with what measurement methods is about as tangible as the asset in question. What follows are three different approaches used for valuing intellectual capital. They are good examples of the approaches that exist; it is hard to say which is the most appropriate for an organization to use.

Approach #1:
Customer relationships & growth-in-value

Skandia Inc., a Swedish insurance company, is the only company in the world I know of which has reported intellectual capital value in tandem with its financial reports. The inconsistency that occurs when valuing intellectual capital was in the past acknowledged on Skandia’s Internet site: Many Swedish companies on the Stockholm Stock Exchange are valued at 3 - 8 times their book value, i.e., the financial capital. This implies that there will be huge hidden values in companies, which are not visible in traditional accounting, yet increasingly larger investments are made precisely in these hidden assets. Such investments concern, [for example] customer relations, information technology, networks, and competence. Skandia has “long maintained that our truly sustainable earnings are derived from the interaction between our intellectual capital and financial capital.” Their synthesis of this relationship was first published as a supplement to their 1994 annual report.

Approach #2:
Intellectual capital is calculable

Strassmann has conducted extensive research toward defining intellectual capital as a calculable number. Strassmann conducted a study of 359 U.S. industrial companies which revealed the collective intellectual capital of these organizations was valued at $1.7 trillion, or 217% of their net financial assets. Strassmann reports that at the end of 1995, Standard & Poor's 500 companies (about 70% of all publicly traded companies) had a combined $1.12 billion fixed assets, and a market value of $4.5 billion. When categorized as overhead, intellectual capital is typically charged against profits. Some argue that this is inaccurate because while a cost to acquire intellectual capital may exist, writing it off as an expense does not consider the on-going value the intellectual capital has. Strassmann’s calculations are a means of quantifying the value of intellectual capital, which as mentioned earlier, is only captured in the sale of a corporate entity, and then only captured within traditional accounting as “goodwill”. Redefining intellectual capital investments with calculable benefits can better reflect its proportion of market value. For those interested in his actual calculations see

Approach #3:
“Stick to the basics”

Strassmann and other information experts have created intellectual capital valuation formulas (primarily based on traditional accounting and economic equations) and organizational theories which illustrate their perspectives on information capital. This terminology helps separate and frame the uniqueness of this intangible resource. However, the art and science of accounting has made it 500 years without these innovations and there are those who question its formal introduction onto the corporate balance sheet. It is interesting to note that Microsoft, perhaps one of the most iconic examples of a balance sheet rich with intellectual capital, does not believe such measures should be formally introduced.

Microsoft’s previous chief financial officer Mike Brown said during his tenure that sticking with the basics is the best way to thrive in constantly changing and complex business environment. By focusing on the extremes —at the individual level and the big picture — Microsoft vigilantly manages resources at the immediate level while “keeping internal financial statements simple and meaningful.”

Regardless of the approach, perhaps the takeaway point is that having an inventory of your knowledge assets and analyzing how those assets are invested toward your organization’s success is critical. Whether done with Strassman’s relatively simple balance sheet ratios, or Skandia’s detailed profiles, or just good people management - the exercise requires a shift in perspective from how organizational assets typically are viewed.

What is the source of my information capital?

Take my assets, but leave me my organization and in five years I’ll have it all back.
— Alfred P. Sloan

As a manager you are already responsible for optimal utilization of your intellectual capital, but the tools or approach may not effectively account for information capital performance. The right tools and approach, incorporated into your organization’s daily heartbeat, can help you act on knowledge which enables your intellectual assets to perform at organizational expectations and beyond. Studying changing valuation approaches and accounting methods helps us gain an understanding of how all organizations are part of the knowledge economy, not just those whose end products are obviously knowledge products, such as Google. The companies that not only lead, but define their industry or product, have as a core competency the ability to effectively and immediately evaluate the effective use of their human capital.

The approaches, methodologies, and even service providers to assist you with these evaluations are diverse and the list is exploding. Every organization’s objectives and environment is different; you should select the thought process that is most comfortable for you and best accommodates your needs.

Recognizing knowledge as a strategic resource is the first step, but to manage knowledge as a valuable asset requires evaluating where (and in whom) the knowledge value lies. PPM/Governance tools are specifically designed to collect information about people, their time and their actions for strategic analysis, making them the ideal springboard for whatever overall solution you implement.

Focus on intellectual capital and intellectual continuity may pay-off!

The knowledge society will inevitably become far more competitive than any society we have yet known — for the simple reason that with knowledge being universally accessible, there will be no excuses for non-performance.
— Peter F. Drucker

This Drucker quote clearly was a harbinger of the recent “world is flat“ discussion. Perhaps nurturing the human spirit is not untrue to the bottom line. Thoreau’s comment on the majority of people leading “lives of quiet desperation” may not be specific to vocation or level of visibility, but perhaps indicates the universal need for self-value. If so, giving employees an understanding of their role in value creation is a truly empowering move. And in the emerging era of competition, maybe a rational, justifiable, capitalist strategy.

After years of inconsistent motivation and recognition programs, employees risk becoming jaded and leery of anything that purports that an organization “cares” about them as human beings. To recognize humans as value contributors, versus wage-earners-detracting-from-profits emphasizes what is uniquely human: the ability to reason beyond the boundaries of pre-defined formulas.

This rebellion against pre-fabbed idea boundaries and support of self-motivation is often evident in “Generation X” or “D” co-workers. We seem to have this mixture of awe and disdain for these employees; a twenty-four year-old who was considered an arrogant maverick in one environment becomes a young billionaire in another, bringing to the picture nothing other than himself. That “nothing” sometimes represents over two-thirds of the organization’s assets. That nothing can magically accelerate a sleepy organization in a few short quarters into a market leader. Invoking this financial magic from nothingness has created business practices for consulting firms everywhere. PPM and Governance isn’t magic. It requires involvement and commitment to achieve real results. But, as a tool and as part of an evolutionary process, it can work with the magic that is already within your organization: your environment, your processes, your culture ... and your people.