Intellectual Capital Reporting

Lifestyle enhancers

2011-10-20T00:53:00.000+05:30

Apple, 3M, GE, Sony, Toyota, Procter & Gamble, Samsung, etc. are among some of the well known companies that have been consistently voted into the list of the most innovative companies in the world for many years at a stretch. This begs the question – how do they do it? How do these companies make the list of most innovative companies in the world with such alarming regularity? What is it that they are doing right about innovation that their competition isn’t? After all, isn’t innovation fraught with risk? Before you try and correlate the innovation success of these companies with the quantum of their R&D spend, let me dispel that notion right away. Booz and Company recently published their Global Innovation 1000 study during which they found that seven of the top 10 innovative companies were not even among the top 10 spenders on R&D. On the contrary, the R&D spend of the most innovative companies as a percentage of their annual sales was typically less than 5%, compared to more than 10% for some of the heavy hitters. This study therefore confirms the fact that you cannot throw money at innovation and expect it to happen. The reverse, however, is very true. The same study showed that the most innovative companies were able to generate a higher EBITDA as a percentage of revenue compared to the ones who were not innovating so much! So whereas money cannot generate more innovation, innovation definitely generates more money. And that is the reason why we need to understand what the highly innovative companies do right.

I had to give it considerable thought, but in the end I came to the conclusion that the most successful innovative companies produce an innovation or a series of innovations that enhances our lifestyles by a couple of notches every time. The widespread acceptance and adoption of these innovations move our entire civilization forward a notch, in much the same way that homo-sapiens has progressed through the ages - from hunters to growing their own food as farmers, then to leverage machines to do his work faster during the industrial age and finally to use knowledge to become more efficient at his work during the information age. Let me cite just two examples to make my point.

Sony invented the Walkman portable music player in the late seventies, allowing humankind for the first time to carry their music along with them. Listening to music is a basic human need, since music is the food that feeds our souls. Understanding this need, Sony’s engineers gave vent to their creative genius and designed a compact portable music player. It was a mega hit with the masses for the next two decades and many imitations followed. But if you want to buy one today, you will be hard pressed to find one. Why? Because, although the Walkman made your music portable, its magnetic audio tape based storage technology had limitations of capacity and sequential seek Another enterprising company, by the name of Apple, recognized these shortcomings at the start of the century and their design engineers put their creative minds to work to innovate a portable music player called the Ipod. They introduced digital storage technology along with massive capacity into a device that is probably a tenth of the size of the Walkman. Ipods are such a rage with the masses today that the Walkman has become obsolete as quickly as it became famous. Such is the popularity of the Ipod today that any true music lover will not be caught without one today or at least an imitation of it. However, the larger point I want to make is that in creating the Walkman and the Ipod, both Sony and Apple enabled civilization at large to progress a notch by liberating it from the clutches of unportable music players.

Let us take another example. We all know the tremendous benefits humankind has derived from the invention of the modern motor car. Transportation has become much faster due to the motor car enabling us to be more productive in our day compared to the worker of the nineteenth century. However, after a century of guzzling gas the world over, car makers realized that the motor car could not be sustained to run on gasoline forever, since the world’s oil reserves were depleting at an alarming rate. This is when car makers got into a frantic race to develop cars that could run on alternative energy sources such as electricity, solar energy, etc. Many even developed commercial variants of their alternate energy cars. However, the company that achieved the most amount of commercial success in this regard was Toyota with its Prius car. Unlike other manufacturers, Toyota did not seek to develop a purely alternate energy car. Instead they developed a hybrid, a car that can run on gas as well as electricity. Their engineers installed an electric motor alongside the petrol engine and innovated to develop a Hybrid system that makes the electric motor act as a high-output generator to produce regenerative braking during deceleration. Simply put, it means that the car is storing the braking energy as electric energy to be used later for cruising without petrol. Ingenious! In one stroke, Toyota solved multiple problems – their hybrid approach doubled the mileage of the Prius compared to other petrol only cars, their regenerative hybrid system overcame the problem of the limited battery capacity of pure electric cars and at the same time their hybrid approach ensured that the performance of the car was not compromised in any way. The Prius was first introduced in the late nineties. Since then many other manufacturers have introduced commercial hybrid cars of their own and I believe that this trend is only going to increase in the years ahead. The larger point in this example is that with the hybrid Prius, Toyota enabled its Customers to address the issues of dwindling oil reserves and pollution without compromising in any way on everything they had come to expect from a transportation vehicle such as a car. Once again, Toyota managed to push the envelope and move civilization forward by a notch with its hybrid car innovation.

The ability to innovate and introduce commercially successful products and services is to me yet another pattern of Intellectual Capital – I have coined the name ‘Lifestyle Enhancers’ for this pattern. Make no doubt, innovative ability is a rare ability and one fraught with risk. Yet it is a type of Intellectual Capital that many large companies mentioned at the start of this article have harnessed and molded into commercial success. All of these companies are household names today - some of them have come into existence only in the last decade but have made their mark very quickly with their ability to innovate at every step of their existence. Such is the power of innovation, which is only a subset of Intellectual Capital. What would it be like if a company could harness all aspects of its Intellectual Capital? Your guess is probably better than mine.

Using IC to beat the Nifty hands down

2011-06-09T23:36:00.005+05:30

IC practitioners the world over have produced tomes of literature in the past two decades to prove the value of Intellectual Capital in the modern Knowledge economy. There is not an iota of doubt about the importance of Intellectual Capital within the worldwide IC community. Countless modern Management Gurus - including Robert S Kaplan and David P Norton, inventors of the highly popular Balanced Scorecard and Strategy Map – and other thought leaders of our times have waxed eloquent about how it is the intangible assets in an enterprise that provide lasting value and competitive advantage to the business. They have even conceptualized and published many different frameworks for discovering, measuring and managing the IC of firms.

But what about the average man on the street? Does he understand the concept of IC as easily as he understands accounting concepts such as a Balance Sheets and Income statements? What about the average investor? Does he bother at all to investigate the quantum of intangible assets within the business before making his investment decision? The answer to my mind is an emphatic NO. For all the volumes of literature produced by the IC community over the last twenty five years, the common man remains blissfully ignorant about the role of IC as a critical value driver of the modern knowledge economy. However, whenever I have ventured personally to explain the relevance and importance of IC to the average man directly, I have found ready and immediate acceptance of the concept by him or by her each and every single time. This leads me to believe that the common man is perhaps not ignorant about IC, he is just constrained. He is compelled to ignore IC because he just does not have any source that dispenses IC information to him readily. This compulsion on his part results in a lack of demand for IC related information and consequently business leaders are only too happy to not provide the supply. We are therefore left in a cycle of deadlock where there is no demand for IC because there is no supply of IC related information and there is no supply of such information just because there isn’t any demand. This cycle needs to be broken before IC can become relevant and topical in the business context. But how?

In my own small way, I have attempted to do this by enabling investors to inspect the Intellectual Capital of the 50 top Indian businesses (Nifty stocks) every quarter. This is still a proof of concept application at the moment and I call it the icTracker. The icTracker enables the investor to ask three simple and fundamental questions of every firm in the Nifty list.

Question 1: Is the business making money?
This is the most fundamental question that any investor wants to ask. Nobody wants to invest in a loss making proposition, however the fact remains that accounting profits as published by firms in their income statements do not correctly reflect whether the business is making money. What we really want to know as an investor is whether the business is making economic profits. In other words, are accounting profits enough to cover the cost of capital and then some? We use an IC concept known as the EVA (Economic Value Added) for this purpose. EVA was popularized by Stern Stewart & Co in the early nineties. Many businesses worldwide took to this concept like fish to water, believing that this was one of the fundamental measures of success for any business. To us, it is only the first step but a very important step. We want to pick businesses that consistently have a positive and hopefully increasing EVA. In case we find that EVA is negative during some time periods, we need to probe whether it is due to genuine reasons such as large capital expenditures incurred for driving future growth. But to keep it simple, always look for consistently positive EVA.

Question 2: Do knowledge assets dominate the business?
If the answer to Question 1 is YES we move on to Question 2, where we ask whether knowledge assets are the dominating assets in the business. In other words, we want to ensure that we stay from investing in businesses that are dominated by physical or financial assets. Why? Just because we want to invest in businesses that have a high degree of competitive advantage. It has been proved repeatedly that competitive advantage is derived from Knowledge assets rather than physical or financial assets. Investing gurus such as Warren Buffet have gone to the extent of coining their own word for such advantage – moat. Buffet likes to invest in businesses that have a high degree of economic moat. And we should too. In the IC world, measuring Knowledge Basis – the ratio of the Intellectual Capital to the Total Value of the firm – gives us an idea in percentage terms whether knowledge assets dominate the business. Here we should look for a ratio of more than 50% consistently over a period of time, which indicates that the business has a high degree of competitive advantage and is also able to maintain the same over the said period of time.

Question 3: Is the stock undervalued?
If we got this far, then clearly we have been able to identify a business which consistently makes money and has a consistently high proportion of knowledge assets. With these two simple questions we have been able to zero in on an attractive investment proposition. All that is left to ask now is whether the timing is right for making the investment. For this we check whether the stock is undervalued. How? The Intellectual Capital of the business is already computed based on the published results. The Book Assets are also available from the published Balance Sheet. Add both of them up and divide by the number of shares to get the intrinsic value of the stock. Compare this to the market price which is also available and we know instantly whether the stock is undervalued and hence a right time for investing.

That’s it. In just three easy steps that all leverage concepts from the field of Intellectual Capital, we have been able to identify a good investment for the long term. How powerful is that? I would have to say extremely powerful but perhaps it is powerful because it is extremely simple. icTracker answers the above three questions for all Nifty stocks graphically by showing the performance of the stock over the last three years. This makes the analysis even simpler – even a guided teenager can make good investment picks using this tool. But does it work in the real world? I wanted to find out myself. So I did a hypothetical calculation. I found that if I had invested Rs 1 million in the Nifty five years ago on 1 April 2006, that amount would have grown to Rs 1.714 million five years later on 31 Mar 2011. The same Rs 1 million invested in the top 5 recommendations from the icTracker on the same date would however have grown to an amazing value of Rs 5.747 million five years later. That is a return in excess of 3.35 over the Nifty! This is of course assuming that I would use the icTracker every quarter to re-balance my portfolio.

That in short is called using the power of Intellectual Capital to beat the Nifty hands down! Have I interested you sufficiently in the power of Intellectual Capital now?

Taking IC to the mainstream

2011-05-06T19:07:00.001+05:30

The subject of Intellectual Capital has existed for over 20 years now. The Swedish Konrad group was the first to recognize the contribution of intangible assets to the performance of a firm, way back in 1989. Based on their findings they proposed a list of 35 indicators, including indicators on Human resources and structural assets of the firm, which should be reported externally by the firm to its stakeholders. This was followed in 1996 by a more exhaustive and prescriptive approach by Brooking. She recommended that every firm should audit all of their intangible assets, the goal being to put a financial value to every such asset. The Intellectual Capital Audit was formulated for this purpose containing 30 ways to audit various types of intangibles using 158 questions ranging on a variety of issues. Many other prescriptive approaches for measuring Intellectual Capital followed, including the Intangible Asset Monitor by Sveiby in 1997, The Intellectual Capital Index by Roos & Edvinsson also in 1997, the IC Navigator by Thomas Stewart in1999, the Value chain scoreboard by Baruch Lev in 2001 and the Intellectual Capital Dynamic Value by Professor Bounfour in 2002. The growing significance of Intellectual Capital’s role in the new economy even saw the Governments of countries such as UK, Austria, Sweden, Iceland, Denmark, Germany, UK, Japan, Australia etc. develop and publish country specific guidelines on how to report Intellectual Capital. The Austrian government even went so far as to make such reporting mandatory for universities – the crucibles of higher education and learning in the country.

But for all the effort that has been put in by experts and Governments to bring Intellectual Capital into the mainstream, it unfortunately has remained on the sidelines, confined largely to the academic domain. The business world has failed to make the management of Intellectual Capital as one of its primary focus areas, despite overwhelming evidence of the benefits of doing so. For instance in India, considered the second largest Knowledge economy in the world after the US, only one large-cap company takes the trouble of publishing an Intellectual Capital Report in its Annual Report. A few others who started similar initiatives a few years ago have quietly shut those down for reasons best known to them. What could be the reason for such apathy towards Intellectual Capital by the mainstream business community?

In the preface to his ground breaking book “Intellectual Capital”, Thomas Stewart dismisses the possibility that the idea of Intellectual Capital will become a fad like re-engineering because he argues “there is nothing to sell”. Good ideas like Intellectual Capital however, get accepted in the mainstream not merely because they are good as an idea but because they have a commercial benefit. Stewart realizes the folly of his own argument quickly and goes on to recount with striking detail in the rest of the book how Intellectual Capital is a pot of gold waiting to be tapped. He suggests that IC practitioners have an obligation to reconcile the theoretical and practical sides of Intellectual Capital by
1. Devising a knowledge management toolkit that makes and saves money
2. Designing efficient methods for identifying knowledge assets in the organization
3. Proposing methods for the governance of organizations whose main assets are intangible
4. Developing practical methods of valuing intellectual assets of the organization
This was way back in 1998. Thirteen years have passed since Stewart published his ground breaking ideas but the situation has changed little since then. Knowledge Management did assume center stage for a while in the late nineties and early 2000s, but quickly fizzled out thereafter. Perhaps the application of Intellectual Capital got too tilted towards Knowledge Management when it came to the mainstream. Many a firm tried building gigabyte sized databases for capturing and encapsulating their knowledge, only to find out it was an effort in vain. They quickly discovered that knowledge is ephemeral, its usefulness highly dependent on the context of the situation in which it is applied. Such application requires real human intelligence which cannot ever be replaced by the artificial intelligence that they tried encapsulating in their databases.

I got attracted to the field of Intellectual Capital about four years ago. From the very beginning I wanted to address the question of how to commercialize the concept of Intellectual Capital, because then and only then would the concept find widespread mainstream acceptance. With this background, I deliberately focused on the fourth suggestion made by Stewart – valuing Intellectual Assets. I reasoned that if I could devise a reasonably accurate method of valuing the Intellectual Capital of a firm at a point in time, this information could be used by potential investors for their benefit. And the more the investors benefited, more would be the acceptance of the concept. The ICTracker product was born out of this thinking. At the present time, ICTracker calculates the Intellectual Capital of the top 50 listed Indian firms once every quarter. The Intellectual Capital thus calculated is added to the published Networth of the firm to get the total firm value, which is then compared against the prevailing Market cap to make an assessment of whether the firm is over valued or under valued. The algorithm used for calculating the Intellectual Capital of the firm is based on the Intangibles Scoreboard methodology by Gu and Lev (2002). The basic approach advocated by them has been modified by me to take care of troublesome real life concepts such as minority interest, goodwill, accounting intangibles, risk premium, liquidity premium, preferred capital, employee stock options, etc. These modifications result in an output that can be practically used by investors to beat the broader market index itself. Calculations made by me show that over a period of five years from Jan 2006 to Dec 2010, predictions from the ICTracker would have resulted in a gain in excess of 43% over the Sensex and the Nifty indexes.

More importantly, I have been able to simplify the process of stock picking using the concept of Intellectual Capital into three easy steps. The first step is to check whether the firm is making money - not profits but cash. We use EVA for this purpose, which calculates the excess money the firm has leftover after paying its cost of capital. So to begin with we look for firms that are making money every quarter. Secondly, we look for the knowledge content of the firm – is that excess money coming from tangible assets or intangible assets? In general, we prefer firms that are making money from intangible assets since they have a competitive advantage in the marketplace that is hard to replicate. For this we look at the Knowledge Basis of the firm – the ratio of the firms Intellectual Capital to its total worth. We want to pick firms with a high Knowledge Basis compared to the rest of the firms in the industry. Having selected firms that are making money and that have a high Knowledge basis, the final step is to look at whether the firm is undervalued. That is the signal to make an investment in the stock, since investors will always want to buy low and sell high. That’s it. That is how simple I want the practical application of Intellectual Capital to be. As I said earlier, the product is limited to the top 50 Indian stocks at the present time but I am making efforts to include all Indian stocks in the future. If I get there, I will then focus on stocks in other Knowledge markets. Meanwhile, I invite you to comment on what else can be done by IC practitioners to increase the widespread adoption of Intellectual Capital and bring it to the mainstream.

The downside of Scale Enablers

2011-02-28T00:19:00.000+05:30

In my previous post, I had described how structural capital can be used to have unlimited scale in a business. I had provided two examples – how Automatic Teller Machines were instrumental in scaling the operations of banks at negligible marginal cost and how the Internet itself had been used by Google to scale its advertising business to the point where it has become a near monopoly in a very short span of ten years. Readers will surely find other examples which fit the pattern of scale enablers. Here is one more - how about the invention of the moving assembly line in a manufacturing shop? The assembly line mechanism may be taken for granted in today’s manufacturing world but when it was first deployed by Henry Ford in the early 1910s, it revolutionized the automobile industry, enabling Ford to scale its manufacturing operations significantly and get a leg up on the competition within a short period of time. Note that scale enablers, by definition, need to create a massive impact for the firm that deploys them. For instance, all the scale enablers that I have described in the examples so far have created such a massive impact that they have become an industry standard – meaning that subsequent businesses have no option but to follow the scale enabling operational model of the leader. Here’s the proof - can you imagine a bank today that hopes to sustain and scale its operations without the help of ATMs? Can you imagine an automobile manufacturer producing cars without a moving assembly line in its plant? And can you imagine any Google competitor that can successfully best its advertising business without the help of the Internet? Even with the help of the Internet all of them are having a hard time at present – but that is another matter. The point I am trying to make is simply this - Scale enabling Intellectual Capital based on the deployment of Structural Capital is a sure recipe for the unlimited growth of any business.

Having being convinced of this fact, the question that naturally arises is – Is there any downside to scale enabling Intellectual Capital at all? Surely it cannot be a silver bullet. The answer in fact turns out to be in the positive. There is a downside to scale enablers and quite a significant downside. The problem with Structural Capital is that it does exactly what it is programmed to do. It is therefore both inhuman and unforgiving – and that is exactly its downside, especially when it has to deal with real human beings. This realization in fact dawned on me very recently while I was in the middle of one of my own experiences with scale enabling Intellectual Capital. However, let me illustrate this point using the same examples that I have used so far in describing Scale Enablers.

Let’s take the example of the ATM. Has it ever happened to you that an ATM has actually dispensed you the incorrect amount from what you requested and what has actually been debited from your bank account? The chances are quite rare that this could have happened to you, but have you heard or read about such incidents happening with others? What if the ATM dispensed the correct amount but the notes dispensed are soiled or even mutilated. This is more in the realm of possibility and this could have definitely happened to a few of us. More practically, have you ever had an ATM dispense you high denomination notes because it was out of smaller denominations? This has probably happened to all of us. All of these incidents lead to high customer dissatisfaction – the only problem is that the ATM cannot help you any further. If it was the bank teller, you could have a resolution there and then to these incidents, but when dealing with an ATM, resolving such incidents of Customer dissatisfaction are too time consuming and too costly. In fact more often than not, they go unmentioned and hence remain unresolved.

Let’s move to Google – I had mentioned how Google has become the undisputed king of the Internet advertising world using its scale enabling Internet interface that lets its Customers open an account, create ads, select distribution parameters, make payments, run those ads and browse through automatically collected and pre-analyzed ad diagnostics. However, have you had any reason to be dissatisfied with Google’s advertising service? You had better not, because if you were, you would have no idea whom to turn to. Google does not assign its Customers with a Relationship Manager who can be reached directly in times of a crisis. At best, you could reach Google’s Customer service and be confronted with its automated voice response system. Or you could drop Google an email? The resolution time and cost for both you and Google will be quite high though, because both of you would now have to work outside the boundaries of a scale enabling automated system whose marginal costs are designed to be next to zero.

The truth is that businesses that have driven their growth using the scale enabling Intellectual Capital model have first fine tuned their Structural Capital to be as close to being faultless as is humanly possible. This by itself is a capital intensive and time intensive process. Alternatively, other successful businesses have deployed “good-enough” systems and have backed up failure points in those systems with good old human capital – such as call centers, relationship managers, engagement managers, etc. The success of Intellectual Capital therefore depends on the quantum and mix of components deployed. Just as the secret to a good recipe is the right ingredients in the right proportions, so also the secret to business success with Intellectual Capital is a judicious mix of Human Capital, Structural Capital and Relational Capital. And that is exactly how I define Intellectual Capital in the first place.

Scale Enablers

2010-09-02T15:35:00.000+05:30

In my last post I wrote about how reach-enabling Intellectual Capital is helping businesses overcome the scarce availability of talented human capital, such as teachers and doctors. This time I will extend the analogy to include the average line worker and in the process reveal yet another paradigm in the successful deployment of Intellectual Capital, something I call ‘Scale Enablers’.

Let me start by asking you to recollect the last time when you had to personally visit your bank. No, not a drive-through ATM, but your actual bank premise in order to conduct a banking transaction with the personal guided help of your bank teller. Do you remember the approximate time frame, even within the ballpark of a month or two, when you had to this? I bet you can’t. Because neither can I. You can put the blame on the lack of your personal bank visits solely on the ubiquitous ATM or Automatic Teller Machine, which have mushroomed by the hundreds in every possible heavily frequented nook and corner of your city and which have made available your bank to you 24x7. These ATMs enable banking functions such as cash withdrawals, check deposits, money transfers, balance information, account queries and many other common banking transactions, eliminating the need for you to ever visit your bank again. As surely as these ATMs have made your life easier, they have also incurred huge capital expenditures on your bank. Why then, you ask, are banks incurring such huge costs? Well for one, they have figured out that deploying ATMs not only reduce the requirement for hiring bank tellers (saving monthly salaries, office space, pensions, etc.) but also the need for having full fledged branches itself, thus shaving off huge amounts costs of their lease and rental expenses. But more importantly, the bank is able to serve more customers using ATMs which directly enhances the scale of operations of the bank at no marginal cost. This is because an ATM, once installed, can easily serve 100 customers or even twice or thrice that number each day without any additional cost. ATMs therefore are the scale enablers of the bank. A business that can scale its operations without significant requirements of either talent or variable cost is a business worth investing into because such a business can target unlimited growth. ATMs cause banks to fall into just such a category. But ATMs after all are a part of the structural capital of the bank, aren’t they? Perhaps you are beginning to realize now how powerful the impact of Intellectual Capital can be, when it is deployed as a scale enabler.

Once you have understood the value of ATMs for banks, you can easily understand the value of all other types of automatic vending machines (AVMs). They follow the same principle as ATMs except that they dispense various items of consumer interest such as cola, coffee, fruit beverages, snacks, newspapers, magazines and even condoms, instead of cash. Although the dispensed item varies, in each case AVMs extend the scale of operations of the corresponding business, enabling it to operate from remote locations such as highway rest areas, airport lounges and rail stations, office cafeterias, mall entrances and sidewalks and even from public restrooms! Next time you spot a humble ATM or an AVM therefore, try to look at it more respectfully. These humble machines have eliminated the need for human labor in the same way that industrialization era machines replaced farm hands. They have contributed to the smooth scaling of the businesses that own them, contributing to cost effective growth of the business which in turn has generated more wealth for the owners of those businesses.

One of the best examples that I have encountered of a business that has used the Scale Enabling Intellectual paradigm not only to grow its business by leaps and bounds but in fact to create an overpowering dominance so as to block out all competition, is our very own friendly search engine company aka Google. Such is the overwhelming influence of Google in the Internet search world that most Internet users are not aware that other search engines even exist. Google is not only the undisputed king of search but it has also very cleverly extended its reign into the world of online advertising. Online ad revenue is the single largest source of income for Google. Hence you would be forgiven for thinking that Google has armies of sales personnel interacting with its customers every day for generating those online ad revenues every day. Nothing could be further from the truth. I have been a customer of Google for more than three years now and to this day I have not yet interacted with any Google personnel. Most of my interactions so far have been through the Google web site and on the rare occasion I have also used e-mail. Yet I cannot think of any other business which has served me for over three years without the need of human intervention for a single business process, including account opening, which is typically the most human intensive of all customer facing processes. Can you? In business parlance, this means that for every additional revenue dollar that Google pulls in, it Cost of Goods Sold (COGS) is negligible or perhaps even zero, which means that its Operating Margin is very high. All Google has to do then is to manage its staff salaries and Administrative expenses to ensure that its Net Profit Margin remains high (27.57% for Year ending Dec 2009). Are you surprised then that Google is so highly valued by the Capital Markets? In a short span of just 12 years (it was founded on 7 Sep 1998), Google has come out of nowhere to occupy the 12th slot in the list of top companies in the US by market capitalization. Its market cap as on 31 Aug 2010 was a whopping $143.7bn, just behind well established behemoths such as General Electric, AT&T and IBM. That is the power of the Scale enabling Intellectual Capital model.

Companies such as Google have proved that structural capital can be deployed successfully for achieving unlimited scale in the shortest amount of time and with maximum profitability. Can we therefore afford to write away Google’s success as a one-time fluke instead of recognizing and understanding the pattern of Intellectual Capital embedded in its business model so that we may spot other winners early on in their growth cycle? The message is clear – always be on the lookout for businesses that are working on or have already devised scale enablers. Businesses with such scale enabling assets are the ones that will generate massive value for themselves and their owners in the future. And with a little smartness and a healthy dose of diligence you could benefit from their future too!

Reach Multipliers

2010-06-17T13:39:00.000+05:30

Teachers are a scarce lot nowadays. Teaching is a noble profession no doubt and a highly honorable one too, but like a lot of other noble professions nowadays it is losing its shin in this modern age. There is no glamor in being a teacher anymore; hence not very many of the younger generation aspire to become teachers these days. Consequently their tribe is only decreasing. Paradoxically with the increasing population, school enrollments are on the rise. With the result that the demand for teachers today is more than it was ever before. I see a shortage of teachers in primary schools, secondary schools, junior colleges, engineering colleges, medical colleges and Universities. In short, I see a shortage of teachers in the whole teaching system. Yet I also see more and more schools and colleges coming up everyday. It requires an explanation. How are these schools and colleges managing to teach their increasing number of students with lesser numbers of teachers? I was prepared to see visiting teachers from other faculties, cramped classrooms reflecting a higher student to teacher ratio and self-study student groups in those schools where teachers were missing altogether. And I did see all of these. But I also saw something else. A handful of innovative institutions had attacked this problem by multiplying the reach of their teachers. They had installed video conferencing equipment in their classrooms using which multiple students at dispersed locations could attend the lecture of a single teacher at the same time using the power of video conferencing. In effect these institutions had managed to solve the problem of scarcity of human capital by strapping structural capital in the form of video conferencing equipment to their human capital, the combined effect of which enabled them to reach out to a larger number of students in geographically dispersed locations!

I was hardly surprised this time when I saw the same solution being applied effectively in another noble profession – medicine. Like good teachers, good doctors are also becoming a rarity of late. And patients who can afford it always seek a second opinion especially when they have to make a decision based on the opinion of their doctor. Some innovative hospitals have resorted to video conferencing technology to enable their patients to seek a second opinion from doctors in other hospitals, perhaps those in their own network of hospitals. Case history of the patient is available to the remote doctor electronically which he can browse and consult with the patient simultaneously over video. This much is becoming pretty common. Meanwhile medical solution providers are working on building technology solutions that will enable doctors to remotely examine patients and even conduct surgeries remotely using remote controlled robotic arms. This may sound like science fiction right now, but we are getting there slowly but surely. This is one more instance of specialists reaching out to a larger audience beyond the confines of their own physical boundaries through the leveraged use of structural capital.

While video conferencing has been enabled in leaps and bounds by gigantic advances in telephony, the Internet has also been a great enabler in this regard. One example of this is webcasting, a medium that is being increasingly adopted by businesses nowadays to peddle their products and services. The traditional approach would have been to invite a select audience into an attractive downtown location, make the sales pitch, feed them lunch or dinner and offer them networking opportunities with their peers. This high cost approach is a rarity nowadays. Webcasts are not only cost-effective for the business itself but also time-effective for the target audience, since they do not have to commute anywhere but can attend the conference right from their desktop. Moreover, webcasts enable the business to reach out to a worldwide audience at the same time which would be physically impossible using the traditional approach.

Structural capital that enables businesses to address much larger audiences than they can do at present is a very attractive proposition to every business. It is so attractive that I have coined the term “Reach Multipliers’ to denote such capital. Reach multipliers are critical for any business to increase the reach of its human capital manifold. Those businesses that have devised reach multipliers are well on their way to achieving the next level of growth in their business lifecycle. Others will be constrained by the limits of reach of their human capital.

As attractive as Reach multipliers are they still are dependent on the presence of human capital in the back-end. The scale that can be achieved using Reach multipliers is a limited therefore by the amount of human capital in the back-end. The question that arises then is – Is there a way of achieving unlimited scale? Turns out that there is and some have already done it. Wait to read about it in my next post.

The Power of Personalization

2010-06-10T17:31:00.000+05:30

Have you ever wondered why in this day and age of giant shopping malls, branded retail chains, self help shopping and barcode based point of sale systems, there are still some Mom and Pop stores that manage to survive and even do well despite having none of the above mentioned advantages? Perhaps, you yourself frequent one or more such stores regularly – it could be your neighborhood baker, convenience store, grocery store or even your local co-operative bank – without realizing why it is you do so. Here are some clues - Does the owner of the store greet you with a smile? Does she know you by name and address you by your name? Does he go out of his way to suggest good deals? Does he even engage in a bit of a casual conversation with you at times? In short, does he try to personalize your visit to the store? Do you leave the store with the feeling that you have been served well, served personally and have been given preference over other customers. That last point is the essence of generating repeat business. As human beings, we all have the innate need to be recognized and for our desires to be pampered. Personalization is just a high sounding term that satisfies this need.

Mom and Pop stores have known for years that big name commercial chains cannot compete with them on the personalization front – it is just impossible to know every customer by name when you have thousands of them. And hence they have leveraged this knowledge to their advantage and managed to survive and even thrive during the retail boom of recent years. Yet what I am about to discuss today is not the friendly personalization in neighborhood stores that you and I have come to experience often. I am going to discuss the commercialization of personalization itself. Yes, you read it right – the commercialization of personalization itself. But wait a minute - Isn’t personalization an intangible thing? – is the thought that crosses your mind immediately. How can you even describe an intangible, leave alone make any attempt to commercialize it? This sounds insane.

Does it? I could have perhaps agreed with your thinking had I not had two very compelling experiences of the commercialization of personalization. The first one was when a good friend of mine had a need to hand out corporate gifts in his company’s name to a select list of his prospects in order to promote his business. I short-listed a corporate gift provider for him and together along with him visited the provider’s office. There we were presented with a variety of gift articles ranging from pens, cups, mugs, key-chains, card holders, stress busters, T-shirts, etc. all of which could be personalized with the corporate logo and the tag line. The shape of the gift did not matter. Neither did its size nor the material from which it was made of. The corporate logo could either be printed or it could be embossed or outlined or even engraved on the gift. Having being sufficiently impressed by this personalized display, all that was left for us to do was to select the gifts that fitted our budget and place our order, which we did right then and there. The gifts were delivered to my client after three days, which he is handing out to his clients and prospects and impressing them every day. Business is also picking up of late, he informs me.

My next experience was more personal. I recently came across a retail chain which sells T-shirts, mugs, clocks, picture frames and other articles that can be personalized with your picture and slogan of your choice. They have a variety of such articles on display in their store, which you can browse through and select. In the middle of the store is a table full of sleek computers where you can choose the background design of your choice. Having done that, you get your photo clicked (handy nowadays due to mobile cameras), add a slogan and hand it over to the designer behind the computer to put it all together. Within 15 minutes or so the designer mixes your picture, the selected background pattern and the slogan text to create a design that will fit on the article that you have selected. After you are satisfied with the design, it is finalized and the design is printed on the article in the store itself. After 30 minutes or so you can walk out of the store with your personalized article.

Do you see now how personalization is being commercialized? Yet you ask, what is so great about it? It looks so straightforward and simple. Let me tell you, it wouldn’t be great if it wasn’t simple. And in hindsight things always look straight forward. But if you apply your mind you will realize that commercialization of personalization requires a mixture of human, structural and relational capital. The human capital is by way of skilled designers who can apply their creative and designing skills to quickly create computer based designs. The structural capital is by way of having computers, a catalog of readymade designs and special transparency printers and embossing machines that can transfer the design to the article at hand. And finally relational capital is by way of having links with suppliers who supply the bland gift articles of the desired quality and of course customers such as yourself who will go out and spread the word once you have experienced delight with this service.

What about price? My experience was that personalized articles are being sold at a price which is at least two to three times the price of the bland article. Can you imagine what that does to the seller’s profit margins? Your guess is as good as mine. The power of personalization is in not only leaving the Customer with a sense of delight but also in doing it in a highly profitable manner.

Franchising – Structural Capital in action

2010-05-31T19:48:00.000+05:30

I had the opportunity to visit a franchising exhibition recently where more than 100 different businesses of various types had put up stalls staffed with smartly attired and neatly groomed salespeople trying their best to convince visitors why their franchise business model was the best choice to opt for as a new franchisee. The businesses on hand ranged from education (coaching classes), fashion clothing, food and beverages, jewelry, real estate agencies, healthcare, solar energy, finance and securities, libraries, childcare, coffee shops, etc. While the diversity of businesses present was tremendous, there was a uniform thread running through all of them that had brought them together to that exhibition in the first place – all of these businesses were capable of growing through the franchisee route. Franchising as a business model is hugely popular and successful especially in the retail world. Next time you have a value meal at McDonald’s realize that you are actually at a franchise of McDonald’s and not at a Company owned Store. If you still have doubts, look at the top of your receipt and you will read the name of the franchisee that is actually operating that particular McDonalds location. It is estimated that more than 50% of all retail sales in the US and one third of all retail sales in the UK come from franchises. Such is the reach and penetration of this model.

Franchising in its simplest form is an arrangement in which the owner of a product, process or service (franchisor) licenses the distribution of these products by someone else (franchisee) in the name of the franchisor in exchange for royalty income. The franchisee brings physical and financial capital to the relationship in the form of location space and cash, while the franchisor provides the know-how of the products and services and the process of selling them. Franchising is therefore an instance where the monetization of intangible assets of the business (in this case, of the franchisor) is easily demonstrated.

The question however is why do franchisors opt for franchising instead of opting for the traditional route of opening company owned stores? Aren’t they giving up some of their profits to the franchisee in the process? Indeed they are, but they are also avoiding the risk of opening a store in a new location when they do not have knowledge of the local business climate. Secondly, they avoid bloating their own employee rolls since the staff at the new location belongs on the roster of the franchise. Finally by opting for the franchise route they convert the need for capital expenditure for opening a company owned store into capital income by way of franchise agreement fees from the franchisee. Isn’t that terrific?

The next question that arises then is that if franchising is such an inviting proposition, what are the key drivers for its success? What are the critical success factors for this model to be successful? The answer to that question in simple words is Structural Capital, in this case the franchisor’s Structural Capital. This has to be developed to such an existence that it can be leveraged in far-away locations without too much of an additional effort on the franchisor. Let’s take an example. Suppose you have decided to open a coffee cafe franchise in your neighborhood because you can feel the business potential for just such a café. You have also identified the franchisor and have signed the franchise agreement and paid the initial fees. This is when the franchisor’s work begins. Based on the size of your shop, the franchisor has to provide you the interior décor plan and organize to have the décor made to specifications including the all important front signage. The signage by the way reflects the franchisor’s brand which itself is a significant portion of its structural capital. Brand building is a long term and capital intensive process. Suffice it to say that a well known brand is highly critical to the success of the franchising model. Next, the franchisor has to provide your café with bean crushing and coffee dispensing machines. Cash registers are next, loaded hopefully with Point of Sale software that connects directly to the franchisor’s central database everyday for sales data updates. Next, the franchisor has to give you access to his ordering system, either phone or web based, using which you can re-order supplies like cups, spoons, stirrers, etc. and maintain your minimum inventory levels. In order to deliver your orders, the franchisor has to update its delivery schedules and processes to include you in the loop. Once you have started your café, the franchisor has to keep track of your daily sales in its central database and invoice you for supplies and royalty income on a monthly basis. If your coffee dispensers develop any type of snag the franchisor has to be able to dispatch technicians to your location as soon as possible. This is the scenario for a simple coffee café. Multiple products/services create more demands on the structural capital of the franchisor. However one thing is clear, the structural capital has to be automated as much as possible in order to accommodate increasing volumes. Structural Capital riding on human hands is a sure sign of non-scalability and hence failure of the franchise model.

In summary, franchising is a very mature business model which has been used successfully the world over by many businesses, especially in the Retail sector, to grow their businesses very quickly. It works because franchise owners are entrepreneurs who are highly interested in their own success unlike store managers whose primary interest is their monthly paycheck. Franchise owners bring local business climate knowledge to the table and they undertake the risk of running the business successfully. A franchisor whose structural capital is automated and scalable has a very good chance of expanding his business through franchising.

Is there a case for Intangible Expense Reporting?

2010-05-10T19:23:00.002+05:30

I had recently blogged about the need for publicly listed firms to embrace IC Reporting as a tool for providing their current and prospective investors with more incisive information about their business. A handful of businesses around the world have already adopted this practice but the vast majority is yet to start, perhaps they are awaiting industry or regulatory guidance in this matter. Meanwhile there is another school of thought among the IC community that suggests that a more practical and less stringent approach would be to have businesses report their expenses incurred on developing intangible assets along with their statement of accounts. The logic behind this suggestion is that businesses already keep track of their operating expenses and capital expenditures. Hence it should not be too difficult to keep track of specific expenses incurred on developing intangible assets. Let’s try and dissect this approach and try to understand its pros and cons.

Let’s set the ground rules first. Let us agree that we are only considering the interest of investors here. There are other stakeholders that could also benefit from an Intangible report on the firm such as employees, suppliers and partners, yet we are not addressing their concerns here because these stakeholders have a direct access to the business through which they can get reliable information about the business that is useful to them. Investors however do not have access to any such direct channels and have to rely solely on the formal communication from the business as the only authoritative source of reliable information about the business.

Next, let us think about what investors are interested in. Very simply they are interested in Return on their Investment or ROI. ROI is the bottom-line interest of every investor. Yet it is not enough for the management to commit a particular ROI to investors which they will accept at face value. Investors also need to see the proof of why their investment in the business will be a multi-bagger.

An astute investor will choose to invest in those industries whose products and services will be in great demand in the coming years. Within that industry, the investor will then choose to invest in that specific firm which is best geared up for catering to the forecasted demand of the industry. Choosing the industry whose products and services will be in demand in the future requires a thorough understanding of the macro-economic environment of the geography where the industry is located. Investors rely on a variety of research reports and other inputs for deciding the industry of their choice. But once an investor has decided on the industry that he wants to invest in, all that remains to be done is choosing the firm that is best equipped to meet the demand for products and services of that industry.

At this point investors will start looking at performance of the various firms in the industry, one at a time. And all they will have for doing so is the published financials of the business. Since investors know that more than 70% of the value of any business is generated by intangible assets, this is what they will try to figure out from the financial statements, but will fall woefully short. Let us assume here for the sake of argument that the published financials for the business also include the expenses specifically made for developing intangible assets. Is this a good assumption? Will this really work in practice? Technically it is very easy for accountants to ‘group’ intangible expenses and publish the same along with their financials. However, let us look this situation from the point of view of the company’s managers, the people who will be responsible for publishing this information in the first place. What is their objective? Clearly they are motivated by making the most amount of operating profit for the business, since that will fetch them the maximum compensation (assuming their compensation is linked to operating profits). And how is operating profit calculated – simply by deducting all operating expenses from all operating income. If managers now have an avenue of categorizing some operating expenses as capital expenses, what do you think they are going to do? They will clearly reduce operating expenses and increase capital expenses, which in turn will directly inflate profits in the current period at the cost of deflating profit in future periods since all capital expenses need to be depreciated in the future. This will directly benefit managers when their performance is reviewed for the current period but it will hurt investors who will be left with reduced profits in the future. A discounted cash flow analysis of the business will show that the value of the business is less now. Therefore what is good for managers will turn out to be not so good for investors. It is exactly this behavior of managers that is curbed by accounting guidelines that have strict rules for determining the expenses that can be capitalized in the statement of accounts.

The above argument against reporting of expenses incurred on intangibles is in the best case – that is when all such expenses are actually incurred on developing intangible assets. However, since accounting principles in this matter are not yet evolved, frivolous practices may soon kick in around expenses that center on the ‘grey’ area. For instance, all or part of employee wages may be shown as expenses incurred on developing human capital. Expenses incurred on annual maintenance of information technology assets such as computers, video conferencing equipment, etc. may be shown as expenses incurred on developing structural capital. And routine expenses incurred by salespeople for soliciting customers may be shown as expenses on developing customer capital. These and other such ‘creative’ accounting practices will flourish to the point where operating expenses will be negligible. Is this a desirable state? You may say it is desirable for managers but investors will be worse off than they are now.

The conclusion I am arriving at therefore is that whereas the suggestion for reporting of intangible expenses is a noble thought, in practice it will only lead to obfuscation, deceit and chicanery. Instead what we need is an Intellectual Capital Report of the business that is drafted by an independent IC professional. This report should be published along with the statement of accounts and it should be audited by external IC professionals in the same manner that the accounting statements are audited by external accounting professionals.

I invite fellow IC professionals to submit their own point of view to this discussion.

Packaging – Relational Capital in action

2010-05-04T15:28:00.001+05:30

Of the three components of Intellectual Capital - Human, Structural and Relational – it is most difficult perhaps to understand the contribution and value of Relational Capital in real life. I decided therefore to focus this week on the one industry that contributes immensely, entirely and solely to the Relational Capital of its Customers. I am referring here to the multi-billion dollar packaging industry dominated by players such as Tetra Pak, Alcan Packaging, Crown Holdings, Alcoa, Amcor, Rexam, etc.

The importance of packaging is critical to the successful selling of any product, especially in the Retail sector. New product launches especially benefit from an attractively designed package that clearly engraves the value of the product in the minds of the consumer. Initial sales of such products are driven by the attractiveness of the package (and also the price) while repeat sales depend on other product attributes such as quality, durability, reliability, satisfaction, etc. Next time you visit your local grocery store or a nearby shopping mall, try and find new product launches and then take a probing look at the packaging around the product. Compare that package to that of existing products in the same category and you will soon realize what I am talking about.

Packaging is an art, although over the years savvy marketing professionals have detailed it down to a science. Many a time, the package has nothing inherently to do with the product per se, but is designed solely to convey a positive impression and familiarity on the mind of the buyer. For e.g. have you ever wondered why products targeted for kids invariably have cartoon characters depicted on the package? I am quite sure that Mickey, Mini and Goofy have sold more toys, school supplies and snack items than Walt Disney could have ever imagined in his wildest dreams! Yet there is rationale behind this approach. Since the product package is a very tangible item, marketers leverage the physical properties of the package in order to draw the attention of buyers. These include color, shape, size and convenience among other things. Many different rules have evolved in this regard based on the conditioning of the human psyche. For instance, black implies luxury, brown conveys an earthy feel, green projects nature and freshness, sky blue implies purity, etc. The size of the package is determined by consumption patterns – this explains why cola cans have a capacity of 355 ml, a very odd number. The shape of the package is often dictated by optimum storage criteria – this is the reason why even cylindrical or spherical packages like cans and playing balls are aggregated together in rectangular shaped boxes. Finally, the package is often designed to enhance consumer convenience for e.g. fruit drinks packed in tetra-packs have a straw attached to the package and creamy cheese and yogurt packs come with a handy plastic spoon attached to the top.

Lest you get the impression that packaging is relevant only for the retail sector, let me dispel that notion by telling you that nothing could be further from the truth. Packaging is highly important not only to other products but in fact also to services. Consider a software product such as Windows, the Operating System that runs most personal computers on this planet. Microsoft, the maker of Windows, has a virtual monopoly in this category, yet Microsoft invests heavily into improving the User Interface of Windows and releases a newer version of the product every three years or so. The User Interface is the packaging of Windows – it is how you see the product and how you use it and get used to it. Improving it is the only way by which Microsoft can attract you to upgrade your operating system to a newer version every three years and thereby generate new sales on essentially the same product! If Microsoft did not improve the User Interface of Windows, you would have no need to upgrading your operating system, would you? Moving on to services now – let’s take the example of Banking. All banks essentially do the same thing – borrow money at the lowest possible rates, lend it at the highest possible rates and make money on the spread. All banking services therefore fulfill either the borrowing need or the lending need of the bank. Looked at this way, banking is really a commodity service isn’t it? Yet have you noticed how some savvy banks package their services differently. In their bid to attract you (the customer), they pamper you with special privileges such as free debit cards, no annual fee credit cards, gifts at the time of account opening, cash delivered to your home, etc. not to mention exclusive privileges such as private banking and wealth management that are offered only to the choicest few. Similarly airlines, that essentially offer the commodity service of transporting you from point A to point B, ensure your loyalty and your business by packing their service with a loyalty program into which you are enrolled free of cost!

There is no doubt about the huge value that the packaging industry creates. Yet it is a surrogate industry – the tangible packages that the industry develops fulfill the intangible needs of the product manufacturers. The product manufacturer focuses on developing the best quality product at the lowest possible cost whereas the packaging supplier focuses on developing and delivering the packaging concept for the product. This is a great example of how product manufacturers leverage the Relational Capital of their package solution suppliers. The deep relationship between two enables them to work jointly together on the best package for the product. Packaging solution providers are so glued-in on their Customers and their target markets that they themselves invest heavily into developing newer packaging materials such as recyclable and biodegradable materials that are in demand by end consumers. In the process they generate a steady quantum of value add for their Customers which looked at from the perspective of the product manufacturers is really nothing but Relational Capital.

The need for IC Reporting

2010-04-28T13:46:00.001+05:30

Change has been a way of life for mankind, yet change has always been difficult. Throughout history, man has constantly been faced with the opportunity of doing something in a new way, a better way – but that has always met with resistance. To give just one example, do you recall the invention of the personal computer by IBM in the 1940s and the subsequent (by now infamous) remark of IBM Chairman Thomas Watson “I think there is a world market for five personal computers”. In hindsight, we can now say that the personal computer has been largely responsible for the rapid modernization of our society during the last thirty years. So rapid and massive has been this modernization that as a society we have become used to embracing change more and more rapidly – remember ATMs did not exist thirty years ago, the World Wide Web did not exist twenty years ago and mass mobile telephony as we have accustomed to today did not exist even just ten years ago!

Yet today, we are at the crossroads of one more change – this time in the field of accounting and reporting of company performance. Unlike tangible changes outlined in the examples above, this is a softer change. It has to do with the way business accounts are recorded and presented to stakeholders. But why do we need a change in our accounting system, you might ask? What is wrong with it? It isn’t broke, right? So why fix it? The reasons however are many.

Firstly, the present system of accounting is old, very old. The double-entry bookkeeping system of accounting that is in use today was popularized by the Italian monk Luca Pacioli more than 500 years ago! This system relies on recording each business transaction using balancing credit and debit entries in two different ledgers. It is a system that is well understood and it has served us well throughout the industrial era, yet it has one critical shortcoming. The system works by matching revenues to expenses accurately in order to determine income. But it cannot handle value creating transactions that happen much before revenues have been realized. For instance, when the R&D efforts of a pharmaceutical company culminate in the passing of regulatory clinical tests, enormous value is created. Yet the accounting system does not recognize any of it.

The loss would have been limited had it been restricted to the failure to recognize value. But present accounting policies in fact do more damage by mandating the immediate expensing of R&D costs that go into the drug discovery process instead of capitalizing them, thereby recognizing such costs as an asset. The net effect of this policy is a reduction in net income in the year that R&D costs are incurred at the cost of protecting future income. This is a double whammy.

Finally, the accounting system is in total disconnect with the way companies operate in the knowledge economy. We know for certain by now that intangible assets are the primary driver of growth in the knowledge economy. Yet the accounting system is blissfully ignorant to this situation. For example, we all know that the value of Apple is linked closely to the ability of Steve Jobs to lead the company on the path of continuous innovation. Yet, the book value of Apple did not change when Steve Jobs rejoined Apple and it will definitely not change if Steve Jobs were to quit Apple all of a sudden!

Professional accounting bodies the world over have been trying their best to make the accounting system adapt to the knowledge economy. But changing a system that is carved in the hearts and minds of accountants over the last 500 years is easier said than done. In the meantime, investors are getting highly impatient. Genuine investors already know that published income statements and balance sheets are not reliable instruments for making investment decisions. They rely instead on other sources of information such as analysts, insiders, research, tips, etc. Some of these sources are genuine yet others exist only for making a quick buck from gullible investors. Such is our plight today.

But the situation can be remedied and quite easily too. This is where the need for IC Reporting comes in. All that needs to be done is that the annual report (or even quarterly income disclosures) needs to be supplemented by a statement of change in the Intellectual Capital of the company. This way, investors will be able to see not only the financial performance of the business but they will be able to correlate that performance with the investments in intangible assets of the business. They will be able to verify the sustainability of the performance. This in turn will drive down the cost of capital for the business which in turn will make the business more efficient. In short, IC Reporting will enable an unending positive feedback cycle for the business.

Change seems radical whenever it is first proposed. But in hindsight it always seems a no-brainer. IC Reporting is a change whose time has come. We will see this change implemented much sooner than later. And it will be for the good of all of us.

Have we realized the importance of Core Competencies yet?

2010-04-21T15:19:00.000+05:30

The world of strategy professionals suffered an irreplaceable loss last Friday with the passing away of Dr C K Prahalad, who was the Paul and Ruth McCracken Distinguished University Professor of Strategy at the University of Michigan’s Ross school of Business. One of the foremost contemporary business thinkers and management gurus of our time, Dr Prahalad is credited with introducing the world to concepts such as Core Competency, Reinvention, Continuous Innovation, Next practices and to the immensely popular byline “Think Global, Act Local”. The last decade of his life was spent on prodding corporate houses and big businesses to focus on the world’s poor, thereby targeting both sustainable development and inclusive growth.

Like many other students of Business Strategy, I never had the opportunity to meet the great man. I only read his articles and his ideas. I was particularly enamored with his concept of Core Competence in the Corporation, published way back in 1990 along with Professor Gary Hamel of the London Business School. In this 16 page ground breaking article, they wrote

“The diversified corporation is a large tree. The trunk and major limbs are core products, the smaller branches are business units; the leaves, flowers and fruits are end products. The root system that provides nourishment, sustenance and stability is the core competence. You can miss the strength of competitors by looking only at their end products”.

Much before the computer became omnipresent in corporate offices, much even before email became the norm for corporate communications and definitely much before the proliferation of mobile telephony, Professor Prahalad had the clairvoyance to get to the core of the basis for a corporation’s competitive advantage in the market place and expressing it in a metaphor that could be understood by all. By equating core competencies in the corporate to the root system of a tree, he achieved in sending out many clear messages in one single shot, some of them being:

1. Core Competencies are the basis of long term corporate sustainability.

2. Core Competencies are corporate resources and they cut across business units

3. New products and services can be created if core competencies are in place

4. Employees who embody the core competencies of the corporation often get a free hand over others.

In so dearly portraying the importance of core competencies, he also succeeded in elevating the prominence of intangible assets in the enterprise, a concept with which we are still grappling a full twenty years after Dr Prahalad first introduced it to the world. Such was the insightful genius of the man. He constantly exhorted corporate leaders to think outside the box, to ‘see’ opportunities lurking right in front of them, to look beyond existing markets, to always question the assumptions behind price and performance, to constantly search for and build innovative products and to lead customers to such products. He often gave the example of Steve Jobs of Apple and Ratan Tata of Tata Motors in this regard.

Just this month, he summarized his article on “Best practices get you only so far” in the Harvard Business Review by writing “Executives are constrained not by resources but by their imagination”. Memorizing this byline and trying to put it to practice could perhaps be the best tribute to Dr C K Prahalad.

Intellectual Capital – What’s in it for me?

2010-04-07T16:38:00.000+05:30

“What’s in it for me?” IC practitioners, the world over, have probably heard this question more often than not. Answering it, I am quite sure, is not so easy since the answer fluctuates greatly depending on both the background of the person asking the question and his or her specific interest in the field of Intellectual Capital. Nonetheless, let me take a stab at answering this question as generically as possible, using illustrations along the way to convey a larger point.

Intellectual Capital, we know, is a set of intangibles that coalesce to give an individual or a firm a distinct competitive advantage in the marketplace. Want to see the proof? Ask yourself why you prefer to drive an extra mile to do your weekly grocery shopping at a store which looks much cleaner, is well lighted, has spacious aisles, offers free parking and always has all your items in stock. Wait, don’t bother - the answer is in the question itself. However did you ever stop to wonder whether the factors that made you go out of your way and ‘prefer’ a specific grocery store were purely a matter of chance or could it be that someone deliberately crafted these things just to attract and retain demanding customers such as yourself? Intellectual Capital, like most other good things in life, does not happen on its own – it has to be made to happen. The promoters of the grocery store you prefer probably surveyed customers like you on the various factors that would attract you to their store week after week, on the items that are most consumed by you, on the type of store layout you prefer, etc. before even putting a business plan together. The success of that plan was ensured from day one because by responding to the survey, you ensured that the grocery shop owner could fabricate a store that had a competitive advantage and by visiting it regularly you ensure that he can perennially raid your wallet every single week!

Still need more proof? Let me ask you – have you ever changed your dentist, your insurance agent, your tax advisor, your stock broker, your travel agent or even your barber? If you answered yes to any of these, just think of the reason for the change. Was it because the service that you were receiving had become routine? Was there a lack of personal touch? Were you getting herded in along with others? Were you missing individual attention? All in all, was that extra something missing in the service? Yes? You bet. That extra something is called ‘value-add’ in management jargon. Value addition happens when your service professional goes beyond the boundaries of performing the routine transaction and does something exclusively for you. For instance, your dentist could offer you an annual free check-up, your insurance agent could review your existing cover and suggest changes to suit your lifestyle, your stock broker could offer buying and selling tips and your barber could just subscribe to that latest fashion magazine that you could read while you are waiting your turn. Come to think of it, these value additions do not cost much – in most cases they are offered free – but they are the difference between why you stick with your current service professional or decide to take your business elsewhere. These value additions are a part of the Intellectual Capital of the Service Professional and they can literally be the difference between bloom and gloom (not to mention doom) for him or her.

Are you starting to get the point? Intellectual Capital may sound a mouthful, but it is present everywhere if you only care to see. In today’s knowledge era, it has come to be the difference between growth and stagnancy, between prosperity and paucity, between success and failure and even between survival and extinction. The days of plain old order taking are over. Insurance agents, travel agents, stock brokers and other professionals made money hand over fist in the last few decades only because they were in the agency business. If you needed an air ticket you had to buy it through your travel agent. If you needed to invest in stocks you had to talk to a stock broker. Likewise, if you needed an insurance policy you had to solicit an insurance agent. Order taking is best done by computers in the Information era. Computers are far cheaper than humans, can work 24 hrs a day, do not get tired, do not need supervision or food and do not make mistakes. All forms of agency businesses have already been replaced by Internet portals that are housed in giant data centers running multiple computers in redundant fashion. Those agencies that have not yet been hit with this reality are only counting their last days.

So how does this affect me, you say? I am a manager inside a big firm and am therefore insulated from all this change. Do you believe so? Nothing could be further from the truth. What is true for self employed professionals and businesses is true for corporate professionals as well. Look closely at what your job function is, once again. Is your department providing HR support services? Are you the training manager in your firm? Or are you a line manager in charge of production scheduling? Are you? Then you have reason to worry. Know this. HR support services are being increasingly provided by self supporting HR portals from vendors such as SAP and Oracle. Training, or more importantly learning, is increasingly assuming the form of CBT (Computer Based Training) that is delivered to the trainee on his computer in a digital format at the time of his choice. And production schedules in manufacturing shops are being increasingly generated by ERP (Enterprise Resource Planning) software installed in-house. In short then, is your job function one step closer to being taken over by a computer? Is it a candidate for automation? If it is possible, it will happen. Obtaining competitive advantage through ruthless cost cutting is one of the most common outcomes of the Information era and it is bound to affect you as well. The only question is when.

What then should I do, you ask? The answer is strikingly simple too. Have you seen that poster of man rising from the posture of an ape many eons ago first to stand erect on his own two feet, then to walk, run and then use his hands for making tools for hunting? You couldn’t have missed it. That picture just got updated with an additional image towards the end – man using his brain. And that is what you need to do. I know by now, that you need proof. This time proof is easier. The Information era rewards those who use their brains much more than those who use their hands. I am not referring to the class distinction between white collar and blue collar workers here, although that would have been sufficient to make my point. But I ask you instead to follow the money trail. Tell me, which are some of the best paid professions? Go ahead name a few. Here, let me help you out. Investment Bankers, Surgeons, Fashion Designers and Lawyers who are at the top of their field are still people who are making money by the fistful. I am sure you wouldn’t grudge a New York lawyer his hourly rate of $400 – he is worth it you say. Similarly you wouldn’t stoop to bargain the price of a Louis Vuitton handbag would you? The name itself is worth more you say. Or would you negotiate the fees of the heart surgeon who is scheduled to perform a bypass surgery on your spouse next week? Definitely not, right? Well then ask yourself, why you would be willing to pay exorbitant sums to these people? The answer is because they have spent their lifetime in gathering specific knowledge and know how it can be used for your benefit. That is their Intellectual Capital. They are specialists. The Information era punishes generalists by replacing them with computers and rewards specialists with fame and fortune. The message is clear now - develop your own Intellectual Capital and become a specialist.

Intellectual Capital v/s Intellectual Property – What’s the difference?

2010-03-31T14:43:00.008+05:30

One question frequently pops up during my presentations and discussions on Intellectual Capital with industry captains – “Aren’t you referring to Intellectual Property?” My answer is always an emphatic NO followed by a brief explanation of the difference between the two. Soon however, the multiple recurrence of this question prompted me to apply my mind to answering this question more definitively. So here goes.

I start first with the dictionary meaning (Webster’s) of the three words:

Intellectual – showing a notable mental capacity; guided or developed by relying on the Intellect.

Capital – an advantage or asset

Property – something owned; right of possession

Next, I extrapolate the above definitions to infer the meaning of the two phrases on hand as follows:

Intellectual Capital – An advantage or asset that is developed from the use of notable mental capacity.

Intellectual Property – A right or possession that is developed from the use of notable mental capacity.

This is as far as we can get using the dictionary. But the difference between the two phrases is already starting to emerge. While both IC and IP are developed from the use of intellect or mental capacity, IP has explicit ownership rights associated with it whereas IC does not. This is not to say that IC cannot be owned. It just cannot be owned explicitly, meaning to say that unlike IP which can be patented explicitly, IC does not usually have a legal title of ownership attached to it. This is the essential difference between the two. However by no means is this all. There are many more differences lurking underneath this academic perspective of the two phrases, of which I enumerate seven differences below in no particular order:

IP can be legally protected – Most countries around the world have patent protection laws that enable individuals and firms to register and patent their intellectual property – most notably their inventions and innovations. Patent protection laws are mainly responsible for the decision of firms to invest in R&D activities in industries that thrive on the output from continuous research - such as Pharmaceuticals and Biotechnology. IC on the other hand resides within the confines of the firm’s boundaries and needs to be protected where necessary using any combination of secrecy, discipline, procedure, agreements, contracts, etc.

IC is more intangible than IP – At the time of patenting an IP, the owner has to make a full disclosure of the property by including relevant drawings, descriptions, prototypes, etc. that clearly explain the functioning of the intellectual property. This makes the IP somewhat tangible, since even if the IP in question is a process, it can be visualized and understood clearly from the documents available in the patent file. IC on the other hand is much more intangible and moreover it usually has no accompanying documentation. For example if the IC of an auto ancillary firm is to produce world class spark plugs, then such IC is perhaps the outcome of a judicious combination of stringent procurement standards, quality controlled manufacturing processes, automated testing systems, continuous skill enhancement of workers, empowerment on the assembly line, a wholesome rewards and recognition policy and a brand that has been nurtured and built over the years. Each of these intangibles may be resident in and owned by different departments within the firm, but it is only when all of them come together in the right combination that IC, and hence competitive advantage, accrues to the firm.

IC is a process, IP is an event – The question that arises from the foregoing paragraph is “Surely with a little additional effort, IC can be converted into IP?” After all there are many benefits to be had from the advantage of legal protection. This is easier said than done. This is because IP is the outcome of a research project which is outcome based – meaning the research process leads to a definite invention or innovation which can be patented. Once patented, the IP becomes static. IC on the other hand is highly dynamic. In the example that we have seen previously, the auto ancillary firm may have to continuously invest in brand building, scour suppliers for lighter and longer lasting raw materials, investigate newer and more effective training methods, ensure industry leading rewards program, etc. to sustain its IC and competitive advantage in the marketplace. Thus unlike IP, IC to my mind is a continuous improvement process.

IP can be traded – This property arises from the fact that IP has an associated ownership title. Therefore, like other tangible assets, it can be traded, rented, leased, bought, sold, sub-let and loaned for financial consideration. IC on the other hand, is relevant only within the context of the firm that has developed the IC and hence it cannot be traded like IP in the same way.

IP has a life – This is one of the key differences between the two. All patents have a life depending on the type of the patent. For instance in India, patents for food, drugs and insecticides have a life of 7 years and all other patents have a life of 14 years. The patent expires at the end of its life, at which point the Intellectual Property becomes public property, available for the general benefit of mankind. IC on the other hand does not have a finite life. For instance, the formulation used in making the popular Coca Cola drink is knowledge that is confined within the company for more than hundred years now. The secret formulation and its use is Intellectual Capital that is a closely guarded secret and that has provided the Coca Cola Company with a sustained competitive advantage. Had the company chosen to patent the formulation instead, the secret would have been out in the open by now and the process of making Coca Cola would not have been so mysterious anymore! Correspondingly Coca Cola would not have been such a desirable brand anymore.

IP does not necessarily provide Competitive Advantage – This difference is very important. IP protection laws ensure that the returns from the investments made in developing the IP accrue solely to the owner of the IP and not to unscrupulous overnight raiders. This does not necessarily mean that IP leads to a competitive advantage. In fact, just the opposite may be true. Remember the clash between Matsushita’s open VHS format and Sony’s proprietary Betamax format in the nineties. Even though Betamax had better technology, Matsushita obtained the competitive advantage by licensing VHS technology openly and inexpensively to its competitors thus driving Betamax out of the market.

And finally, IC is a superset of IP – Even in the case where firms invest in and patent their IP, they still have to do many other activities to successfully market the IP. Some of these include material management, production planning and control, quality control. Safety, Branding, Promotions, Advertising, Dealer development, etc. Each of this activity is perhaps an island of Intellectual Capital within the individual department. When done consistently and in a coordinated manner, the islands join together and appear to give the IP an image which is larger than life, leading to its successful marketing. But therein lies to my mind the biggest difference between these two – IC is a superset of IP. In other words, a firm may be able to obtain competitive advantage without IP, but it cannot obtain competitive advantage without IC.

Does Outsourcing diminish the Intellectual Capital of a firm?

2010-01-28T22:08:00.000+05:30

A studious reader of this blog asked me a very pertinent question the other day – does outsourcing diminish the Intellectual Capital of a firm? Her reasoning being that outsourcing - by definition - reduces the number of in-house employees, which therefore should correspondingly reduce the Human capital of the company! Makes sense on the face of it doesn’t it? This line of thought naturally raises the follow-up question – If outsourcing diminishes the Intellectual Capital of a firm, why is it in vogue? Why is it that firms across the globe spend enormous amounts of time, money and energy on outsourcing? Hmm… now that is a tough one. We have to believe that no management worth its salt would deliberately diminish the firm’s Intellectual Capital - since we know that Intellectual Capital is the very source of its competitive advantage in the market place. So how then do we resolve this paradox?

We will have to scratch the surface to find the answer to this one. First, let us understand why firms outsource jobs in the first place and what it is that they outsource? Rampant outsourcing, as is prevailing today, has come about due to the passionate advocacy by Management Gurus to focus on Core Competencies and ‘buy’ everything else that is peripheral for the firm, in the regular course of delivering its products or services, from the external market. Thus it has come to be that a manufacturer of computers focuses on the design of the internal circuit board and overall computer performance, but buys the chips that sit on the board from the external market. Similarly, a Telecom service provider focuses on enhancing the reliability and scalability of its telecom network while delegating the task of handling customer complaints to an external call center. Other examples abound, but in each case you will find that the firm that the outsourced jobs are peripheral from the point of value addition to the firm. The point I am making is that no firm deliberately and willfully out sources its core competencies. Outsourced work is commodity work from the firm’s point of view. Hence it is best performed by those who can provide the maximum cost benefit to the firm.

Second, outsourcing peripheral jobs requires a core competence in interaction and supervisory governance of the external supplier. In the case of the Computer manufacturer this may translate to having in-depth knowledge of the various product lines of the multitudes of chip manufacturers and the ability to negotiate the best price. In the case of the Telecom service provider this may translate to constant monitoring of the service quality of the call center. And so on. The point here is that while firms can and do outsource peripheral work, they cannot outsource the supervision of such work. Such supervision or governance therefore becomes a new Core competence for the firm. Without such supervisory competence in place in-house outsourcing can be a terrible disaster waiting to happen.

Finally, many a firm that outsource existing jobs train their existing staff (whose jobs are being outsourced) into either accepting a supervisory position or re-train them in another area of core competence for the firm. The Human Capital of the firm therefore gets automatically reinforced and enhanced in the process.

So if you sum it all up, outsourcing enables the firm to focus on its core competencies, reduces the cost of doing business, stimulates the creation of newer core competencies as well as enhances the value of the firm’s Human capital - all in one shot. A bit like having your caking and eating it too, isn’t it? No wonder outsourcing continues to be in vogue. It took me a bit of verbiage, but I think the reader got the answer she was looking for.

The growing insignificance of the annual report

2009-06-29T23:14:00.004+05:30

The month of June is an important month for investors. I am an investor myself, holding a portfolio of about 20 odd companies spread across diverse industries. I look forward to the month of June eagerly every year, for it is during this month that most companies dispatch their annual reports to their investors. The annual report contains details of the company’s performance during the financial year, which typically ends on the last day of March for most Companies. Hence it is quite natural for investors to be excited at the prospect of reading about all the happenings in their invested company in the past one year and to get critical insights about its prospects for the future. The annual report is supposed to be just that report. Yet if truth be told, nothing could be further to the contrary. Most, if not all, investors whom I know including myself give the annual report just a cursory glance before consigning it to the realms of the recycle bin. The contents of the annual report is not trash by any stretch of the imagination, yet the utter lack of usefulness of its content for investors year in and year out just defies common sense. Let’s look at the contents of a typical annual report to try and understand the reason behind this anomaly.

The first chapter of any annual report is an introductory statement by the Chairman of the company. The sole purpose of this statement is to create a feeling of warmth and generate goodwill amongst investors. Point taken, yet investors are better comforted by the warmth of wads of notes willowing in their wallets and the assurance of a repeat performance every year. Mere words and motherhood statements that find their way many a time into this section are a drag on investor patience. Hence the Chairman’s statement can be safely skipped without much risk.

Next follows the auditor’s certificate. Considering the fact that auditors are obligated by their profession to follow a boilerplate template while issuing this certificate, this section can be safely skipped as well.

Of late, many companies include a report on Corporate Governance which typically appears at this point in the annual report. In the name of Corporate Governance this report provides attendance records of the directors of the company at board meetings. In effect, investors are informed how many meetings are attended by directors but their contribution at such meetings is conveniently given the pass over. Hence this section is also worthy of skipping.

At this point, we reach the two sections which form the meat of any annual report – the financial statements and the management discussion and analysis. The financial statements and the associated explanations of the numbers that appear in numerous foot notes are about the most useful piece of information that one can find in an annual report. However, in this day of electronic updates, this data is already available on multiple financial web portals weeks before the annual report reaches the investor’s hands in physical form. This leaves the discussion and analysis section from our point and view. There is no defined format for this section. The quality and quantity of information revealed in this section varies with industry, company, management outlook and many other factors. If the company is interested in highlighting the drivers of the company’s performance, it should normally be found in this section. Many companies do try and give as much information as possible in this section about the drivers of their growth, now and into the future. Many others hold back in the fear of revealing sensitive company information. Still others are clueless about the reasons for their growth or lack thereof and end up making general risk free statements in this section.

Of the approximately 20 annual reports that I receive and read every year, I find a great difference in the thickness of these reports. I have read annual reports ranging from 15 pages to more than 150 pages. I have also observed that some companies follow the annual reporting process to the letter disclosing only as much as is legally required while a handful others try to go above and beyond the letter and try to comply with the spirit of annual reporting which is what investors are really interested in. The true spirit of annual reporting requires companies to not only analyze their past performance but also give a fair assessment of its future prospects based on the state of core competencies of the company and external economic conditions. Alas, this remains a distant dream as of now. Yet it can be done easily by including a section the Intellectual Capital of the company. A well designed Intellectual Capital Report that tracks the intangible assets and growth drivers of the company year on year is a good tool for informing investors about the inherent strengths of the Company. It will only take a few leaders to start disclosure of their intangible assets in this manner for the remainder to follow. The alternative is for the government to step in and introduce regulation requiring compulsorily disclosure of such information.

An asset that appreciates with time

2009-03-01T01:17:00.000+05:30

We live in very interesting times. The economic transformations that are changing the fundamental s of our social behavior and the very fabric of our life are tremendous. For instance, email was unknown in the corporate world prior to 1990. Today in a span of just under 20 years email has become so pervasive that, most if not all, businesses would be unable to function efficiently without email communications. Mobile phones were largely unknown prior to 1994. Today, in a span of 15 years the mobile phone has become so ubiquitous that it has rapidly shed its image of a luxury item and now become a necessity. In the Indian context, ATM banking was largely unknown in the country prior to 2000. Today in a span of just 10 years ATMS have proliferated so fast and so much that some banks have actually started limiting the number of teller assisted cash withdrawals that customers can make each month.
Economic change is not only happening, it is happening more and more rapidly. Consider this. Until the 1800s, farming was the main occupation of people. The primary requirement for farming is land - the more the better. Unfortunately, the land that we have inherited is not only limited but with time the increasing population has only hastened to increase the per capita demand on it. In the 19th and 20th centuries the focus shifted from farming to manufacturing, driven to a large extent by the industrial revolution. The spotlight during this time was on increasing productivity, using machines in place of human labor. Machines had a huge advantage over humans – they could work faster, they produced output of consistent quality, they did not get tired and they could work all three shifts if needed. During these two centuries machines came to dominate our lives like never before – their acceptance eased by their promise of freeing us from drudgery and making more free time available for our creative use. While machines changed our lives forever during the industrial era, it took many centuries for the focus to shift from farming to manufacturing.
Yet the next change happened within the next 200 years, when we crossed over from the industrial era into the knowledge era. Today machines are no longer a source of competitive advantage. If I can buy a machine so can the competition. The increased productivity that both of us have is not enough of an advantage anymore. To sell our goods, we both need to add value. There are various ways of adding value – but all of them require leveraging the intellectual capital of the organization to provide a product or a service that is superior to what the competition can provide. This in turn requires the systematic management of Intellectual Capital, since that is the very source of competitive advantage in the knowledge era. In fact, unlike physical assets like machines and land which get depreciated over time and financial assets which get depleted with time, intellectual capital is the only asset that appreciates with time. Doesn’t this sound a bit like having your cake and eating it too? Yet it is true. Very few businesses have realized this truth since we are still in the formative years of the knowledge era. But those that have will surely survive and even thrive in this era and survive into the next.

Value sustains through recessions

2009-02-23T00:18:00.001+05:30

Many economists believe that the present economic depression is as bad as the great depression of the 1930s. I was not born then, neither were most people around me, hence I cannot tell for sure. But as I wade through these most difficult times I dare to ask, how has this recession changed our spending habits? How many of us have stopped dining outside in restaurants because of the recession? Or stopped seeing movies in multiplexes? Or visiting shopping malls and buying stuff, we probably could do without? To those who can sincerely answer these questions in the affirmative, I bow my head in salute. To the remaining vast majority of mere mortals like myself, I say that although we cannot curtail our basic inclination to splurge (thanks to the multiple credit cards that have been thrust upon us by ever willing banks) , we can definitely fine tune our instincts to seek out the best value deals and extend our purchasing power ever more. We need to stretch that dollar and make it go further. We need to chase value. Whether you are a seller or a buyer, you need to chase value. Individuals, businesses, suppliers, customers and investors, all need to chase value. While this is a most noble intent even in the best of times, in recessionary conditions like these it could mean the very difference between survival and extinction. And why is that? Simply because history has proven time and again that recessions and booms are cyclical. One simply follows the other. Much as we believe the adage that whatever goes up has to come down, it is also equally true that whatever goes down has to come up! The point being that this recession will end for sure – in the meantime we have to survive by seeking more bang for our buck.

Which brings us to the question – how should investors seek value? And how should businesses publish and report value. As far as investors are concerned, value investing is a field which is very well researched and understood. Yet it fails in many situations because the value investor relies solely on the published financial results. In times like these, the value investor has to look at more than just the financials. He has to understand the underlying value creating processes of the businesses that he is investing in. Similarly, business houses need to publish more than just the financial statements. They need to inform their investors about the characteristics of their business that generate value for their customers and how they are focused on managing and growing those very parameters.

Interestingly both purposes can be served easily via an Intellectual Capital (IC) Report. Business houses need to start publishing an IC report along with their annual report or even with their quarterly disclosures. Investors on the other hand need to start demanding such reports from the management of their holding businesses and use it for making value based investment decisions.

The diverse sources of value

2008-12-23T23:38:00.000+05:30

Value sources exist in multiple places within an organization, many times by design and many other times, simply by chance. These value sources can broadly be classified as

• Localized value source – a competency that exists entirely within a single department e.g. the paint shop inside an automobile plant. A high quality paint shop would have the latest painting equipment, workers highly trained in the use of such equipment and relationships with suppliers of high quality automobile paint among other things. This paint shop is equipped to undertake high quality paint jobs within six sigma levels of quality tolerance norms, each and every time.
• Centralized value source – a competency that is located centrally by design and serves the needs of multiple departments in the company e.g. the purchasing department of a retail chain. Such a department will be staffed with personnel who are experts at designing tenders, have acceptable selection and rejection processes as well as long term relationships with suppliers of repute. This department is equipped to create value to the organization and the customer by buying the best quality products at the lowest price.
• Scattered value source - a competency that exists in various pockets of the company and is brought to bear during times of need by those who are aware of its existence e.g. the presence of creative personnel with movie making skills in an advertising agency that specializes in outdoor print media. Such personnel may be over qualified for the job; nonetheless they possess value that can be leveraged during times of need by people in the company who are aware of their special skills.
• External sources of the first order – External competencies reside outside the organization and are activated due to networking effects. First order sources are those where the company is in a position to say ‘We don’t do this job but know someone who does it very well’.
• External sources of the second order – These are external sources of value where the company knows someone who knows someone else who can get the job done. In a world that is enamored with outsourcing low value-add activities, the ability to nurture and activate external sources of value is a highly critical competency.

Understanding the diverse sources of value enumerated above is simple enough. The challenge lies in identifying, measuring, valuating and reporting such value sources to stakeholders. Traditional means of reporting such as the Balance Sheet and the Income statement are designed for reporting financial value only and are woefully inadequate and lacking when it comes to reporting intangible value. This situation calls for the use of an IC Report.

An IC Report is a statement of the change in intangible assets of the company linked to the core competencies that create value for the company. Not only does the IC Report highlight the strategic core competencies of the company but it also valuates the same in monetary terms. This enables investors, especially long term investors, to determine the sustainability and future potential of the company. It also enables the Company’s management to stay focused on the areas of its strength and to take such actions that consolidate and grow such competencies.

How IC Reports can benefit prospective employees

2008-12-02T00:14:00.001+05:30

Employee turnover is an undesirable byproduct of the Information age. Gone are the days when employees were known to eke out a career in a single company, be counted as a loyalist and retire with a healthy pension and a company embossed gold plated watch. Today’s knowledge workers seek challenges every day in the hope of maximizing her knowledge and hopefully her income. Job dissatisfaction in today’s age is not something that knowledge workers take lightly or tolerate for long. The worldwide mushrooming of job portals and manpower staffing agencies has ensured that fresh opportunities are always just a click or a call away. More often than not the new opportunity also comes tagged along with a higher pay packet, negating all resistance to the lure of the switch. At the same time changing jobs is fraught with peril lest the new job parallels jumping from the frying pan into the fire. Hence just as investors study the balance sheet of a company before putting their money in it, prospective employees should study the Intellectual Capital (IC) Report of the company before betting their career on it.

An IC Report is a statement of the change in intangible assets of the company linked to the core competencies that create value for the company. Prospective employees, especially those at the mid to senior management levels, should scour this report to pinpoint exactly where they will be able to add value and where they will be able to gain value in the value chain. They should approach personal interviews armed with this knowledge, using the meeting only to confirm their assumptions with the interviewer. The interviewer on the other hand should be armed with data about the human skill gaps that need to be plugged in the company’s value chain on order to be in a position to make hiring decisions in a snap. Thus an IC Report would enable prospective employees to select the right Company as well as Companies to select exactly the right employees. Performance Management would remain a mere formality thereafter.

Reporting Intellectual Capital to Shareholders

2008-12-02T00:13:00.001+05:30

Research has shown that between 50 to 75% of the market value of public companies reflect intangible assets such as innovation processes, patents, brands, trademarks, customer databases and other forms of Intellectual Capital. The traditional accounting system is ill equipped to capture and record the value of these assets since often their value changes without a transaction having taken place, whereas the entire accounting system is predicated on the concept of recording movements in money by recording each and every monetary transaction. The annual report containing the balance sheet, statement of profit & loss and cash flow shows the changes in money stock and flows during the year. Yet more often than not shareholders have to make their own assumptions on how such changes must have impacted the Intellectual Capital of the company.

And this is for those who are bold enough to try. Most do not bother making the effort. If it be true that intangibles contribute up to 75% of the market value of companies, then it is up to the company to ensure that interpretation of the changes in Intellectual Capital of the company is not left to chance. The best way to achieve this is to publish an additional chapter in the annual report containing an Intellectual Capital Report - a statement of changes in the intangibles of the company. An Intellectual Capital Report is a balance sheet of the intangible assets of the company. And it is the best way to communicate to shareholders and other stakeholders how the company is sustaining and generating its value creating processes.

Prospecting Customers using IC Reports

2008-12-02T00:12:00.000+05:30

Intellectual Capital has come to represent the most valuable asset of Companies in the Knowledge era. This is quite unlike the industrial era where capital expenditure in the form of factories and productivity in the form of economies of scale represented drivers of growth and value. The most effective businesses today drive growth by continuously focusing on high value added activities such as research, design and innovation and by outsourcing low value added activities such as manufacturing to low cost producers. Growth in the knowledge era is influenced not so much by economies of scale as it is by a constant churn of innovative products and services. If this be true, then the challenge before Companies today is to effectively communicate their value added drivers to prospective customers in order to gain their trust and their business.

An Intellectual Capital Report is a statement of changes in the company’s intangible assets for a given period much like a balance sheet is a statement of changes in the company’s financial assets for the period. Hence, just as the balance sheet shows whether the company’s financial assets are increasing or decreasing, an Intellectual Capital Report also quantifies the amount and direction of change of the company’s intangible assets. Further, a well written Intellectual Capital Report helps the reader understand the linkages of the Company’s intangible assets to its core competencies and helps explain the value adding processes inside the Company. Prospective Customers can use such a report to understand precisely whether the drivers of value that they seek from their supplier exist there without suffering multitudes of Powerpoint slides from its sales staff. In other words, just as the balance sheet can be used to ascertain the financial health of a supplier, an Intellectual Capital Report can be used to ascertain its Knowledge health. In so doing, the Intellectual Capital Report also becomes an important pull based marketing tool, albeit much more effective than marketing based on costly push based advertising.

Benefits of Intellectual Capital Reporting

2008-12-02T00:01:00.000+05:30

It is common knowledge today that the real growth drivers of business in this knowledge era are not Physical assets, but rather the Intangible assets of the Company. These assets, better known in the academia as Intellectual Capital, are well researched, understood and broadly categorized into Human, Structural and Relational Capital. Some examples of these are:

Human Capital	Structural Capital	Relational Capital
Employee Education Index	Internal Processes	Customer Satisfaction Index
Average Tenure	Databases	Repeat Business
Number of Days of Annual Training	Patents	Investor feedback
…	…	…

It is therefore in the interest of every Company to measure and publish their own Intellectual Capital in order to be able to manage the Company’s growth and communicate the intrinsic value of the Company to investors and lenders.
By many estimates, Intellectual Capital represents more than half the market value of public Companies. In the case of some Companies such as Google and Microsoft this estimate may even be as high as 90%. Experts agree that Intellectual Capital will be important going forward as the growth driver of the knowledge economy in the future, if it is not so already today. Measuring, managing and publishing information about Intellectual Capital will therefore become as important an activity to Companies in the future as publishing financial reports is today.
Intellectual Capital Reporting can benefit a wide section of audiences:

Companies could use an Intellectual Capital Report to measure the effectiveness of their Corporate Strategy and fine tune it.
Investors and Lenders could use it to understand the Company’s value creation processes and the basis for sustainability of the same in the future.
Prospective Customers could use it to understand whether the Company has strengths in the areas it desires from its suppliers.
Potential employees could use it for selecting the right Company where they can hope to make a career for themselves. The side benefits of this could be reduced attrition and reduced knowledge leaks to competition thereby creating a circular loop for increased Intellectual Capital.
Investment Bankers could use an Intellectual Capital Report for matching potential suitors after mirroring the strengths and weaknesses of each company to conceive of a combined entity that would be stronger than each one individually.
Fund Managers and Retail Investors could use it for discovering under and overvalued stocks, provided valuation information is disclosed along with the Report.
Bankers could use it to better quantify the risk of lending to the company thereby managing the amount of nonperforming assets in their loan portfolio.
Finally society at large will itself benefit, since the combination of above benefits would result in efficient utilization of Capital thereby leading to the creation of more businesses and hence more jobs.