Tuesday, December 23, 2008

The diverse sources of value

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.

Tuesday, December 2, 2008

How IC Reports can benefit prospective employees

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

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

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

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 CapitalStructural CapitalRelational Capital
Employee Education IndexInternal ProcessesCustomer Satisfaction Index
Average TenureDatabasesRepeat Business
Number of Days of Annual TrainingPatentsInvestor 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.