Scale Enablers

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

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

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

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?

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

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

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?

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?

“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?

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:

1. 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.


2. 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.


3. 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.


4. 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.


5. 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.


6. 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.


7. 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?

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.