Wednesday, April 28, 2010

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.

Wednesday, April 21, 2010

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.

Wednesday, April 7, 2010

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.