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An intellectual accounting: Why do intellectual capital measures focus on the wrong

This article appears in the issue February 1999 [Volume 8, Issue 2]

Unless you are trying to value and sell your business to Michael Milken for more than he last offered, most of the literature on intellectual capital just isn't relevant to day-to-day business needs.

A term much in vogue, "intellectual capital" was first used to provide a quantified explanation for the disparity between a company's market value (what the investing public values the firm at) and book value (what the accountants say the assets are worth). The once financial-only concept now gets used to describe everything from smart ideas in a R&D database to a patent. Although the term stands for both a quantified value and whatever constitutes that value, pundits are consistent in believing IC is something that can be measured and managed to yield greater business value.

Although the concept blankets such a broad spectrum, rarely do the measurements focus on the most relevant subject for a business: Does it make sense to invest in bolstering IC or not?

The Swedish insurance company, Skandia, was the first to add intellectual capital to its annual financial statements in 1994. Its original goal was to show lead indicators to the investing public of what drove future growth¥sound underwriting skills. The capacity for underwriters to gauge and price accurately emerging risks is the key to profitability for any insurance business. Skandia needed to ensure that type of expertise was being shared with its global partners and new employees.

Its director of intellectual capital, Leif Edvinsson, developed IC measures to gauge how well Skandia progressed against those goals. And, they provided a more in-depth explanation of what propelled the company's market value, including customer relationship programs and knowledge management initiatives.

Edvinsson developed a model for thinking about where intellectual assets can be found: human capital, what your employees bring to the table (skills and ideas), and structural capital, what remains when they leave (smart processes, systems and databases).

Patents became known as IC because they represent an innovation with legal value that can be quantified by being traded, bought or swapped.

Skandia's work fostered several books on IC, one from Edvinsson, another from Fortune's Tom Stewart. Fast Company noted how each book named double-entry accounting as the nemesis to accurate quantification of today's corporate value. And both authors said it has been hidden in "goodwill," an accounting term for intangible values that do not appear on a balance sheet but account for a large part of the payment in the buying and selling of knowledge-intensive firms, like consultancies with few fixed assets.

Those publications also provided fuel to the fire for consulting firms that had latched on to the knowledge management concept. Their interest was in selling engagements that could improve how a company managed IC, a very different goal from discerning why the market is willing to pay so much more for a company's stock than its book value.

Understanding how good ideas, competent and committed employees or strong customer relations foster growth is an intriguing and important question. It is relevant to those interested in buying and selling companies. But it does not address the concerns of most businesses today. They need to question whether an IC improvement project will provide a higher return on investment than other initiatives.

Building the business case for an IC project requires that a company make a set of assumptions about how improvements to their business will play out financially. The final measurement, whether it is an ROI or EVA measure, is not the most relevant choice. The logical assignment of quantitative measures to qualitative benefits is the key to valuing IC projects.

A British utility company, interested in improving the cross-selling capabilities of its service personnel, needed to understand how a knowledge management solution would impact its financial performance. It identified 12 areas where performance would be improved and made modest assumptions.

For example, if mechanics had that tool, would they sell one more product per year? Once everyone agreed to those small performance increases, putting a financial value to it was straightforward: number of mechanics to net profit of one product. By aggregating those benefits and comparing them to other competing projects, the IC project was deferred. Its yield was smaller than other proposed projects.

There is a huge difference between valuing goodwill and estimating the future value of a project to better manage patents. Don't let a fashionable term turn attention from what is most important: improving business performance.

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