Conventional accounting fails to measure the value of intellectual capital, but markets clearly reward it.
Intellectual capital includes the talent of staff, the value of proprietary knowledge and processes, and the value of relationships with customers and suppliers.
Intellectual capital is just that: a capital asset consisting of intellectual material. To be considered intellectual capital, knowledge must be an asset able to be used to create wealth. Thus, intellectual capital includes the talents and skills of individuals and groups; technological and social networks and the software and culture that connect them; and intellectual property such as patents, copyrights, methods, procedures, archives, etc. It excludes knowledge or information not involved in production or wealth creation. Just as raw materials such as iron ore should not be confused with an asset such as a steel mill, so knowledge materials such as data or miscellaneous facts ought not to be confused with knowledge assets.
Intellectual Capital As an Asset
From the standpoint of traditional accounting, intellectual capital frequently does not fit the definition of an asset. Generally, under accounting rules, an asset must be tangible; it must have been acquired in one or more transactions, so that it has a known cost or a market value; and it must be under the control of the party whose asset it is said to be. Thus, scientific skill is not an accounting asset, but laboratory equipment is.
Intellectual capital theory argues that this definition is too narrow and hinders businesses from seeing, managing, or building knowledge assets. This in turn inhibits companies’ ability to compete and prosper in an economy in which knowledge has become an important source of profits. The intellectual capitalists use a looser definition: an asset is something that transforms raw material into something more valuable. It is a magician’s black box. Inputs get put in—a few handkerchiefs, say; the asset does something to transform them; and out come outputs worth more than the inputs —rabbits, maybe. The question of ownership and control matters less than the question of access. A corporation might not own scientific expertise (in the form of a cadre of employees, for example), but it has the use of it and can exert a quasi-proprietary influence over how it is used.
Intellectual capital, then, is knowledge that transforms raw materials and makes them more valuable. The raw materials might be physical—knowledge of the formula for Coca-Cola is an intellectual asset that transforms a few cents’ worth of sugar, water, carbon dioxide, and flavorings into a dollar’s worth of refreshment. The raw material might be intangible, like information. Knowledge of the law is an intellectual asset; a lawyer takes the facts of a dispute (raw material), transforms them through his knowledge of the law (an intellectual asset), to produce an opinion or a legal brief (an output of higher value than the facts by themselves).
Though financial accounting does not measure intellectual capital, markets clearly do. Stock in companies in the pharmaceutical industry, for example, generally trade at a high premium over the book value of their assets, and the companies’ return on net assets is abnormally high; but if their spending on research and development is added to their capital, both their market-to-book ratios and their returns on assets come to resemble those of less knowledge-intensive companies. (There is a slowly growing movement to find ways to account for intellectual capital and report it to stockholders. Scandinavian countries, particularly Denmark, are leaders in the field.)
Indeed, it was the unusual behavior of the equities of knowledge-intensive companies that first drew the attention of analysts to intellectual capital. The term seems to have been employed first in 1958, when two financial analysts, describing the stockmarket valuations of several small, science-based companies, concluded that “The intellectual capital of such companies is perhaps their single most important element,” and noted that their high stock valuations might be termed an “intellectual premium.” (Morris Kronfeld and Arthur Rock, “Some Considerations of the Infinite,” The Analyst’s Journal, November 1958, p. 6.) The idea lay dormant for a quarter of a century. In the 1980s, Walter Wriston, the former chairman of Citicorp, noted that his bank and other corporations possessed valuable intellectual capital that accountants (and bank regulators) did not measure.
Intellectual Capital Analyzed
Karl-Erik Sveiby, a Swede, intrigued by the anomalous stockmarket behavior of knowledge-intensive companies, began an investigation that produced the first analysis of the nature of intellectual capital. Sveiby, his colleagues, and Affärsvärlden, Sweden’s oldest business magazine, noticed that the magazine’s proprietary model for valuing initial public offerings broke down for high-tech companies. Sveiby concluded that these companies possessed assets not described in financial documents or included in the magazine’s model. With a like-minded group of associates, he sat down to puzzle out what these might be. In “Den Osynliga Balansräkningen Ledarskap ” (“The Invisible Balance Sheet”), 1989, they laid the foundation stone for much of what has come after by producing a taxonomy for intellectual capital. Knowledge assets, they proposed, could be found in three places: the competencies of a company’s people, its internal structure (patents, models, computer and administrative systems), and its external structure (brands, reputation, relationships with customers and suppliers).
After some tinkering by others—the pieces are now usually called human capital, structural (or organizational) capital, and customer (or relationship) capital—Sveiby’s model still stands. It has made managing intellectual capital possible by naming its component parts. Shortly thereafter, Leif Edvinsson, an executive at the Swedish financial services company Skandia, persuaded his management to appoint him “Director, Intellectual Capital”; Skandia became the business world’s most conspicuous laboratory for intellectual capital studies.
Ideas whose time has come flower everywhere at once. Ikujiro Nonaka and Hirotaka Takeuchi in Japan began investigations of how knowledge is produced that resulted in “The Knowledge-creating Company” (Harvard Business Review, November–December 1991), and Thomas A. Stewart synthesized U.S. research in intellectual capital in “Brainpower: How Intellectual Capital is Becoming America’s Most Important Asset” (Fortune, June 3, 1991).
Every company or organization possesses all three forms of intellectual capital. Human capital consists of the skills, competencies, and abilities of individuals and groups. These range from specific technical skills to “softer” skills, like salesmanship or the ability to work effectively in a team. An individual’s human capital cannot, in a legal sense, be owned by a corporation; the term thus refers not only to individual talent but also to the collective skills and aptitudes of a workforce. Indeed, one challenge faced by executives is how to manage the talent of truly outstanding members of their staff: how to use it to the utmost without becoming overdependent on a few star performers, or how to encourage stars to share their skills with others. Skills that are irrelevant to a company’s business—the fine tenor voice of an actuary, for example—may be part of the individual’s human capital, but not of his employer’s.
Structural capital comprises knowledge assets that are indeed company property: intellectual property such as patents, copyrights, and trademarks; processes, methodologies, models; documents and other knowledge artifacts; computer networks and software; administrative systems; and so forth. A data warehouse is structural capital; so is the decision-support software that helps people to use the data. One knowledge-management process is converting human capital—which is usually available to just a few people—into structural capital, so it becomes shareable. This happens, for example, when a team writes up the “lessons learned” from a project so that others can apply them. Some structural capital can be said to be owned in common; open-source software is an example. In general, however, proprietary assets, whether intellectual or otherwise, are of more strategic value than assets equally available to competitors.
Customer capital is the value of relationships with suppliers, allies, and customers. Two common forms are brand equity and customer loyalty. The former is a promise of quality (or some other attribute) for which a customer agrees to pay a premium price; the value of brands is measurable in financial terms. The loyalty of a base of customers is also measurable, using discounted cash flow analysis. Both are frequently calculated when companies are bought and sold. In a sense, all customer capital should eventually reflect itself either in a premium price or a sticky buyer–seller relationship.
Every organization possesses intellectual capital in all three manifestations, but with varying emphasis, depending on its history and strategy. For example, a chemical company might have as a knowledge asset the ability to concoct custom chemical compounds that precisely match its customer’s needs. That asset might be people-based, residing in the tacit knowledge of dozens of skilled chemists; it might be structural, found in an extensive library of patents and manuals, or databases and expert systems; it might be relationship-based, found in the company’s intimate ties to customers, suppliers, universities, etc. Most likely, of course, the asset—skill at making custom chemicals—is a combination of the three. A company that takes a strategic approach to intellectual capital will examine its business model and the economics of its industry to manage the combination of human, structural, and customer capital in such a way as to create value that competitors cannot match.
At least three characteristics of intellectual capital give it extraordinary power to add value. First, companies that use knowledge assets deftly can reduce the expense and burden of carrying physical assets, or can maximize their return on them. For example, transportation companies can use information networks and skill in logistics and load management to maximize their utilization of assets like rail cars and containers. Second, it can be possible to get enormous leverage from knowledge assets. The value of an aircraft can be realized over just one route at a time, whereas that of an airline’s reservation system is limited only by the number of people in the world. In a study of the chemical industry that examined 83 companies over 25 years, Baruch Lev, professor of accounting at New York University, found that R&D spending (one form of investment in intellectual capital) returned 25.9% pretax, whereas capital spending earned just 15% (about 10% after tax, approximately the cost of capital).
Third, human and customer capital are the primary sources of innovation and customization. The increasing sophistication of machinery and information technology has led to the automation of more and more repetitive tasks. These manufacturing economies of scale are sources of competitive advantage in industrial processes. At a certain point, however, their value diminishes: the more it is possible to do a task the same way twice, the harder it is for one company to differentiate its offerings from its competitors’. When this happens the value of innovation, customization, and service increases; all are highly dependent on intellectual capital.
Making It Happen
Treat knowledge as an asset only if it is capable of yielding an economic return.
Build human capital by developing the skills, competencies, and abilities of individuals and groups who deliver value to customers.
Convert human capital into structural capital by organizing the exchange and sharing of knowledge.
Use knowledge assets to reduce the expense and burden of carrying physical assets, or to maximize return on those assets.