Measuring intangible assets - the state of the art 9781845444013, 9780861769445

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Volume 8 Number 1 2004

ISBN 0-86176-944-9

ISSN 1368-3047

Measuring Business Excellence The Journal of Business Performance Management

Measuring intangible assets – the state of the art Guest editor: Bernard Marr

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Table of contents Measuring intangible assets – the state of the art Guest editor: Bernard Marr Volume 8 Number 1 2004

Regulars

Feature articles

Access this journal online

2

Guest Editorial

3

Measuring intangible assets – the state of the art

18

Bernard Marr and J.-C. Spender

Quality focus

Book reviews

6

Baruch Lev and Juergen H. Daum

Measuring knowledge assets implications of the knowledge economy for performance measurement

Bernard Marr

Bahrain budgets Power of finance goes beyond counting cash Focus on books Events Focus on the Web

The dominance of intangible assets: consequences for enterprise management and corporate reporting

69 72 74 77 79 81

Human resource management and business performance measurement

28

G. Roos, Lisa Fernstro¨m and S. Pike

Accounting for intellectual capital: rethinking its theoretical underpinnings

38

Robin Roslender

Reporting on intellectual capital: why, what and how?

PMA conference announcement

85

Note from the publisher

86

46

Jan Mouritsen, Per Nikolaj Bukh and Bernard Marr

Assessing national and regional value creation

55

Leif Edvinsson and Ahmed Bounfour

Intellectual capital – does it create or destroy value?

62

Ante Pulic

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Guest editorial Measuring intangible assets – the state of the art Bernard Marr

Bernard Marr is a Research Fellow at the Centre for Business Performance at Cranfield School of Management and a Visiting Professor at the University of Basilicata, Italy. Prior to joining Cranfield in 1999 he held a research position at the Judge Institute of Management Studies at Cambridge University. He is the co-author of the books Weighing the Options: BSC Software and Automating your Scorecard, both jointly published with Gartner. Bernard is chairman of the international PMA Intellectual Capital Group, Intangible Assets Editor of the journal Measuring Business Excellence, and member of the editorial board of the Journal of Intellectual Capital and the International Journal of Learning and Intellectual Capital. For more information please see: www.som.cranfield.ac.uk/som/ cbp/bwm.htm

Abstract In this introductory editorial to the special issue ‘‘Measuring intangible assets – state of the art’’ I outline the background and rationale of this special issue and introduce the various contributions. All contributors are members of the PMA Intellectual Capital Group which was formed to address the issue of measuring intellectual capital. The articles in this special issue outline implications of the knowledge economy for measuring, reporting, and valuing performance of both, private enterprises as well as public organizations. Keywords Intangible assets, Intellectual capital, Measurement, Financial reporting

Background Corporate performance measurement and management has been transformed over the past decade. Many private enterprises as well as public organizations have shifted their focus away from the financially biased measurement systems primarily based on accounting information. This shift was provoked by the changing nature of global markets and a new business environment. In this new business environment, power has shifted from the sellers to the buyers, knowledge has become a fundamental factor of production, and the right relationships with customers, suppliers, and stakeholders are crucial. Many of these assets are intangibles that lay the foundation for differentiation and innovation, which are vital drivers of sustainable business performance. In consequence, any corporate performance measurement and management systems needs to reflect this change in order to provide managers or analysts with the relevant information on their intangible value drivers. To address this important issue the PMA Intellectual Capital Group was founded as a special interest group of the Performance Measurement Association (PMA). The PMA is a global network for those interested in the theory and practice of performance measurement and management (see www.performanceportal.org). The Intellectual Capital Group of the PMA was established in recognition of the growing interest and importance of measuring and managing intellectual capital (IC). The PMA IC Group is a global and multidisciplinary network of thoughtleading academics and practitioners who jointly facilitate and participate in cross-disciplinary knowledge transfer in the area of measuring and managing intellectual capital and intangible assets. Its aim is to raise the awareness of intangibles and knowledge-based assets as critical value drivers in today’s economy and actively engage in global knowledge transfer. Participants in this group come from a wide spectrum of disciplines including strategy, finance, accounting, economics, HR, IT, operations, etc. and engage in a broad range of research projects. With the start of my new role as Intangible Assets Editor of Measuring Business Excellence and as chairman of the PMA Intellectual Capital Group, I assembled this special issue to report on the state of the art in measuring intangibles. The intention is to raise some important issues and hopefully fuel a wider discussion and further research in this vital field of study. All contributors to this special issue are members of the PMA Intellectual Capital Group and were deliberately selected to provide a multi-disciplinary view of the field.

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Contributions to this special issue The first article is by Baruch Lev and Juergen Daum, who outline why intangible assets have become important factors of value creation in today’s knowledge economy. The authors highlight that individually these assets are often commodities and only create value in combination with other factors of production. In their article, Lev and Daum outline the implication for corporate performance measurement and management systems. The article outlines how total factor productivity can be assessed in organizations as a means to better understand organizational performance in order to objectively measure the productivity and efficiency of the entire enterprise. The second article by Bernard Marr and J.-C. Spender addresses the importance of measuring knowledge-based assets in today’s business environment. The article reviews the evolution and the increasing importance of knowledge as an asset – from data, over information, to knowledge as proficient practice. Based on the dissimilar views of knowledge assets Marr and Spender identify existing approaches proposed in the management literature and practice, and match them with the different view of knowledge. This analysis raises some issues of how to measure knowledge assets and their value creation in today’s complex business reality. In the third paper Go¨ran Roos, Lisa Fernstro¨m, and Stephen Pike discuss intellectual capital from a human resource perspective. The authors review the research into the relationship between human resource management (HRM) and business performance and highlight the change of the HR function into the more strategic HRM role. Roos et al. show that the resourcebased approach of intellectual capital may provide the key to quantifying the links but emphasize that work to date has shown that it may not be possible to clearly separate HRM from other management actions to quantify the effects of HRM. To overcome this the authors suggest the holistic value approach which is based on rigorous measurement. In the fourth article Robin Roslender discusses intangibles through the accounting lens. The accountancy profession is closely associated with the measurement and reporting of performance. Many initiatives are currently underway to address the accounting for intangibles and intellectual capital. Roslender outlines that as long as the accountancy profession seeks to progress accounting for intellectual capital within the confines of prevailing accounting theory, the prospects for a successful outcome appear remote. The author suggests that alternative theoretical precepts need to be explored, an exercise that also has implications for the future development of financial reporting. The fifth article in this special issue is by Jan Mouritsen, Per Nikolaj Bukh and Bernard Marr who address the issue of how to report on intellectual capital. Linking into Roslender’s paper, the authors emphasize the shortcomings of traditional financial reporting and suggest intellectual capital statements as a tool to overcome the existing information gap. This new way of reporting on how intellectual capital drives value creation is based on narratives and measures. The application of such an approach is exemplified using a case study from a Danish firm. The penultimate article is a closing commentary by Leif Edvinsson and Ahmed Bounfour who pick up the point made by Pulic and re-emphasize the importance of measuring intellectual capital on a regional and national level. This article highlights the importance of understanding how value is created on a national level in order to enable governments and organizations to better navigate through the knowledge economy. In the final paper of this issue Ante Pulic emphasizes the importance of viewing any expenses made to build or enhance intellectual capital as an investment, instead of a cost. Pulic introduces a methodology to calculate added value with the difference that intellectual capital is seen as a resource that has to be managed in the most efficient way. Pulic defines a new index that measures the value creation efficiency of intellectual capital and suggests using this as an improved methodology to understand value creation, not only on a business level but also on a regional and national level. Empirical applications of the index show that while revenue, profit and GDP may indicate successful performance, IC efficiency may indicate the opposite, that value is being destroyed and not created.

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The aim of this special issue is to lay the foundation for a wider discussion on how to measure, report, and value intellectual capital and intangible assets. I herewith invite more papers that may support, discard, or test theories and ideas put forward to date. The need for improved measurement, reporting, and valuation of intangibles is critical and it is down to scholars and practicing managers to discuss, apply, and test new approaches in order to forward our understanding in this vital field.

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The dominance of intangible assets: consequences for enterprise management and corporate reporting Baruch Lev and Juergen H. Daum

Baruch Lev is Professor of Accounting and Finance at New York University, Stern School of Business, the Director of the Vincent C. Ross Institute for Accounting Research and the Project for Research on Intangibles. He is a internationally recognized expert for accounting and reporting issues related to intangible assets, working closely with such institutions as the US Securities and Exchange Commission and the Financial Accounting Standards Board, OECD, the EU, and the Brookings Institution (Web site: www.baruch-lev.com/). Juergen H. Daum is Chief Solution Architect in the Business Solution Architects Group SAP AG, Walldorf, Germany. He was previously program and product manager in SAP’s core development group and was responsible for the repositioning of SAP’s financial and accounting applications, mySAP Financials, and played a key role in shaping the SAP Strategic Enterprise Management solution. Prior to joining SAP he was the CFO and controller of a German IT company (Web site: www.juergendaum.com).

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Abstract Intangible assets have become important factors of value creation in today’s knowledge economy. However, individually they are often commodities and only create value in combination with other production factors. Therefore, in order to manage for performance and value, companies and their managers, as well as their investors, need a better understanding of their role as part of the entire value creation system of an organization. The article outlines possible features of an improved management and corporate reporting model. In order to objectively measure the productivity and efficiency of the entire enterprise, the article outlines how total factor productivity can be assessed in organizations as a means to better understand organizational performance. Keywords Intangible assets, Financial reporting, Management activities

Introduction At the beginning of the 1990s a significant change regarding the asset compositions of business enterprises became apparent. During the 1980s the book value of corporations has been constantly shrinking in relation to market value. The residual, which is often regarded as the capital markets view of the value of a corporation’s intangible assets, was rising. As a result, in only ten years the relation between book value and value of intangibles has been totally reversed for the average S&P500 company: between 1982 and 1992 the value of intangibles increased from 38 percent to 62 percent of market value and book value decreased from 62 percent to 38 percent. This drew attention to the rising phenomenon of intangible assets. Pioneers in the field created awareness for intangibles as the new source of corporate value and growth, and to the serious information deficiencies related to these assets. Research (Nakamura, 2003) indicated that in the late 1990s the annual US investment in intangible assets (e.g. R&D, brand enhancement, employee training) was roughly $1.0 trillion, almost equal to the total investment of the manufacturing sector in physical assets ($1.2 trillion). Furthermore, investments in intangibles, particularly those that enable enterprises to innovate, bring in returns that are significantly higher than costs of capital and the returns of fixed asset investments, even in traditional industries such as the chemical industry (Lev and Aboody, 2001). Today, the role of intangibles as value and growth creators is accepted among economists, investors and managers (Neely et al., 2003). There seems general agreement that traditional (accounting-based) information systems are not able to provide adequate information about corporate intangible assets and their economic impact. This has serious implications as it

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DOI 10.1108/13683040410524694

causes volatility of stock prices, which results in undue losses to investors and misallocation of resources in capital markets. As a consequence, intangible-intensive enterprises are confronted with excessive cost of capital, hindering their investment and growth. Corporate outsiders have even less access to such information and the resulting information imbalance can lead to excessive trading gains to corporate insiders, destroying investors’ confidence (Lev, 2001; Hand and Lev, 2003). The ‘‘intangibles movement’’ has succeeded in the first phase of its mission: in creating awareness and an active discourse about the economic role of intangible assets and their consequences. However, the time has come to move to the next level – into practical application. For this, two major issues need to be addressed: (a) Intangible assets by themselves neither create value nor generate growth: they need to be combined with other production factors. They need efficient support and enhancement systems – otherwise the value of intangibles dissipates much quicker than that of physical assets. Corporate reporting and internal management systems must therefore provide a more holistic view that allows investors and managers to evaluate the performance of the total value creation system of the company, including its various production factors, assets, processes and procedures in their combination. The focus needs to be on total factor productivity. (b) The value of intangible assets is related to the future. They represent capabilities and ‘‘potential’’ for future growth and income. Our current management and corporate reporting practice are primarily focused on backward looking information. This needs to change towards forward looking information and we must adopt a more dynamic approach than traditional performance management concepts that are based on annual budgeting. Instead, planning has to become an integral part of the monthly or weekly performance management process. Regular checks of an enterprise’s total factor productivity might become a standard procedure in the performance management process in order to enable constant optimization of total factor productivity. Below we describe first the changes in the economy which triggered the need to measure and manage the intangible value drivers of organizations. We then discuss the economic difference between traditional assets and intangible assets before we outline possible features of an improved management and reporting model, which include a concept for how to measure total factor productivity in organizations as a means to better understand organizational performance.

Towards the knowledge economy The growing intangible assets base of corporations represents a symptom of a larger economic transformation – the transformation from the industrial economy, characterized by a seller’s market and industrial mass production, to today’s knowledge economy, where companies have to operate in open global buyer’s markets and where differentiation has become a key success factor. This requires continuous innovation, customer centricity and high quality customer services. This need for continuous innovation and customer centricity, which is reinforced through open global markets, required companies in the last decades to invest more and more in their innovation and adaptation capabilities as well as in customer attraction (brands and relationship building). The result is that more and more resources are put into the preparation of operative activities (for instance in R&D, brand building, building customer relationships, employee education, flexible supply chain networks or information technology infrastructure), instead of execution (such as producing, selling and delivering products and services). The outcome in the form of assets created – e.g. human capital, R&D pipeline, or brands – represent not so much the result of invested financial capital but rather a by-product of wellmanaged operative activities and processes. As a result, the operations model of modern companies has evolved into a complex model, where activities that create business potential for the future, such as product development or customer relationship building, become an integral part of the operations model. The traditional distinction in accounting between acquisition of

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assets (creation of growth potential) and its exploitation (operations) is becoming blurred. In the same way as the company environment is constantly changing, so are the intentions and goals of the stakeholders. Therefore, the value-creating constellation that is the basis for the operations model cannot remain fixed. Instead, it has to be continuously adapted. Therefore, we need a more future oriented and dynamic approach to enterprise management. That is why traditional financial and management accounting is failing to adequately support management in today’s environment: it is too narrow, too inflexible, and too much focused on the past and present (see Figure 1). Awareness for intangibles is an important first step, but focusing on and optimizing single intangible assets and the processes that creates and utilizes them is not enough. Instead, companies must constantly optimize their entire bundle of production factors in order to create sustainable value for customers, shareholders and other stakeholders. This requires a holistic view of the entire value creation system of a company that allows it to create economic value through the intelligent combination of its various value creating processes, its competencies, resources and assets. It requires focusing on an enterprise’s total factor productivity.

Economics of intangibles Current financial statements in their present form only give a limited account of the real economic conditions of a company. They provide no information about the growth and adaptation potential of a company, nor do they disclose how efficient the company is in utilizing its bundle of resources, assets and capabilities to generate future revenue and income. From an

Figure 1 Towards the operation model of the knowledge economy (Daum, 2003a)

New Operations Model

Traditional Industrial Operations Model

Product Develop.3 Procurement

Manufacturing

Sales

Delivery

Ph. Assets / Financial Capital

"Seller's Market"

Supplier

Fullfillment1

Ph.Assets

HR

CRM2 Fin. Cap.

Customer

Int. Assets

"Buyer's Market"


Time horizon: month, quarter


Time horizon: quarter1, 1-2 years2, 3-5 years3


More direct relationship between in- and output


More indirect relationship between inand output


Resources/assets can be acquired and deployed short-term
Reporting and Controlling tools: P&L, fin. statement, capital flow and accounting


More resources must be developed internally
Reporting and Controlling tools: ?

Reporting instrument giving information about "competencies" and resources:

Reporting instrument that gives information about success in implementation:


Dynamic complexity in business system: a growing tension between value creation and value extraction

B/S and Cash Flow Reports

P&L and Cost Accounting


The distinction between "assets" and "operations" blurred

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economic perspective this efficiency might be the key differentiator of companies. In order to be able to optimize and manage this efficiency, mangers have to be aware of the economics of intangibles. Intangibles are inert – by themselves, they neither create value nor generate growth (Lev, 2002a). Their value is context specific. For example investments in e.g. training only generate financial value (lower costs or higher revenues) when it is combined with other factors, such as improved business processes and the availability of the right information systems. Without efficient support and enhancement systems, a company is not able to translate the potential its intangible assets represent into value for customers and shareholders and even worse: without such tools the value of intangibles dissipates much quicker than that of physical assets. For example the capabilities of highly qualified scientists at Pfizer, Roche or Schering will not result in marketable products without appropriate supporting processes for drug research and development. In the same way that a large patent portfolio at Dow Chemicals and IBM is by itself of little value without an intellectual property management system that helps to monitor and oversee all available patents, that supports periodic analysis of the entire portfolio in order to determine new patent use and thus value creation opportunities, and that keeps track of the corresponding ‘‘value extraction’’ projects and programs. Intangibles are not only inert, many are also commodities since most business enterprises have equal access to them. Pharmaceutical companies have similar access to the best pharmaceutical researchers. Most companies can license patents or acquire R&D capabilities via corporate acquisitions. Since competitors have equal access to such assets they do not create a competitive advantage by itself and as a result, at best, return only the cost of capital (zero value added). The inertness and commoditization of most intangibles have important implications for today’s corporations, their managers and investors. Because intangibles require appropriate support systems and specific ‘‘organizational recipes’’ to create value for customers and to make a difference in the market, the organizational infrastructure of a company becomes a critical ‘‘production factor’’. With organizational infrastructure we mean the business processes and systems that transform tangible and intangible assets into bundles of assets that help to create a competitive advantage and to generate sustaining cash flows. Such organizational infrastructure is non-commoditized (i.e. unique), as it supports the given mission and culture of the enterprise in its specific environment. Thus, the organizational infrastructure represents the major intangible of the enterprise (Lev, 2002a).

A company’s organizational infrastructure is a bundle of systems, processes and business practices that helps the company to achieve its objectives. What we therefore need is a new focus on organizational infrastructure – the engine and transmission belt for creating value from all type of assets. This infrastructure is not static, instead, it needs to be continuously adapted to new market and business conditions to sustain the company’s effectiveness for value creation. This adaptation capability itself is part of the organizational infrastructure of an enterprise. How fast and appropriate an organization is able to adapt to new business conditions is a key competence of the enterprise. Like un-coding the human genetic code, understanding the ‘‘enterprise code’’ – the organizational infrastructure with its processes, recipes and the capability to change – will enable us to answer critical questions. In the following sections we will try to lay the foundation for such an approach – with the focus on the management system and corporate reporting. This may not be complete yet; however, our main intention is to show the direction for designing new management and reporting systems.

A new management system and corporate reporting framework Companies appear, to both outsiders and the management, as a ‘‘black box’’. Without a suitable model to understand the internal and usually complex black box systems, it is not possible for the observer to gain valuable and decision oriented insights into their performance.

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To the investor, for example, the company represents a unit whose purpose is to generate maximum sustainable cash flows and he can choose in an open capital market which company to invest in. His difficulty lies in correctly assessing what strengths a particular company has in comparison to other companies to transform today’s investments into the highest possible future return (e.g. dividend payments and increases in the market value). The investor needs to understand not only the current performance, but also has to come to a conclusion how this performance will develop over a particular time span, namely the time he intends to hold the stock (Daum, 2003a). The traditional information system designed to help here are the published financial statements in form of income statement and balance sheet. When companies were operating on the basis of cost and financial capital efficiency in relatively stable markets dominated by sellers, this reporting and management system was adequate. The income statement contained sufficient information regarding cost efficiency by detailing production costs and overhead – the essential drivers of operational productivity in manufacturing companies. The balance sheet contained additional information about the effective use of tangible assets (such as machinery and equipment) and financial capital. All this enabled the investor to make a relatively prudent assessment of the future performance of the company. This contrasts with the situation today where the balance sheet only contains a small fraction of the actual company value, and where the income statement does not reflect any more the value creation system of today’s businesses. The goal of a new management and reporting approach is to look inside the enterprise and to portray the mechanism that mobilizes the relationships between invested and available resources, external business partners and the structural capital of the company, such as business processes, organizational procedures, information technology infrastructure, work processes etc., that create value for customers, shareholders and other stakeholders. Most financial reporting and performance measurement concepts fall short because they just provide a financial picture that shows how effective a company was in the past to utilize its resources. They provide no information about the development of the competence base of the company for generating future revenues (or reduced costs) in all of the dimensions relevant. We must therefore expand accounting and control systems to enable companies to optimize, manage and report on their real value creating activities and processes. Important information for managers and investors concerns the enterprise’s value chain (Lev, 2001), the fundamental economic process of innovation that starts with the discovery of new products, services or processes, proceeds through the development and implementation phase to commercialization of the new products or services. This innovation process is where much of the economic value is created in today’s knowledge based businesses. To measure the performance of this process would represent a step forward both for internal decision making and external reporting. Figure 2 depicts such a system of measures. But because the true value of intangible assets becomes apparent only within a specific context, the entire enterprise value creation model, in which corporate resources and tangible as well as intangible assets are created and – in particular – utilized, must be taken into account. Thus, it is important to develop a strategy for bundling all sources of value creation potential into a single ‘‘recipe for adding value’’. The enterprise performance management system An important prerequisite for the ability of corporate management to manage for sustainable value creation is the availability of objective information on the status of all relevant value creating activities. Figure 3 (left side) shows a generic model for the systematic development of a holistic enterprise performance measurement system that describes a holistic view for enterprise control – the Tableau de Bord (see e.g. Epstein and Manzoni, 1997; Gray and Pesqueux, 1993; Daum, 2002). This business scorecard enables the systematic monitoring of performance as well as of emerging opportunities and risks in the company’s overall value creation system. It is a cornerstone of the new enterprise management system.

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Figure 2 Lev’s value chain blueprint (Lev, 2001)

Discovery and learning

• Research and development

• Organizational Capital, processes

Commercialization 7. Customers

4. Intellectual Property

1. Internal renewal

• Work force training and development

Implementation

• Patents, trademarks, and copyrights

• Marketing alliances

• Licensing agreements

• Customer churn and value

• Coded know-how

• Online Sales

• Brand values

8. Performance 5. Technological feasibility 2. Acquired capabilities • Technology purchase • Spillover utilization • Capital expenditures

3. Networking • R&D alliances and joint ventures • Supplier and customer integration

• Revenues, earnings, and market share

• Clinical tests, Food and Drug Administration approvals

• Innovation revenues • Patent and know-how royalties

• Beta tests, working pilots

• Knowledge earnings and assets

• First mover

9. Growth prospects

6. Internet

• Product pipeline and launch dates

• Threshold traffic • Online Purchases • Major Internet alliances

• Communities of practice

• Expected efficiencies and savings • Planned initiatives • Expected breakeven / cash burn rate

In addition, companies need management processes that permit quick and efficient exchange of background knowledge between individual managers to ensure optimal usage of this information and enable managers for dynamic strategy and performance management. Such processes include a strategic management process that establishes a continuous strategic dialog throughout the company and thus ensures that the company remains ahead of external developments that could harm its competitive position and the value of its competence base. Companies must also have a process for performance management that optimizes the exploitation of existing assets and potential in order to achieve short-term profitability goals. Both ‘‘enterprise management processes’’ need to be linked with operational management processes through clearly defined checkpoints (see Figure 3 – right side). The main intention of this concept is to enable managers to react fast to changing market conditions in order to leverage new opportunities and to systematically limit known and emerging new risks. It should enable managers to optimize enterprise performance and its total efficiency in a dynamic environment. This is important, because the dynamics, volatility, risks, and trade-offs in the business system increase with the level of intangible assets. Instead of an annual planning exercise as it is usually triggered by the annual budgeting process, planning becomes an integral part of the monthly or weekly performance management process. A key support process for this is forecasting. Its intention is to bring changes in the underlying business conditions to the fore and allow managers to do something about it before they materialize – both from the strategic perspective in order to adapt the overall value creation

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Figure 3 The management system (Daum, 2002)

Tableau de Bord

Management Proceses

Overall View

Adapt/Define Strategy

Financial Results

Market / Customers

• Revenues, Profit, EVA • Return on Intangible Assets

• Market shares • Customer satisfaction • Reliability

Change Management

Processes / Resources

• Supply chain efficiency • Value added per person • IT efficiency

Strategy Management Process

Define Objectives

Forecasting

• Status project 1 • Status project 2

Product/Market Development View Discovery • No. of successful discoveries • No. of usable suggestions from the user groups • Effectiveness of R&D Alliances

Implementation

Commercialization

• Return on development investments • No. of registered patents • Success and error quota of beta tests • Time-to-market

• No. of marketing partners • Market shares • Innovation revenues (revenues of products < 2 years) • Brand value

Performance Management Process

Measure Performance

Check Technical Feasibility

Prototyping

CRM Cockpit • Average customer lifetime value • Lead conversion rate • Customer satisfaction • Service quality

Market Research

Product Lifecycle Management Implementation

Operational View Supply Chain Cockpit

Decide how to adapt

Adjust operations

“Go” Decission

• Delivery reliability • Lead time • Utilization / costs • SCM flexibility

Strategic Analysis

Production Planning

Demand Planning

Engagement Sales

SCM Procure Raw Material

Test & Release

Business Development

Lead Generation

CRM Delivery

Production

After Sales Support

Customer Service

Resource Management View Human Resources • Productivity • Vacancies quota • Fluctuation

Information Techn.

Finance

• Cost efficiency • Reliability • Service quality

• Working capital employed • Costs per transaction

HR

Assets

Finance

Support Processes/Resource Management

recipe of the company when needed, and from the performance management perspective to manage trade-offs, leverage opportunities and limit risks in order to optimize short term performance. This focuses the attention of managers on the future instead of the past. Such a management system enables managers to make better decisions which help to achieve sustained profitability. It becomes itself an important production factor and a major part of the enterprise’s organizational infrastructure. Having such a system in place, a company is able to improve also external corporate reporting and communication. Forward looking and holistic corporate reporting The objective of corporate reporting is to provide investors and other external stakeholders with a better insight into the enterprise. By giving them an overview of all value-creating activities from an economic view-point it should allow stakeholders to better assess the true potential of a company as well as its ability to achieve sustainable results. For example, in addition to financial statements, companies could publish supplemental information on business strategy and business models, along with operational and intangible key performance indicators via so called supplemental corporate reports. Working groups of the US Securities and Exchange Commission (SEC) and Financial Accounting Standards Board (FASB) have suggested this approach (SEC, 2001; FASB, 2001). The ‘‘intellectual capital statements’’ proposed by the Danish government or the MERITUM guidelines represent a similar step (Marr et al., 2003;

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Daum, 2003a). Thus, the same concept that is used for internal enterprise management, as described above, can be used as a basis for external corporate reporting. It might be less detailed than the internal performance reporting systems and some information will be excluded from the external reports for competitive reasons. To enable this kind of practice to gain widespread support, industry-specific standards for key indicators and reporting layout are a necessity (DiPiazza and Eccles, 2002). Also a simple ‘‘push’’ procedure will no longer be sufficient in external reporting. Important stakeholder groups must be included in a constant and active dialog to retain their commitment to the company. Today, companies need to maintain a continuous and active bi-directional dialog with important external stakeholders in order to get and keep them engaged in the enterprise: stakeholder relationship management becomes a daily top management task and needs therefore to be integrated with the internal management processes.

Enterprise total factor productivity Having in place an integrated framework, including enterprise model, management system, corporate reporting and communications, does not only allow managers and investors to understand the performance of an enterprise, it also allows them to better understand the business economics of organizations. Following the changes of indicators in one area and watching their effects on other areas will help them to understand the sensitivities and the economic logic that rules within their business model and ‘‘organizational recipe’’. This enables them to better estimate the effect certain market changes or management actions will have on company performance and on the future value and on the potential in its current competence and assets basis. However, this kind of ‘‘learning’’ is still based on estimations and subjective assessments. What is missing is an objective measure for the productivity and efficiency of the total system, which can serve as a reliable reference for the evaluation of the impact of changes in single value creating processes, procedures and assets/resources on total enterprise performance. The concept of enterprise total factor productivity provides this kind of measurement and reference (Lev, 2002a). ‘‘Total factor productivity’’ is a term used in macroeconomic growth theory. Macroeconomic growth theory deals with the economic development of nations, with special focus on the drivers of growth (measured for example by GDP change). These drivers fall into two categories: (a) Increases in factor inputs, such as growth of the labor force and capital investments (property, plant and equipment); and (b) improvements in total factor productivity – the total productivity of the factor inputs. For example, the gross product of corporate businesses in the USA increased in 2000 (relative to 1999) by $443.2 billion, while consumption of physical capital increased by $57.9 billion and the compensation of employees by $289.1 billion. Thus, the aggregate spending of $347.0 billion on capital and labor in 2000 produced an increase of the gross product by $443.2 billion – $100 billion more than the increase in total factor input. The cause for this ‘‘added value’’ can be found in the US economies total factor productivity – the efficiency of its corporate business processes, organizational designs and incentive systems, which is enabling US corporations to generate an output level substantially higher than invested inputs. An efficient organizational infrastructure enables the company to generate value added from the invested resources. This added value relative to invested inputs reflects the productivity margin of the enterprise and represents the source of shareholder value and employee and stakeholder welfare. The organizational infrastructure enables the enterprise to use its resources in a productive manner, resulting in enhanced productivity, profits, and shareholder value. It reflects the company’s unique capabilities to

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create value from commoditized resources (see Figure 4). Because the organizational infrastructure is of unique nature, it is not an asset or capital, but an enabler of all other assets, tangible and intangible, that supports them in their specific function in the enterprise’s value creation system. Since the contribution of the organizational infrastructure to productivity is essentially a reflection of managerial capabilities and their execution, the enterprise total factor productivity can serve as an objective basis to assess management’s capabilities and success. If for instance two companies, A and B, increase capital investment from 100 to 110 units, while A’s product grows 10 percent and B’s 20 percent, the conclusion is that B’s management was more capable than A’s. This approach to evaluate the enterprise total factor productivity, i.e. the efficiency of a companies’ organizational infrastructure, provides new valuation and control tools for managers and investors (Lev, 2002b). Measurement of enterprise total factor productivity To gain quantifiable insights into the value and impact of organizational infrastructure, Lev and Radhakrishnan (2002) developed a methodology for valuing company-specific organizational infrastructure. The estimation process is schematically depicted in Figure 5.

Figure 4 The value-creation chain based on the organizational infrastructure (Lev, 2002b)

THE ENABLER

RESOURCES PHYSICAL CAPITAL

LABOR

CUSTOMERS : Brands, Trademarks

INNOVATION: R&D, Adaptive Capacity

PRODUCTIVITY

PROFITS/VALUEADDED SHAREHOLDER VALUE

Figure 5 The valuation of organizational infrastructure (Lev, 2002b)

RESOURCES/INPUTS

Product Growth

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=

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Organizational X

Infrastructure

Lev and Radhakrishanan determined through statistical analysis for a sample of 300 public companies the contribution to revenue growth of the four major resources: physical assets, labor, brands, and R&D. The results show that some companies are more productive than others. They generate higher revenue growth from the same given level of resources than other comparable companies. Figures 6 and 7 show the average annual contribution of organizational infrastructure to product growth between 1995 and 1997 for some selected companies (dark bar) against subsequent stock performance over 1997-98 (bright bar). The measure of organizational infrastructure, i.e. enterprise total factor productivity, captures and shows the real growth potential, which leads in subsequent years to shareholder value creation. The organizational infrastructure measure seems to provide a far better insight into a company’s growth potential. The research by Radhakrishnan and Lev indicates that investment in the organizational infrastructure, in good management and good management systems, clearly pays.

Conclusion and outlook Productivity is the top priority of nations and business enterprises. Increased productivity of resources is the major driver of nations’ welfare (standard of living, employment), and of companies’ profits and shareholder value. But productivity management and optimization, as many believe, does not start with the valuation of individual intangibles, undoubtedly major drivers of growth and value. In fact, it should start with an understanding of the role intangibles

Figure 6 Organizational infrastructure and shareholder value – for selected chemical companies (Lev, 2002b)

Chemical

Dow Chemical Stock Return

E-TFP

Du Pont

FMC Corp

-1

-0.5

0

0.5 Return(97 to 99)

1

1.5

2

2.5

[OI(97)-OI(94)]/OI(94)

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Figure 7 Organizational infrastructure and shareholder value – for selected retail companies (Lev, 2002b)

Retail

Home Depot

Wal-Mart

K-Mart

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

0.8

Return(97 to 99) [OI(97)-OI(94)]/OI(94)

play in the overall ‘‘value creation system’’ of an organization. Thus, the corporate organizational infrastructure as enabler for generating value added from input resources, both tangible and intangible, becomes the critical factor and driver of enterprise total factor productivity. Macroeconomic studies estimate that about one-third of the differences in income per capita among countries comes from differences in capital, and the remaining two-thirds from efficiency differences (Clark and Feenstra, 2001). That efficiency is also the major source of differences in the performance of business enterprises. Corporate executives that are interested in measuring the performance of their business as a whole should therefore pay more attention to the total factor productivity of their company and its major driver: the efficiency of the organizational infrastructure. The above-described concept of organizational infrastructure provides a measure of enterprise efficiency relative to others. Thus, it can also be used to support management in optimizing the total factor productivity of their enterprise. Correlation analysis between an enterprise’s total factor productivity and a set of detailed key performance indicators for the major operational value drivers and value creation processes, as presented in the Tableau de Bord above, might help to identify the major levers for value creation. This type of analysis might become an integral part of a company’s performance management process in the future: a institutionalized check in the analysis and planning phase to identify in a systematic way optimization opportunities from a total factor productivity perspective. This will allow a company to constantly optimize its enterprise total factor productivity. It will also enable it to adapt its business processes and business model to changes in the market place, which usually causes disruptions in its value creation system, without loosing productivity or to at least to regain quickly the former

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productivity level. The above outlined approach could contribute to standardized measurement and reporting of how intangibles drive performance. In the long-run, when companies disclose such measures more widely, this approach would allow us to perform more detailed macro-economic research to further investigate the value creation of intangibles.

References Clark, G. and Feenstra, R. (2001), ‘‘Technology in the great divergence’’, in Davis (Ed.), National Bureau of Economic Research: Working Paper No. 8596, p. 5 (www.nber.org/books/global/clark-feenstra10-18-01.pdf). Daum, J.H. (2002), Intangible Assets and Value Creation, Wiley, Chichester, 2002. Daum, J.H. (2003a), ‘‘Intellectual Capital Statements: Basis fu¨r ein Rechnungswesen- und Reportingmodell der Zukunft?’’, Controlling, 15. Jg., Mu¨nchen, No. 3, p. 143-53. Daum, J.H. (2003b), ‘‘Intangible Assets und die Optimierung der Enterprise Total Factor Productivity’’, Controlling and Management, 47. Jg., Wiesbaden, No. 2, p. 129-35. FASB (2001), FASB Business Reporting Research Project, Improving Business Reporting: Insights into Enhancing Voluntary Disclosures, Norwalk (http://www.fasb.org/brrp/BRRP2.pdf). Epstein, M.J. and Manzoni, J.-F. (1997), ‘‘Translating strategy into action’’, The Balanced Scorecard and Tableau de Bord, Vol. 79 No. 2, pp. 28-36. Gray, J. and Pesqueux, Y. (1993), ‘‘Evolutions actuelles des syste`mes de tableau de bord. Comparaison des pratiques de quelques multinationales ame´ricaines et francaises’’, Revue Francaise de Comptabilite´, February 1993, pp. 61-70. Hand, J. and Lev, B. (2003), Intangible Assets: Values, Measures, and Risks, Oxford University Press, Oxford, UK. Lev, B. (2001), Intangibles: Management, Measurement, and Reporting, Washington, DC. Lev, B. (2002a), ‘‘The importance of organizational Infrastructure (OI)’’, Financial Executive Magazine, July/ August. Lev, B. (2002b), ‘‘Intangibles at a crossroads: what’s next?’’, Financial Executive Magazine, March/April. Lev, B. and Aboody, D. (2001), R&D Productivity in the Chemical Industry, New York, NY (http:// pages.stern.nyu.edu/~blev/chemical-industry.doc). Lev, B. and Radhakrishnan, S. (2002), ‘‘Structural capital’’, Working paper (www.baruch-lev.com). Marr, B., Mouritsen, J. and Bukh, P.N. (2003), ‘‘Perceived wisdom’’, Financial Management, July/August, p. 32 Nakamura, L. (2003), ‘‘A trillion dollars a year in intangible investment and the new economy’’, in Hand, J. and Lev, B. (Eds), Intangible Assets: Values, Measures and Risks, Oxford University Press, pp. 19-47. Neely, A., Marr, B., Roos, G., Pike, S. and Gupta, O. (2003), ‘‘Towards the third generation of performance measurement’’, Controlling, Vol. 3 No. 4, pp. 61-7. DiPiazza, S.A. Jr. and Eccles, R.G. (2002), Building Public Trust: The Future of Corporate Reporting, New York, NY. SEC Taskforce (2001), Strengthening Financial Markets: Do Investors Have the Information They Need?, New York, NY (www.fei.org/finrep/files/SEC-Taskforce-Final-6-6-2k1.pdf).

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Measuring knowledge assets – implications of the knowledge economy for performance measurement Bernard Marr and J.-C. Spender

Bernard Marr is at the Centre for Business Performance, Cranfield School of Management, UK. Tel: (44) 01234 75 11 22, E-mail: [email protected] J.-C. Spender is at the Open University Business School, Milton Keynes, UK. Tel: (1) 212 751-5132, E-mail: [email protected]

Abstract The business world has enthusiastically adopted the idea that knowledge has become the most strategic of corporate assets, the principal basis for competitive advantage. This enthusiasm has not, however, been matched by an understanding of how to operationalize knowledge. It seems we argue that knowledge is important largely because it is a different kind of asset. While this is perplexing and suggests that it is important to understand the strategic significance of the different kinds of organizational knowledge, it also raises operational issues for managers. How are they to identify knowledge assets, and measure them? We offer tentative proposals for a new approach to assets evaluation. Keywords Knowledge management, Intellectual capital, Assets valuation

Introduction Knowledge is the most important source of competitive advantage – at least that is what many scholars and managers now tell us. Terms and ideas such as knowledge management, the information age or even the knowledge-based theory of the firm have emerged over the past decade (Bell, 1999; Prusak, 2001). They match recent significant developments in management theory and practice, especially the increased application of information technology (IT) to handle organizational knowledge. It is reported that annual expenditures on IT are running at over $600 billion in the USA and $2 trillion globally (Brown and Brudney, 2003). Over 81 per cent of the leading businesses in Europe and the USA report they are actively engaged in KM activities (Cabrera and Cabrera, 2002). But plainly this attention to the organization’s knowledge is not a new phenomenon – organizations have always depended on knowledge. Bureaucracy is sometimes defined as organization on the basis of knowledge. Likewise organizations have always relied on innovative ideas and the knowledge of their employees for their competitive advantage. It is often suggested that we live in a new knowledge-intensive period. Though, if we look at the history of ideas (e.g. Menand, 2001) the 19th century seemed as fertile a time for new knowledge and resulting social change as does the present. We can also see that the pattern of social change and development of commercial knowledge in, as a well researched example, Philadelphia USA, at the start of the 20th century, was probably as tumultuous as in our own time (Freeman et al., 1992; Spender and Kijne, 1996). But the manipulation of knowledge and information – the fundamental characteristic of the tertiary sector – is plainly overtaking the manipulation of metal, the essence of the secondary sector, as the source of economic value (Reich, 1992). Much of this is evident in the growth of

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DOI 10.1108/13683040410524702

the service sector. But an even greater amount seems to be the result of the transformation of all sectors to be more knowledge- than capital-intensive. This has made today’s ‘‘business models’’ quite different from yesterdays and, as a result, today’s organizations strive to better understand and manage the relationship between what they know and their value delivery. There has never been a stronger interest in corporate performance management approaches, which use performance indicators to provide insights into organizational performance (Marr and Schiuma, 2003). This improved understanding of value creation can then be used as the basis for strategy creation or assessment, to motivate people to do the right things, and to communicate with external stakeholders (Marr et al., 2003). The realization that knowledge is an important factor for organizations and critical to their strategic advantage has given organizations new problems with their performance measurement and management. Managers want to understand how to manage and measure their knowledge based assets better while, at the same time, there is increasing pressure on managers to measure benefits and cost effectiveness of their organization’s knowledge management initiatives. In this article we discuss the important issue of how managers can measure the value of their organization’s knowledge. But before we discuss any approaches to measure or manage knowledge we will analyze the increased importance of knowledge in today’s business environment. We will then outline the evolution of knowledge in a business context. It is seen as a review of the state of the art in the field before we draw up implications of this for corporate performance management and measurement and provide our look into the future.

Is knowledge more important to organizations today? The business environment has changed over the past decades. Whereas after the two world wars there were booms, creating a sellers’ market, in most of the developed countries global trade has gradually changed this towards a buyers’ market. Such markets do not absorb all goods produced, they are saturated. Consumers are better informed and more demanding. Differentiation and innovation become critical. This also means that traditional cost-focused management tools do not provide managers with adequate information. Understanding of the external competitive forces has to be supplemented by an understanding of the organizations resources and how they can be combined to provide better value.

The general trends include increased globalization. The economic world is ‘‘shrinking’ and access to tangible resources does not alone provide a sustainable competitive advantage. Traditional assets are increasingly transient. So is technical knowledge. There is improved access to information and knowledge through vastly greater amounts of information technology, most notably the Internet. The increasing collaboration between firms means that firm boundaries are increasingly blurred. Economists and management scholars have reacted to some of the issues by putting forward new theories of the firm. In 1959 Drucker defined knowledge as an important resource. Machlup (1966) was the first modern economist to analyze knowledge and related areas. In 1977 Teece published the results of new research on the transfer of knowledge and its impact on innovation. Following the work of economists like Solow (1956) and Arrow (1962) on ‘‘learning curves’’ there was growing interest in knowledge as a different kind of economic resource. Nonaka and Takeuchi (1985) helped crystallize this with their book about ‘‘the knowledge creating company’’. Their thesis is that the one sure source of lasting competitive advantage is knowledge. They draw particular attention to the more tacit dimensions of knowledge. The key theories and their contribution to how organizational knowledge is framed are outlined below. J Evolutionary views. J Resource-based views. J Knowledge-based views.

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Managers realize that when formulating a corporate strategy it is not enough to simply identify the competitive forces, opportunities, and threats of the industry as suggested by Porter (1980). In addition managers have to identify their organizations’ corporate competencies and resources in order to evaluate their strategic opportunities (Andrews, 1971). Different firms develop different distinctive competencies (Selznick, 1957) and the question they have to ask themselves is: does the organization have the appropriate competence to pursue particular opportunities? Andrews (1971) brings the strategic importance of competencies into focus when he states ‘‘opportunism without competence is a path to fairyland’’. This view of competence-based competition was framed by Penrose (1959) and later enhanced by Wernerfelt (1984), Rumelt (1984) and Barney (1986) who are now generally seen as formulators of the modern resource-based view of the firm (Foss, 1997). The resource-based theorists see firms as heterogeneous entities characterized by a unique resource base (Nelson and Winter, 1982; Barney, 1991). This base increasingly consists of knowledge based assets (Stewart, 1997; Roos et al., 1997; Lev, 2001; Sveiby, 2001, 1997; Marr and Schiuma, 2001). The knowledge of a firm should be the central consideration on which to ground the organization’s strategy and the primary basis on which a firm can establish its identity and frame its strategy, as well as one of the primary sources of the firm’s profitability (Grant, 1991). Therefore, firms need to identify and develop their intellectual resources in order to establish and maintain a competitive advantage and to increase their performance (Petergraf, 1993; Prahalad and Hamel, 1990; Teece et al., 1997). This has led to the development of the knowledge-based view of the firm that considers knowledge as the principal source of economic rent (Grant, 1991; Grant and Spender, 1996; Spender, 1994).

The evolution of knowledge in business Below we give a brief overview of the evolution of the theory of knowledge as a resource for organizations. It is less a review of the historic sequence of events and more an outline of the evolution of concepts. Our intention is to highlight the shift of interest from data as an organizational asset towards information and finally knowledge. In our brief discussion we intend to link the dissimilar concepts to the differences in management concepts and theories of the firm. Initially the view of knowledge was driven by everyday usage and information technology, an implicitly positivistic approach that emphasized the creation of data through measurement, and its capture and storage. There was a strong link with IT as a document and information management system. The data-intensive theory of the firm spun around bureaucratic rationality and a view of the organization as a machine. Data was first generated and then stored as input for the production process. But as business uncertainty increased the self-evident nature of data was challenged. A distinction was clarified between data and information – information is more than data. Approaches to the management of knowledge moved away from the data storing towards capturing and mapping information. This was a more interpretive approach that involved elements of sense-making as well as psychological and socio-psychological aspects of information (Weick, 1979, 1995). Davenport and Prusak (1998) went one step further and argued that knowledge is neither data nor information, and that the difference between them is often a matter of degree. In their definition data is described as structured records of transactions, whereas information has the character of a message with a sender and a receiver. Human agency is implied at both ends of the communication. Information must inform; it is data that changes the receiver’s perceptions. Knowledge is a fluid mix of framed experience, values, contextual information, and expert insight that provides a framework for evaluating and incorporating new experiences and information. It originates in and is applied in the mind of the knower. In organizations, it often becomes embedded not only in documents or similar inorganic forms and repositories but also in human forms such as organizational routines, processes, practices, and norms.

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This view of knowledge in closely aligned with an open systems approach and an organic view of the firm. It supports the evolutionary concepts of the firm where knowledge is path dependent. Today this discussion about the nature and creation of knowledge continues on a more epistemological level (e.g. von Krogh et al., 2000). It is clear that there has been little attempt to identify the ways the different views of knowledge resources (data, information, knowledge) impact the means we must employ to measure and manage these knowledge resources in our organizations.

What are the implications for organizational performance measurement? In the following section we review some to the approaches to measuring and managing knowledge and how they might relate to some of the above views on organizational knowledge resources. Positivistic view of organizational knowledge assets The positivistic view of data as a knowledge-based asset would allow us to economically value the existing stock of knowledge-assets and to account for them similarly to financial assets in financial statements. One of such approaches is human resource accounting (HRA) which was introduced several decades ago with the intent of assessing and quantifying the economic value of employees and their knowledge in order to facilitate better managerial decision making (Sackmann et al., 1989). Bontis et al. (1999) report that none of the HRA experiments have been a long-run success, that too many assumptions have to be made of which some violate common sense. Another approach is the Tobin’s q (Brainard and Tobin, 1968; Lerner, 1944). It approximates the ratio of the market value of the firm to the replacement cost of its assets. If the latter is lower than the former than the company concerned is making higher than normal return on its investment. Knowledge-based assets are traditionally associated with high ‘‘q’’ values. However, it is difficult if not impossible to find these replacement costs for knowledge-based assets.

Economic value added (EVA), trademarked by Stern Steward and Co., is often suggested as a more comprehensive performance measurement approach by subtracting operating expenses, taxes and capital charges from the net sales. It has been suggested to use EVA as a substitute measure for the return on organizational intellectual resources (Marchant and Barsky, 1997). In order to accurately reflect organizational reality it would be necessary to include up to 164 areas of adjustments which increases the complexity as well as its vulnerability (Bontis et al., 1999). More importantly, EVA uses book values of assets as the basis of their calculations. The problem with this approach is that when it comes to knowledge assets, we do not have any book value, and nor do we have accurate surrogates such as market value or replacement value. Interpretive view of organizational knowledge assets The interpretive view of information as a knowledge-based asset would allow us create causal relationships of how information is an input for other higher-level objectives. Knowledge assets are seen as data combined with the meaning that would allow organizations to use it as a factor of production. A tool fitting into this paradigm is the balanced scorecard (BSC) with its four measurement perspectives – learning and growth, internal processes, customers, and financial (Kaplan and Norton, 1992, 1996). The learning and growth perspective would be the natural home for indicators measuring knowledge-based assets – even though Bontis et al. (1999) suggest that the meaning of this perspective is not very clear as it includes IT, technology, as well as human based assets. Especially the latest publications on the BSC suggest that instead of just being a collection of measures in four perspectives causal links between the different measures should be established

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and visualized in so called strategy maps (Kaplan and Norton, 2000, 2003). However, there has been criticism about this approach claiming that the assumed relationships in the balanced scorecard are logical rather than causal (Norreklit, 2000, 2003). Other models based on BSC type approaches such as the Skandia Navigator (Edvinsson and Malone, 1997), the Intangible Asset Monitor (Sveiby, 1997), and Ericsson Cockpit Communicator would all fall into this category. However, the argument of simply mapping performance drivers and outcomes seems to be challenged by theories put forward by the resource-based view of the firm (Wernerfelt, 1984; Rumelt, 1984; Barney, 1991). Penrose (1959), for example, argues that resources or assets of firms exist as a bundle, and others state (Dierickx and Cool, 1989; Lippman and Rumelt, 1982), that these resource bundles impact performance with causal ambiguity and that it is difficult to identify how individual resources contribute to success without taking into account the interdependencies with other assets (Alchian and Demsetz, 1972).

Organic view of organizational knowledge assets The organic view of knowledge as a resource views knowledge as a dynamic and tentative combination of data, meaning, and the ability to generate proficient practice. It is a more dynamic view of knowledge in action that implies embedded skills, organizational routines and a susceptibility to path dependency. The puzzle, of course, lies in the relationships between these three knowledge types. Nonaka and Takeuchi presume the interchangeability of explicit and tacit knowledge. Roos and Roos (1997) highlight the need for information on the transformations from one intellectual capital category into another suggesting interdependencies between knowledge-based assets. Lev (2001) notes that intangibles including knowledge are frequently embedded in physical assets and in labor (the tacit knowledge of employees), leading to considerable interactions between tangible and intellectual assets in the creation of value. Spender (1996) argues that managers, in pursuit of the organization’s rationale and identity, must create contextually-contingent syntheses between his four types of knowledge. If there is more than one type of knowledge, it follows that each type may have to be measured separately. Ways to address this complexity in measurement includes intellectual capital statements which provide a narrative approach that tries to capture the interdependencies (MERITUM, 2002; Mouritsen et al., 2002). The narrative format allows organizations to express the value of their knowledge-based resources and how they interact with other knowledgebased assets to create value. They can then outline their knowledge management initiatives, allowing them to consider a set of measures to track the implementation and evaluate its impact. Dynamic visualization approaches such as the navigator approach (for example see Gupta and Roos, 2001; Marr et al., 2003) or the value creation map (Marr et al., 2004) extend the cognitive mapping techniques offered by Eden and Spender (1998) and suggest it is possible to map direct as well as indirect dependencies reflecting the embeddedness and path dependency of knowledge-based assets. The navigator model is a conceptual map that depicts the presence and importance of tangible and intangible resources and the transformations of these resources in accordance with achieving the organization’s strategic intent (Neely et al., 2003). In the navigator (Figure 1) the size of the circles represents the stocks of resources ranked according to their relative importance to the strategic objectives and the width of the arrows represents the importance of the transformations from one resource into others, again in accordance with the strategic objectives. The value creation map follows the same logic but focuses on the knowledge-based assets and the way they interact to directly and indirectly contribute to value creation. A summary of the different understandings of knowledge together with the associated concepts of management, theories of the firm as well as measurement approaches is presented in Table I.

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Figure 1 Navigator model (source Neely et al., 2003)

Table I Views on knowledge and associated measurement approaches KM topic/context

Concept of management

Theory of the firm

Measurement approach

Data (both rules and measurements)

Positivistic (rational decision-making)

Machine (bureaucratic rationality)

Economic valuation of IC

Meaning (information)

Interpretive approaches, sense-making, psychological and socio-psychological views

Cognitive lenses, metaphors, expectations

Cause and effect, strategy maps, scorecards

Practice, activity systems, collaboration, (proficient practice)

Open systems approaches, organic view

Activity networks, action research, evolutionary concepts, path dependency

Mapping of dependent and independent relationships/narratives/ pattern recognition/ complex systems

Knowledge measures, and their philosophical underpinnings The suggestion that there are three rather different types of knowledge assets – positivistic, interpretive, and organic – implies three substantially different approaches to their measurement. While there are some indications of the possible ways of addressing these differences in the previous section, it may be important to get back to the basic philosophical differences between these types of knowledge. One of the principal assumptions behind the positivist approach is that there is a knowable reality. Knowledge comprises justified true beliefs about this reality. This relationship between the knower and reality is reflected in the definition of the organization as purposive and goaloriented. The organization’s goals are the reality to which it is striving. Thus the positivistic type

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of knowledge needs to be measured against the organization’s goals. These are established prior to the organization’s planning and implementation processes, and are, in this sense, independent of them. The interpretivist approach, in contrast, emerges after the organization and its processes. This type of knowledge is constructed by those observing and experiencing the organization and its processes, it is the result of the managers working to make sense of what they observe. It is knowledge that is anchored in the mangers themselves and in their experience rather than in the organization’s prior goals. It is immediately clear that the knowledge demands of the positivist approach are considerably more severe than those of the interpretive approach. The first emphasizes stability and a notion of change within an established frame of analysis. The second is more flexible. As business uncertainty increases it is likely that the first will eventually fail as managers are unable to tease out the complex causal links that give rise to the organization’s results. As a result they will be driven back to trying to make the best sense possible of what is happening, no longer struggling to understand the entire situation. Simon’s (1957) notion of ‘‘satisficing’’ embodies this idea. We see the interpretive approach makes the assumption that management’s knowledge – and, as a result, that of the organization itself – is incomplete. The approach is itself a way of dealing with such incomplete knowledge. Here the criteria against which one can measure the knowledge is obviously not ‘‘the truth’’, for that is dismissed by assumption as unknowable. Rather the test of the knowledge’s quality is an experienced based sense of improvement and understanding – do we understand the situation better than we did? The organization’s knowledge is tentative, as is the positivist’s, but it is not being exposed to falsification. Rather it is being constructed by analyzing the organization’s experiences and applied as the basis for the plan for the next time period. Then it is measured against the next best alternative, not against a theoretically determined optimum. While the positivistic approach focuses on such an optimal outcome, the interpretive approach sub-optimizes. The organic approach to knowledge takes this separation from the situation of total understanding a step further. To consider the organization ‘‘organic’’ is to endow it with behaviors and characteristics of its own, which are not the immediate result of management’s plans. These are readily familiar to us as the unintended consequences of our plans. The key here is not simply the managers’ lack of complete understanding, rather it is there lack of total control over the organization. The criteria against which the mangers’ and the organization’s knowledge must be measured is not that of total control, rather it is that of enough control to be able to move towards the planned outcomes.

Conclusions and final remarks In this article we have outlined the increasing importance of knowledge-based assets in today’s business environment. We offered an integrated set of ways in which knowledge is viewed as an organizational resource: data, information, and proficient practice. These views of organizational knowledge assets were then matched to some existing techniques for measuring knowledge assets in organizations. We believe that the organic view of organizational knowledge most closely reflects the organizational reality today and we hope to have laid the foundation for further discussion of approaches to measure knowledge assets that are embedded in organizational realities. It seems that the time has come to move on from the more simplistic view of data or information assets towards the more dynamic, path dependent, and complex role of knowledge in the value creation process of modern businesses.

References Alchian, A.A. and Demsetz, H. (1972), ‘‘Production, information costs, and economic organization’’, American Economic Review, Vol. 62, pp. 777-95. Andrews, K.R. (1971), The Concept of Corporate Strategy, Dow Jones-Irwin, Homewood, IL. Arrow, K. (1962), ‘‘The economic implications of learning by doing’’, Review of Economic Studies, Vol. 29 No. 3, pp. 155-73.

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Marr, B., Gray, D. and Neely, A. (2003), ‘‘Why do firms measure their intellectual capital’’, Journal of Intellectual Capital, Vol. 4 No. 4, pp. 441-64. Marr, B. and Schiuma, G. (2001), ‘‘Measuring and managing intellectual capital and knowledge assets in new economy organisations’’, in Bourne, M. (Ed.), Handbook of Performance Measurement, Gee, London. Marr, B. and Schiuma, G. (2003), ‘‘Business performance measurement – past, present, and future’’, Management Decision, Vol. 41 No. 8, pp. 680-7. Marr, B., Gupta, O., Pike, S. and Roos, G. (2003), ‘‘Intellectual capital and knowledge management effectiveness’’, Management Decision, Vol. 42 No. 8, pp. 771-81. Marr, B., Schiuma, G. and Neely, A. (2004), ‘‘The dynamics of value creation: mapping your intellectual performance drivers, Journal of Intellectual Capital (forthcoming). Menand, L. (2001), The Metaphysical Club: A Story of Ideas in America, Farrar, Straus and Giroux, New York, NY. MERITUM Guidelines (2002), Guidelines for Managing and Reporting on Intangibles, Madrid. Mouritsen, J., Bukh, P.N., Larsen, H.T. and Johnson, T.H. (2002), ‘‘Developing and managing knowledge through intellectual capital statements’’, Journal of Intellectual Capital, Vol. 3 No. 1, pp. 10-29. Neely, A., Marr, B., Roos, G., Pike, S. and Gupta, O. (2003), ‘‘Towards the third generation of performance measurement’’, Controlling, Vol. 3/4, March/April, pp. 61-7. Nelson, R.R. and Winter, S.G. (1982), An Evolutionary Theory of Economic Change, Harvard University Press, Cambridge, MA. Nonaka, I. and Takeuchi, H. (1995), The Knowledge-Creating Company: How Japanese Companies Create the Dynamics of Innovation, Oxford University Press, New York, NY. Norreklit, H. (2000), ‘‘The balance on the balanced scorecard – a critical analysis of some of its assumptions’’, Management Accounting Research, Vol. 11 No. 1, pp. 65-88. Norreklit, H. (2003), ‘‘The balanced scorecard: what is the score? A rhetorical analysis of the balanced scorecard’’, Accounting, Organizations and Society, Vol. 28 No. 6, pp. 591-619. Penrose, E.T. (1959), The Theory of the Growth of the Firm, John Wiley, New York, NY. Petergraf, M.A. (1993), ‘‘The cornerstones of competitive advantage: a resource-based view’’, Strategic Management Journal, Vol. 14, pp. 179-88. Porter, M.E. (1980), Competitive Strategy, Free Press, New York, NY. Prahalad, C.K. and Hamel, G. (1990), ‘‘The core competence of the corporation’’, Harvard Business Review, Vol. 68 No. 3, pp. 79-91. Prusak, L. (2001), ‘‘Where did knowledge management come from?’’, IBM Systems Journal, Vol. 40 No. 4, pp. 1002-6. Reich, R.B. (1992), The Work of Nations: Preparing Ourselves for 21st Century Capitalism, Vintage Books, New York, NY. Roos, G. and Roos, J. (1997), ‘‘Measuring your company’s intellectual performance’’, Long Range Planning, Vol. 30 No. 3, p. 325. Roos, J., Roos, G., Dragonetti, N.C. and Edvinsson, L. (1997), Intellectual Capital: Navigating the New Business Landscape, Macmillan, London. Rumelt, R.P. (1984), ‘‘Towards a strategic theory of the firm’’, in Lamp, R.B. (Ed.), Competitive Strategic Management, Prentice Hall, NJ, Sackmann, S., Flamholz, E. and Bullen, M. (1989), ‘‘Human resource accounting: a state of the art review’’, Journal of Accounting Literature, Vol. 8, pp. 23-264. Selznick, P. (1957), Leadership in Administration, Harper and Row, New York, NY. Solow, R.M. (1957), ‘‘Technical change and the aggregate production function’’, Review of Economics and Statistics, Vol. 39, pp. 312-20. Spender, J.-C. (1994), ‘‘Organizational knowledge, collective practice and Penrose rents’’, International Business Review, Vol. 3 No. 4, pp. 353-67.

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Spender, J.-C. (1996a), ‘‘Competitive advantage from tacit knowledge? unpacking the concept and its strategic implications’’, in Moingeon, B. and Edmondson, A. (Eds), Organizational Learning and Competitive Advantage, pp. 56-73, Sage Publications, Thousand Oaks, CA. Spender, J.-C. (1996b), ‘‘Villain, victim or visionary?: F.W.Taylor’s contributions to organization theory’’, in Spender, J.-C. and Kijne, H. (Eds), Scientific Management: Frederick Winslow Taylor’s Gift to the World?, pp. 1-31, Kluwer, Norwell, MA. Spender, J.-C. and Grant, R.M. (1996), ‘‘Knowledge and the firm: overview’’, Strategic Management Journal, Vol. 17, pp. 5-9. Stewart, T.A. (1997), Intellectual Capital: The New Wealth of Organizations, Doubleday/Currency, New York, NY. Sveiby, K.E. (1997), ‘‘The intangible assets monitor’’, Journal of Human Resource Costing and Accounting, Vol. 2 No. 1. Sveiby, K.E. (2001), ‘‘A knowledge-based theory of the firm to guide in strategy formulation’’, Journal of Intellectual Capital, Vol. 2 No. 4. Teece, D.J. (1977), ‘‘Technology transfer by multinational firms: the resource cost of international technology transfer’’, Economic Journal, Vol. 87, pp. 242-61. Teece, D.J., Pisano, G. and Shuen, A. (1997), ‘‘Dynamic capabilities and strategic management’’, Strategic Management Journal, Vol. 18 No. 7, pp. 509-33. von Krogh, G., Ichijo, K. and Nonaka, I. (2000), Enabling Knowledge Creation: How to Unlock the Mystery of Tacit Knowledge and Release the Power of Innovation, Oxford University Press, New York, NY. Wernerfelt, B. (1984), ‘‘A resource based view of the firm’’, Strategic Management Journal, Vol. 5 No. 3, pp. 171-80. Weick, K.E. (1979), Social Psychology of Organizing (2nd edition), Addison-Wesley, Reading, MA. Weick, K.E. (1995), Sensemaking in Organizations, Sage Publications, Thousand Oaks, CA.

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Human resource management and business performance measurement G. Roos, Lisa Fernstro¨m and S. Pike

Go¨ran Roos is Chairman of ICS Limited, London, UK. Tel: +44 (0) 207 067 2920, E-mail: [email protected] Lisa Fernstro¨m is at Intellectual Capital Services Limited, London, UK. Tel: +44 (0) 20 7067 2920, E-mail: [email protected] Stephen Pike is Director of R&D, ICS Limited, London, UK. Tel: +44 (0) 207 067 2967, E-mail: [email protected]

Abstract The purpose of this paper is to review the research into the relationship between human resource management (HRM) and business performance. The paper examines the change of the HR function into HRM taking on its current strategic role. Recent work on the links between HRM and business performance is reviewed highlighting the conclusion that while the links are not disputed by researchers using a variety of approaches, the ability to characterize definitive causal links has proved almost impossible. The techniques and resource-based approach of intellectual capital (IC) may provide the key to quantifying the links but again, work to date has proved that it may not be possible to clearly separate HRM from other management actions to quantify the effects of HRM. A solution based on the IC approach involving rigorous measurement is suggested. Keywords Human resource management, Business performance, Intellectual capital, Measurement

Introduction For as long as one person has been engaged in furthering the aims of another, the employer has been concerned with ways of motivating the employee to maximize the effectiveness of the enterprise. While this is true of all enterprises, it has been especially true of the military. At the company level, the work of Fayol (1916) in France and Taylor (1911) in the USA represent the earliest attempts to put management on a more scientific standing and improve the efficiency of companies through better management of their resources and operations. Both Fayol and Taylor tended to concentrate on the activities and processes of companies but their recognition of the employee is visible. Human resource management (HRM) has gone through a number of stages and towards the end of the last century, the shift away from being a cost center to a player in an internal market heralded a new phase in large company HR in which accountability to the company was of prime importance. Coinciding with this change was the rise of new ways of looking at the company, such as the resource-based view of the company as described by Barney (1991), and the more strategic view of the company championed by the intellectual capital (IC) movement. It was now not enough for the HR function of the company to just ‘‘pay its way’’ as an integral operational part of the company. From now on, its role was to be strategic and the concept of strategic human resource management (SHRM) was born.

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DOI 10.1108/13683040410524711

The role of SHRM There is no consensus definition of SHRM but in general SHRM is concerned with the decision grounds about human resource practices, the composition and behaviors of the human resources, and the effectiveness of these decisions given various business strategy and/or competitive situations where the link to strategic management is significant (Wright and McMahan, 1990). SHRM is seen as strategic and political whereas HRM has concentrated in the past on being technically correct. Traditionally, the role of the human resource professional has been to serve as the systematizing, policing arm of executive management. In this role, the HR function served executive agendas well, but has been frequently viewed as a roadblock by much of the rest of the organization. While some need for this role occasionally remains, much of the HR role is transforming itself. To make the changed function effective and relevant requires considerable change since the trend in successful organizations is to become more adaptable, resilient, and customer-centered. Within this environment, the HR function is considered necessary by functional managers, is an employee sponsor or advocate but most importantly, is part of the strategic planning process. Effective HRM is no longer concerned with simply executing a standard set of policies and procedures. Rather, it requires questioning and understanding the relationships between choices in managing people, the strategies and goals of the organization and the possibilities presented by the external environment. HRM requires searching for sets of policies and practices that have a reasonable chance of producing capabilities that are valuable to the company. Organizations choosing policies characteristic of the high-performance workplace, must take a strategic view and be clear about the objectives of the organization, the costs of introducing the program, and the value of the new capabilities the program is expected to create (Hunter, 2002). HRM must assist in the connection of the external and internal environments of the company since competitive environment features rapid technological change and knowledge about the emerging environment is held, to an increasing extent, in the heads of people.

This path is not necessarily easy to follow but it is a prerequisite for organizations if they are to manage human resources effectively. The process may also be frustrating, for many answers will not be readily found or expressed, e.g. the costs and benefits of particular approaches cannot be known with certainty. The future of HRM does not lie in progressive initiatives unconnected to business goals or organizational and environmental realities, neither in the production of standardized sets of best practices. Rather, it lies in ensuring that the choices made in managing people are made sensibly with clear strategic purposes in mind. A significant issue in HR strategy is that of integration with overall business strategy, which in practice is difficult to achieve. A way of handling this problem is for human resource practitioners to achieve an understanding of how business strategies are formed. This involves understanding corporate intentions for growth or retrenchment and methods of increasing competitiveness. They should also gain insight into the perceived need for a more positive, performance-oriented culture and other cultural consequences of an organization’s mission such as commitment, mutuality, communications, involvement, devolution and team working.

Impact of HRM on company performance While the literature available on HRM practices is very extensive indeed, it is largely conceptual and concludes that HRM practices can help to create sustained competitive advantage, especially when they are aligned with a firm’s competitive strategy. There is thus, surprisingly little that actually connects HRM practices with the performance of the business overall. Work that has been carried out in the area has tended to attempt connecting the use of modern HR practices with shareholder return, turnover or some other financial measure by means of techniques like factor analysis.

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One of the best analyses of the company gains from high performance work practices is that of Huselid (1995). He sought to evaluate the links between systems of these practices and company performance. The assumption is that more effective systems of HRM practices, which simultaneously exploit the potential for complementarities or synergies and help to implement a firm’s competitive strategy, are sources of sustained competitive advantage. Huselid’s study contributed significantly in three ways: 1. The level of analysis used to estimate the firm-level impact of HRM practices is the system, and the perspective is strategic rather than functional. 2. The analytical focus is comprehensive. The dependent variables include both intermediate employment outcomes and company-level measures of financial performance, and the results are based on a national sample of companies from different industries. 3. The study provides a test of the prediction that the impact of high performance work practices on firm performance is contingent on both the degree of internal fit, among these practices and the degree of external fit between a company’s system of such practices and its competitive strategy. Interest in the belief that individual employee performance affects company outcomes has intensified as scholars have begun to argue that a company’s employees also provide a unique source of competitive advantage that is difficult for its competitors to replicate. For example, Wright and McMahan (1992), drawing on Barney’s (1991) resource-based theory of the firm, contended that human resources can provide a source of sustained competitive advantage when four basic requirements are met. First, they must add value to the company’s production processes, and second, the skills that the firm seeks must be rare. Since human performance is normally distributed, all human resources meet both of these criteria. The third criterion is that the combined human capital investments a company’s employees cannot be easily imitated. Finally, a company’s human resources must not be subject to replacement by technological advances or other substitutes if they are to provide a source of sustainable competitive advantage. Wright and McMahan’s work points to the importance of human resources in the creation of company-specific competitive advantage. The issue is then whether companies can take advantage of this potential source of profitability. Bailey (1993) contended that human resources are frequently ‘‘under-utilized’’ because employees often perform below their maximum potential and that organizational efforts to elicit discretionary effort from employees are likely to provide returns in excess of any relevant costs. Bailey argued that HRM practices can affect such discretionary effort through their influence over employee skills and motivation and through organizational structures that provide employees with the ability to control how their roles are performed. Cross-functional teams, job rotation, and quality circles are examples of such structures. HRM practices influence the development of a company’s human capital. Recruiting procedures and reliable selection processes will have a substantial influence over the quality and type of skills new employees possess and training further influences development. However, the effectiveness of even highly skilled employees will be limited if they are not motivated to perform and HRM practices can affect employee motivation by encouraging them to work both harder and smarter. Examples of ways to direct and motivate employee behavior include the use of modern performance appraisals that assess individual or work group performance, linking these appraisals tightly with incentive compensation systems and the use of internal promotion systems that focus on employee merit. Given the link between employee behavior, HRM and company performance, a company’s HRM practices should be related to at least two dimensions of its performance. First, superior HRM practices should directly affect intermediate outcomes, such as turnover and productivity since employees have direct control over them. Second, if the returns from HRM investments practices exceed their costs, then lower employee turnover and greater productivity should in turn enhance corporate financial performance. Huselid’s study provides

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broad evidence that there is considerable support for the hypothesis that investments in such practices are associated with lower employee turnover and greater productivity and corporate financial performance. Guest and Peccei (2002) explored the operation of partnership systems at work conceptualized as systems of cooperative exchange between management and labor in organizations. They developed a model proposing that trust, exchange and cooperation are central mechanisms underlying the effective operation of partnership systems. This includes the idea that management and labor, by engaging in mutually beneficial forms of cooperative behavior in organizations, can contribute to the development of potentially self-reinforcing high trust-high performance partnership systems. While recent research suggests that consistency among practices matters for companylevel performance, the evidence is sparse, and in many cases limited to particular industries (Ichniowski et al., 1997). Excepting the work of Ichniowski et al. (1997) and Laursen and Foss (2000) the effect of HRM practices has been examined on an individual work practice basis. However, if Edgeworth complementarities (i.e. doing more of one thing increases the returns of doing more of other things) obtain, the effectiveness of HRM practices will be greater, when applied in systems rather than alone. Laursen (2000) contended that theoretical analysis had focused almost exclusively on identifying complementarities between organizational practices invariant to the type of activity. Another aspect of HRM is that new HRM practices can assist innovative activity, e.g. by decreasing centralization. This amounts to delegating rights so that they are co-located with the knowledge holders, much of which is inherently tacit. The increased use of teams – an important component in new HRM practices – also means that better use can be made of local knowledge, leading to improvements in products and processes. Generally, increased knowledge diffusion, for example, through job rotation and IT may also be expected to provide a positive contribution to innovation.

Scorecard approaches linked to business performance In the 1980s and 1990s, a lot of work investigating business process architectures and models was carried out. Hammer and Champy (1993) devised the CIMOSA approach (computer integrated manufacturing open system architecture), a business process architecture that classifies business processes as management processes, operational processes and support processes. Within this architecture, HRM is classified as a support process together with finance and IT. Therefore there is a need to understand HRM as a business process in order to improve manufacturing performance. The other four models most commonly accepted from the literature include: 1. The Michigan model (Fombrun et al., 1984), consisting of strategic management and environmental pressures, and the human resource cycle. 2. The Harvard model (Beer et al., 1984) consisting of the two parts ‘‘Human resource system’’ and ‘‘A map of the HRM territory’’. 3. Guest model (Guest, 1987) involving four policies to achieve four main HR outcomes these outcomes will lead to desirable organizational outcomes and is similar to the Harvard model. 4. The Warwick model (Hendry and Pettigrew, 1992) consisting of inner and outer context with emphasis on strategy and is based on the Harvard model. These models work well as HRM process guides but are weak on their influence on company performance. In the preceding section, the connection between the use of sets of HRM practices and improved business performance is also demonstrated but the connection to the processes is weak. Thus it can be concluded that the there are useful HRM models and their use improves business performance but it is not known how in detail. In this section, scorecardbased models of HRM will be briefly discussed. The strategic labor allocation process (SLAP) (Bax, 1999), is a resource-based model with value creation in the market as its ultimate aim. In the SLAP-model, distinctive competencies are the

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crucial elements of the organization’s (for profit or non-for-profit equally) business idea and can be directly linked to the labor allocation process. From a methodological point of view, the SLAP model represents an intermediate step between the more traditional models described above and possibilities of an IC approach. Both the SLAP model and IC are resource-based approaches and both are founded on the work of Barney (1991). IC is a holistic approach to business management and includes HRM, integrating it in the value creation map of the company. Despite this holistic viewpoint, a large number of attempts to measure human capital in isolation have been made. Because of the narrowness of their viewpoint, they will be unable to account for the true role human capital and HRM plays in improving business performance since they cannot explain all the salient links without going outside their area. The result of this is that most of the attempts to measure human capital in isolation have no defensible mechanism to underpin them and consequently rely on scorecards, often backed up by benchmarking, to assess the state of human capital management and HRM in companies. Arguably, the most important of these approaches is that of Fitz-Enz (2001), laying a foundation of a methodology for measuring the return on investment (ROI) of human capital by suggesting the ways in which such capital interacts with other aspects of IC to optimize the effectiveness of an enterprise. To estimate the ROI of human capital, Fitz-Enz relies primarily on quantitative metrics but also incorporates some perceptual measures into a scorecard model. This provides guidance on the design of objective and perceptual metrics at the enterprise level. Fitz-Enz claims that changes revealed by these metrics are a function of five indicators: cost, time, volume, errors, and human reactions. Fitz-Enz compares these indices with metrics for functional unit service, quality, and productivity to discover links between them. Based on this, Fitz-Enz proposes a comprehensive system of human capital valuation reporting. This system makes transparent the linkages among people, enterprise goals, and processes or functions and the effects of one on another. To this system, Fitz-Enz adds ‘‘futures’’ scorecards to predict what might be on the horizon and introduces the human capital financial index as another way to monitor changes in human capital revenue, cost, and profit. He then demonstrates how to find economic value in the workings of each of the most common human capital initiatives: restructuring of the HR unit, outsourcing, contingent workforce management, mergers and acquisitions, and benchmarking. A more process-orientated approach is that devised by Human Capital Dynamics (now called Human Capital Capability Inc.) and Cognitive Technologies Group. The end result of this is a scorecard but underpinning the scorecard structure is a three-tier model which has at its base human capital enablers (learning, governance, job design and time), resources (investment, staff, technology and content) and operations (process feedback, staffing, competency development and retention). These produce intermediate outcomes (workforce proficiency, workforce engagement, employee satisfaction, manager proficiency, customer satisfaction, turnover, time to competence and revenue from new products). At the top of the model is company financial performance which comprises income, sales growth, market share and stock performance. Whereas such a structure undoubtedly sets it apart from other scorecard approaches in that it has the ability to predict the effects of HRM actions, its inputs are incomplete with respect to the breadth of managerial actions available to the management team. It can be argued that company performance improvements could be obtained through changes in resource deployment other than human resources. Only the holistic structural models found in an IC system can do this. Becker et al. (2001) offer a scorecard methodology which has been operationalized by ‘‘HRScorecard.com’’. It is designed to give managers specific information on the three key areas of organizational effectiveness: strategic intent, business processes and culture/behavior executed by means of an on-line questionnaire. The methodology has an underpinning structure to separate it from other scorecard approaches and to allow some useful predictive and analytical work to be undertaken. Interlinked key attributes are spread amongst the three areas and are connected as shown in Figure 1.

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Figure 1 Key areas of organizational effectiveness. Source: Becker et al., 2001

The Organisation’s Purpose and Vision

Culture/ Behaviour

Management Style & Behaviour Core Values

Development, Empowerment, Training

Strategy

Workplace Dynamic

Communication

Strategic plan & Objectives Teamwork, Cooperation

Strategic Initiatives, Resource Allocation

Strategic Intent

Attitude to External Business Contacts Sense of Purpose, Confidence & Ability

Business Processes

Reporting, Performance Measurements

External Business Partners & Systems

Information & Communication Equipment

Coordinating Mechanisms Procedural Steps

Interfunctional Information Transfer Systems Software & Documents

The final scorecard-based approach of note is the consulting firm Watson Wyatt’s human capital index. Watson Wyatt have carried out extensive research into human resource practices among North-American listed companies. To investigate the relationship between human capital practices and value creation, a series of multiple regression analyses were conducted, identifying a clear relationship between the effectiveness of a company’s human capital practices and shareholder value creation. A total of 30 key HR practices were associated with a 30 percent increase in market value. The Watson Wyatt study enabled companies to be ranked and compared against each other. The results showed a clear connection between HRM practices, the index developed and the shareholder consequences. In this case, as the underlying structure is relatively simple, predictive and analytical work cannot be conducted.

IC The approach that offers the best prospect of linking HRM practices and business performance is IC, because it is: J holistic with respect to the company and hence will not mis-attribute effects to causes and thereby make false claims about the effects of HRM; J is a resource-based methodology and is automatically in tune with the nature of the entity that is to be managed;

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J able to show which resources and their employment are most influential in the creation of value; and J made rigorous by connecting it to rigorous measurement systems and systems dynamics modeling techniques underpinned by a systems engineering philosophy. IC can be subdivided into three ‘‘generations’’ with the first generation growing from the balanced scorecard philosophy of the early to mid-1990s (Kaplan and Norton, 1996). Table I gives the characteristics of the three generations of IC thinking and methodologies. Although holistic, IC thinking can be applied to discrete management areas within the company such as HRM. For instance, Pike and Roos (2001) have applied it to the measurement of knowledge management practices in companies. For the purposes of measuring the impact of HRM on company performance, only second or third generation IC methodologies are adequate with first generation methodologies offering little advantage over simple scorecard approaches and no advantage over the sophisticated scorecard approaches described in the last section. Bontis and Fitz-Enz (2002) have carried out a study on the causal links within the HR function from an IC perspective. They constructed a causal map that integrated constructs from the fields of IC, knowledge management, human resources, organizational behavior, IT and accounting. The resulting structural equation model shows the effectiveness of an organization’s human capital capabilities. Their key findings were summarized in these five research implications: 1. The development of senior management’s leadership capabilities is the key starting ingredient for the reduction of turnover rates and the retention of key employees. Effective leadership acts as a spark for organizational knowledge sharing and alignment of values throughout the organization. 2. The effective management of IC assets yields higher financial results per employee. 3. Employee sentiment as defined by satisfaction, motivation and commitment has farreaching positive impacts on business performance. 4. Knowledge management initiatives can decrease turnover rates and support business performance if they are coupled with HR policies. 5. Business performance is positively influenced by the commitment of its organizational members and their ability to generate new knowledge. This favorable performance level subsequently acts as a deterrent to turnover which in turn positively effects human capital management.

Table I The three generations of IC Main criteria

Test

1st generation IC and BBS

2nd generation IC, e.g. IC index

3rd generation IC, HVA

Auditable and reliable

Data meets a standard Data addresses looks at the right time frame

No Yes

Partial Yes

Yes Yes

Overhead and ease of use Low measurement overhead Easy to initiate and use

Moderate Yes

Moderate Moderate

Moderate Moderate

Strategic management

Does not allow trade-off decisions Stock

Yes

Yes

Stock and influence

Stock, flow and influence

Yes Partial

Yes Yes

Allows multi-level management Measures stock, flow and influence

Shareholder information

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Yes No

In contrast, Eskildsen et al. (2000) used similar statistical techniques and structural equations to investigate the simplification of the EFQM (European Foundation for Quality Management). One of the interesting findings of their work was that ‘‘leadership’’ and ‘‘policy and strategy’’ were effectively synonymous. While this may look insignificant, in IC terms, it is significant since leadership is a human resource while policy and strategy are organizational resources. The lesson that must be drawn from comparisons such as these is that studies into the means of improving business performance must be holistic. To be confident in defining causal links between management actions in any part of the company and the business result, one has to involve all the company’s actions since the complexity of the modern company means that it is difficult or perhaps impossible to isolate a function like HR from the rest. The seminal second generation IC work is that of Roos et al. (1997). Second generation IC allows the first three of the four bullet-point claims for IC to be met since it is holistic. However, to achieve the fourth requires proper measurement. If a hard and auditable link between HRM practices and business performance is needed, then third generation IC is required. This was devised by Pike et al. (2002) and is described in Figure 2. The model is constructed as a single unit with the systems dynamics model describing the operation of the company including all its key processes, such as the HRM processes and practices. At the same time, a mirror of this model is built with a resource-based emphasis using the techniques of second-generation IC. This gives rise to an IC ‘‘navigator’’, a conceptual map of the company. Together, the systems dynamics model and the navigator describe the functioning of the company. The value hierarchy is a rigorous measurement system based on multi-attribute value theory and measurement theory which correctly combines the effects on the company of changes made by HRM action to the variables in the systems dynamics model.

Figure 2 The holistic value approach (HVA). Source: Pike et al., 2002

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The financial consequence of changes to the company is expressed in simple financial terms from the systems dynamics model and in value terms from the measurement hierarchy. These can then be combined in ‘‘back projection’’ to give a figure for value for money, if required. This methodology was developed by McPherson, Pike and Roos and demonstrated by McPherson and Pike (2001).

References Bailey, T. (1993), ‘‘Discretionary effort and the organisation of work: employee participation and work reform since Hawthorne’’, Working paper, Columbia University, New York, NY. Barney, J. (1991), ‘‘Firm resources and sustained competitive advantage’’, Journal of Management, Vol. 17, pp. 99-120. Bax, E.H. (1999), ‘‘The strategic labor allocation process: a model of atrategic HRM, SOM-theme A’’, University of Groningen Library. Becker, B.E. and Olson, C.A. (1987), ‘‘Labour relations and firm performance’’, in Kleiner, M.M., Block, R.N., Roomkin, M. and Salsburg, S.W. (Eds), Human Resources and the Performance of the Firm, pp. 43-58, BNA Press, Washington, DC. Becker, B.E., Huselid, M.A. and Ulrich, D. (2001), The HR Scorecard: Linking People, Strategy and Performance, Harvard Business School Press. Beer, M., Spector, B., Lawrence, P., Quinn Mills, D. and Walton R. (1984), Managing Human Assets, Free Press, New York, NY. Bontis, N. and Fitz-Enz, J. (2002), ‘‘Intellectual capital ROI: a causal map of human capital antecedents and consequents’’, Journal of Intellectual Capital, Vol. 3 No. 3, pp. 223-47. Cognitive Technologies Group, www.cognitive-technologies.com/ Eskildsen, J.K., Kristensen, K. and Juhl, H.J. (2000), ‘‘The causal structure of the EFQM excellence model’’, Working paper of the Aahus School of Business. Fayol, H. (1916), ‘‘Administration industrielle et ge´ne´rale’’, Bulletin de la Socie´te´ de l’Industrie Mine´rale, No. 10, pp. 5-164, Regular re-editions by Dunod since 1918. Fitz-Enz, J. (2001), The ROI of Human Capital: Measuring the Economic Value of Employee Performance, AMACOM, New York, NY. Fombrun, C.J., Tichy, N.M. and Devanna M.A. (1984), Strategic Human Resource Management, John Wiley, New York, NY. Glebbeek, A.C. and Bax, E.H. (2002), Labour Turnovers and its Effects on Performance: An Empirical Test Using Firm Data, University of Groningen, Groningen, SOM report. Guest, D. and Peccei, R. (2002), Trust, Exchange And Virtuous Circles Of Cooperation: A Theoretical And Empirical Analysis Of Partnership At Work, The Management Centre Research Papers, King’s College London. Guest, D.E. (1987), ‘‘Human resources management and industrial relations’’, Journal of Management Studies, Vol. 24 No. 5, pp. 503-21, Table 11, p. 516. Hammer, M. and Champy, J. (1993), Re-engineering the Corporation, Harper Collins, New York, NY. Hendry, C. and Pettigrew, A. (1992), ‘‘ Patterns of strategic change in the development of human resource management’’, British Journal of Management, p. 139. HRScorecard.com, www.hrscorecard.com Human Capital Capability Inc., www.hcc-scorecard.com Hunter, L.W. (2002), ‘‘Choices and the high-performance workplace, mastering management, part 11’’, The Financial Post. Huselid, M.A. (1995), ‘‘The impact of human resource practices on turnover, productivity, and corporate financial performance’’, Academy of Management Journal, Vol. 38 No. 3, pp. 635-72. Ichniowski, C., Shaw, K. and Prennushi, G. (1997), ‘‘The effects of human resource management practices on productivity: a study of steel finishing lines, American Economic Review, Vol. 87, pp. 291-313.

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Laursen, K. and Foss, N. (2000), ‘‘New HRM practices, complementarities, and the impact on innovation performance’’, LINK Working Paper No. 02, Copenhagen Business School, Copenhagen. Laursen, K. (2000), The Importance of Sectoral Differences in the Application of New HRM Practices for Innovation Performance, LINK, Department of Industrial Economics and Strategy, Copenhagen Business School. McPherson, P.K. and Pike, S. (2001), ‘‘Accounting, empirical measurement and intellectual capital’’, A paper presented at the 4th World Congress on Intellectual Capital, Hamilton, Canada. Pike, S. and Roos, G. (2001), ‘‘Measuring the impact of knowledge management in companies’’, Paper presented at The 5th World Congress on Intellectual Capital, 23rd McMaster Business Conference, Hamilton, Canada. Pike, S., Roos, G. and Rylander, A. (2002), ‘‘Intellectual capital management and disclosure’’, in Bontis, N. and Choo, W.W. (Eds), The Strategic Management of Intellectual Capital and Organisational Knowledge, pp. 657-73, Oxford University Press, New York, NY. Roos, J., Roos, G., Edvinsson, L. and Dragonetti, N. (1997), Intellectual Capital: Navigating the New Business Landscape, MacMillan Business. Taylor, F.W. (1911) The Principles of Scientific Management, Harper and Row, New York, NY. Watson W., www.watsonwyatt.com Wright, P.M. and McMahan, G.C. (1992), ‘‘Theoretical perspectives for strategic human resource management’’, Journal of Management, Vol. 18 No. 2, pp. 295-320.

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Accounting for intellectual capital: rethinking its theoretical underpinnings Robin Roslender

Robin Roslender is at the Department of Accounting, Finance and Law, Faculty of Management, University of Stirling, Stirling, UK. E-mail: [email protected] Robin is a Senior Lecturer in Accountancy at the University of Stirling. He holds a doctorate in sociology and is an affiliate member of the Association of Chartered Certified Accountants. A long standing interest in accounting for the worth of employees informs his work in the intellectual capital field, where he has published extensively in recent years with Robin Fincham. His contributions to interdisciplinary accounting research have resulted him being invited to join a number of editorial boards including the Journal of Human Resource Costing and Accounting, Accounting and the Public Interest and Accounting Education.

Abstract The accountancy profession’s long association with measurement and reporting has ensured that it has made a substantial contribution to the evolving intellectual capital field. While many of the motivations shaping the accounting for intellectual capital project are of a practical nature, the emergence of intellectual capital and the challenges entailed in taking it into account in some way also raise important theoretical issues. As long as the accountancy profession seeks to progress accounting for intellectual capital within the confines of prevailing accounting theory, the prospects for a successful outcome appear remote. Alternative theoretical precepts need to be explored, an exercise that also has implications for the future development of financial reporting. Keywords Intellectual capital; Accounting theory; Measurement; Financial reporting

Introduction The emergence of the intellectual capital field has been heavily influenced by practical (managerial) considerations. The requirement to ensure the effective management of intellectual capital has prompted considerable interest in developing appropriate measurement metrics, reflecting the adage that ‘‘what gets measured gets managed’’. Measurement is widely regarded as a key element of the accountancy profession’s jurisdiction. Consequently it is no surprise that a widely subscribed project of accounting for intellectual capital (AIC) forms part of the intellectual capital field. In addition to focusing on measurement issues, AIC has addressed the challenge of reporting on intellectual capital management. Much of what has emerged under the auspices of AIC departs significantly from the prevailing notions of what accounting entails, however. Despite its practical foundations, the development of AIC is intimately related to the debate about what the theoretical underpinnings of accounting should be. The paper is structured as follows. The next section reviews the development of AIC. Section three outlines the prevailing theoretical underpinnings of accounting as the provision of financial statements. In section four the disjunction between the task of AIC and accounting’s theoretical underpinnings is discussed. The paper concludes with some observations about alternative theoretical precepts that might inform the continued development of AIC, and financial reporting in general.

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VOL. 8 NO. 1 2004, pp. 38-45, Emerald Group Publishing Limited, ISSN 1368-3047

DOI 10.1108/13683040410524720

Accounting for intellectual capital: a brief review AIC is a key constituent of the broader intellectual capital field. Like accounting more generally, it involves two complementary aspects: measurement and reporting. In the case of measurement, what is being measured is an organization’s stock of intellectual capital, and its growth during a specific time period. Reporting intellectual capital entails the formal communication of this information to interested parties. AIC can, therefore, be understood as the measurement and reporting of the success of intellectual capital management, itself a core strategy for pursuing sustained value creation within the knowledge economy. Measuring the success of management’s intellectual capital activities provides a means of accomplishing accountability within the organization. Reporting this information externally extends accountability to third parties, notably the market for capital investment funds. The accountancy profession’s traditional approach to measurement is to place monetary values on the assets and liabilities of an organization. The simplest way of measuring management’s success in ‘‘growing’’ an organization’s stock of intellectual capital is to demonstrate an increased value during a specific time period. Unlike most conventional assets, intellectual capital is seldom purchased for use by an organization. Intellectual capital is created by an organization in much the same way as (home-grown) goodwill. The objective (historical) values associated with conventional assets are largely absent. To compound these difficulties, like goodwill, but unlike most conventional assets, the value of an organization’s intellectual capital regularly increases over time. This is not simply due to the creation of additional intellectual capital assets. As with (home-grown) goodwill, many existing intellectual capital assets are increasingly central to the future value creation process.

Determining the value of an organization’s stock of intellectual capital is an exercise antithetical to conventional accounting measurement. As well as being fundamentally subjective in nature and characterized by a tendency to appreciation rather than depreciation, intellectual capital’s synergistic qualities also conflict with the separability assumptions implicit within the prevailing accounting calculus. Recognizing these difficulties, some early AIC initiatives approached the problem in a novel way. The market value of an organization was taken as a quasiobjective measure of its present commercial worth. The current value of an organization’s stock of intellectual capital was estimated by subtracting the book (or accounting) value of the organization’s conventional assets (and liabilities) from this market value (Edvinsson, 1997). The task of AIC therefore became one of determining the values of the various constituents of this stock of intellectual capital. Taxonomies identifying the constituents of intellectual capital were developed to facilitate this procedure.

In principle it would be possible to report such valuations of intellectual capital assets on an organization’s balance sheet, complemented by an unrealized intellectual capital value reserve. Movements in these valuations would permit assessment of how successful management has been in increasing an organization’s stock of intellectual capital. Although such information may interest individual shareholders, it would add little or no value for the capital market. Since the origins of the organization’s total intellectual capital valuation lie in this market, such an exercise would be largely irrelevant, a purely artificial exercise, with accountants in effect demonstrating that they are capable of retrospectively matching valuations issuing from the capital market. A more proactive approach to AIC was required. A growing number of valuable insights were evident in the managerial accounting rather than the financial accounting branch of the discipline. From the late 1980s performance reporting had become increasingly reliant on non-financial metrics. Rather than attempt to represent performance using cost and revenue information, i.e. monetary values, management accountants had demonstrated that it was both desirable and possible to provide ‘‘accounts’’ incorporating a wider range of quantitative information. In place of the reliability afforded by the cost and revenue calculus, non-financial metrics offered a more relevant approach to the task. Measurement was to be informed by the nature of what was being measured, rather than by the nature of the measurement metrics themselves.

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Such an approach was ideally suited to the challenges of AIC. There was no necessity to attempt to value the constituents of an organization’s intellectual capital. Instead a wide variety of relevant measures could be developed in an attempt to capture the success of management’s intellectual capital-related activities. The balanced scorecard provided one means of reporting such information (Kaplan and Norton, 1992, 1996). Its four generic foci: financial; customer; internal business process; and learning and growth, overlapped extensively with the tripartite taxonomy of intellectual capital constituents: human capital; customer or relational capital; and organizational or structural capital. Similar ideas characterize two of the most influential intellectual capital reporting approaches developed to date: the Skandia navigator (Edvinsson, 1997) and the intangible assets monitor (Sveiby, 1997). Using such approaches, organizations were able to provide the capital market with the information that it required. The switch from attempting to incorporate financial valuations of the components of intellectual capital within an organization’s financial statements to reporting a set of relevant, increasingly non-financial information using dedicated intellectual capital reporting frameworks has gathered pace, with Europe at the leading edge. A group of Danish researchers has pioneered an intellectual capital statement format that is predominantly narrative in nature (DATI, 2000; MITR, 2002; Marr et al., 2003). Organizations are encouraged to identify and report their underlying knowledge management strategy, which in turn provides the basis for the challenges facing management in their value creation endeavors. Success (or otherwise) in respect of these challenges is measured and reported using a relevant set of indicators, the whole report also incorporating various illustrations, sketches and similar visualizations, thereby broadening significantly the meaning that is given to the account of intellectual capital (management). The Meritum Report (2002) commends a similar approach following a collaborative research program with participation by scholars from Denmark, Finland, France, Norway, Spain and Sweden.

The theoretical underpinnings of accounting Most observers view accounting as a predominantly practical activity, something corroborated by the manner in which accounting is taught, either to those who aspire to join the accountancy profession or those who take accounting courses as part of their training for other careers. In the two principal branches, financial accounting and managerial accounting, the emphasis is on formats and techniques respectively. Taxation is largely concerned with the application of specific rules imposed by government agencies, while auditing is heavily reliant on the application of checklists. Accounting’s practical predilections have had the consequence of identifying the challenge of AIC as being concerned with how might it be possible to bring intellectual capital within the accounting framework. What is the most appropriate way of measuring (the growth of) intellectual capital and reporting this in financial statements? A different way of looking at the same issues is to pose the question: why is it necessary to account for intellectual capital? The simple answer is that because intellectual capital is so central to long-term value creation, it must be present within accounts. A more revealing answer is that unless the accountancy profession is able to account for intellectual capital, it is in danger of losing its status as a key management function. Because the profession has been so successful in having its particular approach to the task of management, i.e. financial management as opposed to marketing management or human resource management, accepted as the dominant approach for so long, it must be able to bring intellectual capital within its jurisdiction with minimal difficulty. Whichever way the question is framed, however, the accountancy profession finds itself compelled to explore the largely unseen theoretical underpinnings of accounting and the financial management mode. In so doing, it quickly becomes apparent why the emergence of intellectual capital poses a major challenge to the future prospects of the profession. Riahi-Belkaoui (2000) identifies four elements of an accounting theory as providing the underpinning for the body of practical knowledge or techniques deployed by accountants: 1. The objectives of financial statements;

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2. The postulates of accounting; 3. The theoretical concepts of accounting; and 4. The principles of accounting. Each of these elements has been extensively debated since the initial forays into the realms of accounting theory in the 1920s. Accounting’s social scientific credentials have ensured that these debates are characterized by a significant normative emphasis. In the later 1970s, irritation with the normative approach to theorizing led to the emergence of the positive accounting theory perspective, informed by the methodology associated with the physical sciences (Watts and Zimmerman, 1978, 1979, 1986). Within the objectives element of accounting theory what the ‘‘qualitative characteristics of reporting’’ ought to be has been widely debated. The Trueblood Report (1973) identified seven characteristics: relevance and materiality; form and substance; reliability; freedom from bias; comparability; consistency; and understandability. A similar set of characteristics was identified in The Corporate Report, being argued to meet the needs of a broad range of user groups: equity investors; loan creditors; employees; analysts and advisers; business contacts; the government; and the public (ASSC, 1975). In addition, a more comprehensive set of financial statements was commended, including a statement of value added; an employment report; a statement of future prospects; and a statement of corporate objectives. These and similar contributions were subsequently codified in the course of Financial Accounting Standards Board’s conceptual framework project, whose object was to provide a ‘‘constitution’’ for financial reporting The postulates element of accounting theory provides a set of rules informing accounting practice. They are the most general axioms governing accounting practice, being relatively few in nature. Riahi-Belkaoui (2000) identifies four postulates. The entity postulate requires that financial statements be produced for a specific entity that is separate and distinct from the entity’s owners. The going concern postulate asserts that when producing accounts, accountants should assume that the entity will continue to exist, with no intention to liquidate. The unit of measure postulate holds that accounting is a measurement and communication process of the activities of an entity that are measurable in monetary terms. Finally, the periodicity postulate affirms that it is possible (and desirable) to account for an entity for specific time periods.

Theoretical accounting concepts are described by Riahi-Belkaoui (2000) as self-evident statements or axioms ‘‘that portray the nature of accounting entities operating in a free economy characterized by private ownership of property’’. Three such concepts are identified. Proprietary theory asserts that it is the proprietor who owns the assets and liabilities of the entity, and that financial statements are prepared to reflect this. By contrast, entity theory places the entity at the center of accounting interest, with income earned being the property of the entity until distributed to the shareholders as dividends. Finally, fund theory is ‘‘asset-centered’’. Its primary focus is on the administration and appropriate use of assets. Each accounting concept has significant implications for the way in which accounting is practiced. Accounting principles are most closely related to practice, and thus more concrete in nature. In the UK, Statement of Standard Accounting Practice (SSAP) 2, issued in 1971 and in force until being superseded 30 years later by Financial Reporting Standard (FRS) 18, describes what it terms ‘‘fundamental accounting concepts’’ as ‘‘practical rules rather than theoretical ideals [that] are capable of variation and evolution as accounting thought and practice develop’’. SSAP2 lists four principles (or ‘‘concepts’’), the going concern concept, together with the accruals (or matching) concept, the consistency concept and the prudence concept. The accruals concept requires that any revenues and profits recognized be matched with the associated costs and expenses incurred in earning them. This rule rejects using cash receipts and payments when preparing financial statements. The consistency concept requires that

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financial statements be prepared using the same accounting treatments over time. The prudence concept proscribes the anticipation of revenues and profits, allowing their recognition only when realized, together with the necessity to provide for all known liabilities using the best information available. Several additional accounting principles have considerable force. The cost principle states that acquisition or historical cost is the appropriate valuation basis for the recognition of the acquisition of all goods and services, together with any expenses, costs and equities. This cost is the exchange price (expressed in monetary terms) paid at the time of acquisition for the goods and services acquired. This price serves as the value at which such goods and services are recorded in financial statements, providing the basis for the subsequent depreciation of any assets so obtained. Where exchange involves non-monetary consideration, it is the cash equivalent of what is exchanged that is applicable to the transaction. Closely related to the cost principle is the objectivity principle. Because financial statements are required to provide reliable information to users, they must be objective in nature. The information provided should be free from the personal (subjective) biases of those providing it. There is also a reasonable expectation that similar information would be provided by others, i.e. be underpinned by a consensus among those charged with providing such information. The acquisition (historic) cost of an asset is regarded as meeting the objectivity principle. The price paid reflects a consensual valuation of the worth of the asset purchased, while providing a reliable basis upon which to continue furnishing information on the asset’s value. Employing the monetary unit of measurement for these purposes further reinforces the objectivity principle, being underpinned by a similar consensus. The full disclosure principle requires that what is presented in financial statements constitutes an accurate portrayal of the economic events affecting the entity during a particular time period, and conveys sufficient information to the users of the information. This principle is designed to ensure that no information of interest (substance) to users is omitted or concealed. Full disclosure is, in turn, related to a further pair of accounting principles: materiality and relevance. Materiality is concerned with the significance of specific transactions or economic events within the broader activities of the entity. The accountant should exercise judgment about whether providing any such further information might influence the users of that information. Similarly the relevance principle requires the accountant to decide what set of information beyond the most fundamental should be provided to users in order to present a coherent picture of the activities of the entity.

Mission impossible? The problems facing the accountancy profession in its attempts at AIC should now be evident. As long as it seeks to progress this within the confines of accounting theory as outlined in the previous paragraphs, the prospects for achieving a successful outcome appear remote. The initial difficulty facing the profession is the non-applicability of the cost principle. Although it is possible to identify key intellectual capital assets, e.g. intellectual property, an entity can purchase and include in its financial statements alongside the other categories of asset, the principal source of intellectual capital is within the entity. Equally, while it may be possible to identify a stream of financial transactions associated with the development of these assets, including some that were previously purchased, it is unlikely that they could fully capture the processes involved. The observation that the cost principle permits orderly depreciation is irrelevant. One of the defining qualities of intellectual capital assets is that their value appreciates over time. Intellectual capital assets are not the only assets that can appreciate in value. Land and buildings can evidence significant appreciation in value over time together with investments in equities. None poses the accountancy profession serious difficulty, principally because of an acceptance that their value can be determined with some confidence and incorporated within financial statements. In accounting theory terms, the valuations of such assets meet the criteria of objectivity and reliability. Brands have not been so well regarded. Despite their growing significance in the past 20 years, in the UK it is only those brands acquired as part of a business

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transaction that can be included and reported among an entity’s stock of assets. Any payment in excess of the accepted market value of acquired brands is accounted for separately as goodwill, with both elements being depreciated over finite time periods (Ong, 2001). Valuing home-grown brands or any enhanced values for previously acquired brands remains prescribed despite the existence of sophisticated valuation methodologies. At the more fundamental level of accounting postulates rather than principles, intellectual capital jars with the unit of money measurement postulate. If this particular postulate is taken literally, i.e. conceptualizing accounting as a measurement and communication process of the activities of an entity that are measurable in monetary terms, there can never be any acceptable approach to AIC. This said, AIC does not fall foul of the other three accounting postulates. It is still concerned with accounting for the intellectual capital of an entity, one assumed to be a going concern, and would be an exercise that was carried out periodically. The difficulty lies in the identification of accounting with monetary measurement activities, something which, not surprisingly, is perceived to provide it with an objective and thus reliable foundation. Fortunately some contributors to the development of AIC have not imprisoned themselves within the latter conception of accounting. At its leading edge AIC has embraced a less restrictive approach to measurement, following the lead of contemporary managerial accounting by embracing non-financial metrics whose credibility is determined by their relevance rather than their reliability. Scorecard frameworks rather than conventional financial statements have been devised to report such information. More radical approaches to AIC presently evolving in Europe commend the incorporation of greater narrative content, reflecting an acceptance of the necessity of developing a more holistic view of reporting. Similar motivations have informed calls from within the financial reporting community to consider the merits of adopting a more broadly focused business reporting emphasis rather than that associated with financial reporting (AICPA, 1994; ICAS, 1999; Upton, 2001). What might be learned from these more radical developments in AIC? More generally, what theoretical ideas should drive its future development, and how do they depart from the traditional theoretical underpinnings of accounting outlined above?

Some alternative theoretical precepts The continued development of AIC should be driven by a recognition that such accounts must meet the needs of a wide spectrum of users. This is not a new idea. Many of the commentaries on the objectives of financial statements have identified a variety of stakeholder groups with legitimate interests in receiving financial information. Normally these discussions portray such groups as being additional to shareholders, the group whose interests and needs financial information has consistently privileged. In the case of intellectual capital it is vitally important that employees, as the source of value creation, can identify with the information provided. The greater part of accounting information presently made available is historical in nature. This reflects the (historical) cost principle while meeting the periodicity postulate. Recently there have been signs of a growing willingness to provide some forward looking information, not always financial in nature, within the set of financial statements incorporated within annual reports. A clear dividing line between these two information sets has persisted, however, with financial information being the principal source of reliable insights on the performance of the entity. In intellectual capital reporting, greater emphasis should be placed on plans for future growth, both in terms of target levels of performance and a detailed analysis of the thinking in forming such projections. In addition, there should be a willingness to engage in a process of critical self-appraisal of performance, explaining why earlier projections have not been realized and the changes implemented in the light of such outcomes. The importance traditionally placed on the objectivity of financial information is unhelpful to progressing AIC. Similarly, focusing attention on those elements of intellectual capital that might be readily accounted for in the conventional way, e.g. intellectual property, deflects attention away from more critical sources of value creation associated with human capital. Acknowledging where subjectivity is present, and explaining why it is necessary to exercise subjective judgments, should be recognized as a sign of maturity rather than a fatal departure

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from the precepts of objective inquiry. The continued development of AIC will, therefore, be enhanced by the presence of significant extents of judgment with regard to the choice of what indicators can best capture its growth and how these should be operationalized and deployed in the attempt to provide relevant (rather than reliable) information on the dynamics of the value creation process. These latter developments will produce accounts of intellectual capital that depart markedly from what are usually recognized as ‘‘accounts’’. In practice, leading edge developments such as intellectual capital reports or statements already exemplify. A further development is to make AIC a more inclusive practice, one neither solely nor principally the preserve of accountants. The simplest way of pursuing this initiative is to invite the other management functions to participate in the identification, formulation and articulation of the key indicators to be used in any intellectual capital account. This would be consistent with the pursuit of a business reporting paradigm rather than the traditional, exclusive financial reporting paradigm. A more radical development, consistent with greater employee reporting, is to provide a mechanism for allowing intellectual capital accounts to ‘‘speak to’’ intellectual capital itself, i.e. to its human capital elements (Roslender and Fincham, 2001, 2003, 2004). As part of the exercise of AIC (primary), intellectual capital should be encouraged to produce its own accounts. Instead of accountants providing information on the educational characteristics of the organization’s labor force, customer retention and brand loyalty, or the contribution of in-house knowledge networks, those who contribute these forms of intellectual capital should be encouraged to provide their own accounts of their experiences through intellectual capital self-accounts. Arguably a major departure from the accepted model of accounting, such an approach is consistent with the popular (if sometimes rhetorical) aphorism that ‘‘people are our greatest asset’’. Finally, while the approach to AIC envisaged here will have little use for some of the more technical, transactions-based accounting principles such as accruals/matching, prudence or materiality, alternative principles may emerge to replace them. A more progressive approach might incorporate principles that reflect a good citizen philosophy. In particular there should be a much greater emphasis on ethical considerations, and on how the business acts in ways that will not compromise the long-term prospects of the broader society. In this way, AIC can reconnect with its social accounting roots, thereby rejecting misconceived notions about ‘‘putting people on the balance sheet’’.

References AICPA (1973), Report of the Study Group on the Objectives of Financial Statements, American Institute of Certified Public Accountants, New York, NY (the Trueblood Report). AICPA (1994), Improving Business Reporting – a Customer Focus: Meeting Information Needs of Investors and Creditors, American Institute of Certified Public Accountants, New York, NY (the Jenkins Report). ASB (2000), FRS18: Accounting Policies, Accounting Standards Board, London. ASSC (1971), SSAP2: Disclosure of Accounting Policies, Accounting Standards Steering Committee, London. ASSC (1975), The Corporate Report, Accounting Standards Steering Committee, London. DATI (2000), A Guideline for Intellectual Capital Statements: a Key to Knowledge Management, Danish Agency for Trade and Industry, Copenhagen. Edvinsson, L. (1997), ‘‘Developing intellectual capital at Skandia’’, Long Range Planning, Vol. 30 No. 3, pp. 366-73. Fincham, R. and Roslender, R. (2003), The Management of Intellectual Capital and its Implications for Business Reporting, Institute of Chartered Accountants of Scotland, Edinburgh. ICAS (1999), Business Reporting: the Inevitable Change? Edited by V.A. Beattie, Institute of Chartered Accountants of Scotland, Edinburgh. Kaplan, R.S. and Norton, D.P. (1992), ‘‘The balanced scorecard: measures that drive performance’’, Harvard Business Review, Vol. 70 No.1, pp. 71-9.

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Kaplan, R.S. and Norton, D.P. (1996), The Balanced Scorecard: Translating Strategy into Action, Harvard Business School Press, Boston, MA. Marr, B., Mouritsen, J. and Bukh, P.N. (2003), ‘‘Perceived wisdom’’, Financial Management, July/August, p. 32. Meritum (2002), Proyecto Meritum: Guidelines for Managing and Reporting on Intangibles, Madrid. MITR (2002), Intellectual Capital Statements in Practice, Ministry of Information Technology and Research, Copenhagen. Ong, A. (2001), ‘‘Changes in brand accounting for UK companies’’, Journal of Brand Management, Vol. 9 No. 2, pp. 116-26. Riahi-Belkaoui, A. (2000), Accounting Theory, 4e, Thomson Learning, London. Roslender, R. and Fincham, R. (2001), ‘‘Thinking critically about intellectual capital accounting’’, Accounting, Auditing and Accountability Journal, Vol. 14 No. 4, pp. 383-98. Roslender, R. and Fincham, R. (2004), ‘‘Intellectual capital: who counts, controls?’’, Accounting and the Public Interest, Vol. 4 (forthcoming). Sveiby, K-E. (1997), ‘‘The intangible assets monitor’’, Journal of Human Resource Costing and Accounting, Vol. 2 No. 1, pp. 73-97. Upton, W.S. (2001), Business and Financial Reporting: Challenges from the New Economy, Financial Accounting Standards Board, Norwalk, CT. Watts, R.L. and Zimmerman, J.L. (1978), ‘‘Towards a positive theory of the determination of accounting standards’’, Accounting Review, Vol. 53 No. 1, pp. 112-34. Watts, R.L. and Zimmerman, J.L. (1979), ‘‘The demand for and supply of accounting theories: the market for excuses’’, Accounting Review, Vol. 54 No. 2, pp. 273-305. Watts, R.L. and Zimmerman, J.L. (1986), Positive Accounting Theory, Prentice-Hall, Engelwood Cliffs, NJ.

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Reporting on intellectual capital: why, what and how? Jan Mouritsen, Per Nikolaj Bukh and Bernard Marr

Jan Mouritsen is Professor and Head of the Department of Operations Management at Copenhagen Business School. From 1998 to 2002 Jan Mouritsen was leading the research team that developed the Danish guideline for intellectual reporting on behalf of the Danish Ministry of Technology, Research and Innovation. Tel: (45) 3815 2342, E-mail: [email protected] Per Nikolaj Bukh is currently working as BDO professor at the Department of Accounting at The Aarhus School of Business. During the last 3 years he has acted as a consultant to a number of Danish companies and organizations. Tel: (45) 2086 6790, E-mail: [email protected] Bernard Marr is a Research Fellow in the Centre for Business Performance at Cranfield School of Management and a Visiting Professor at the University of Basilicata, Italy. Prior to joining Cranfield he held a research position at the Judge Institute of Management Studies at Cambridge University. Tel: (44) 01234 75 11 22, E-mail: [email protected]

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Abstract Intellectual capital is an important value driver in today’s organizations. Traditional financial statements do not provide the relevant information for managers or investors to understand how their resources – many of which are intangible – create value in the future. Intellectual capital statements are designed to bridge this gap by providing information about how intellectual resources create future value. Intellectual capital statements can be used as tools to communicate the knowledge-based strategy externally but it can also be used as an internal management tool. In this article we outline the reasons for reporting intellectual capital, introduce the elements of such statements, and present a case example from a Danish mobile phone design company. Keywords Intellectual capital, Disclosure, Intangible assets

Introduction One of the characteristics of contemporary organizations is their clear ambition to develop performance management systems and practices. This agenda calls for more emphasis on the management of resources not conventionally recognized as management concerns. This includes attention to knowledge and intellectual capital (Marr et al., 2003; Mouritsen and Larsen, 2004). Not only do firms recognize a need to somehow develop ‘‘integrated’’ performance management systems (Kaplan and Norton, 2000); so does the capital market (e.g. Amir and Lev, 1996). Both firms and capital markets realize that something has to be done to improve the control and reporting systems currently being used. They need to face the challenge to help develop, communicate, monitor and evaluate firm’s strategies. In addition, strategy is not any more only about positioning the firm vis-a`-vis its competitors. It is concerned also with intangible assets and intellectual capital in the forms of know-how of employees and management, relationships with customers and suppliers, brand, information technology or appropriate organizational form and relevant form of empowerment – the knowledge based resources (Marr et al., 2002; Mouritsen, 1998). Such resources are often difficult to replicate and thus may create extraordinary value. Some indication of this is that firms such as Microsoft or Coca Cola only report the traditional assets in their balance sheets, which account for a small fraction of their market value. This is also the case for manufacturing firms such as Honda or BP where less than 30 percent of market value is reported in financial statements. Even if such measures are debatable, they indicate that there is more to corporate growth than is currently recognized in the financial statement.

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DOI 10.1108/13683040410524739

The value relevance of traditional annual reports is declining (e.g. Lev and Zarowin, 1999) and non-financial information like market size and market penetration are significantly related to market value (Amir and Lev, 1996). For external communication purposes, additional kinds of reporting may therefore be relevant. This is partly the reason why some firms, especially in the Scandinavian countries, have experimented with intellectual capital statement to disclose information about intellectual capital to external stakeholders. The intellectual capital statement is often a supplement to the annual report, where the firm’s strategy for managing knowledge and the activities initiated to pursue the strategy are documented and explained. Often such a statement discloses efforts to orchestrate, upgrade and monitor knowledge activities rather than to recognize them in financial terms. It attempts to show a firm has managed its knowledge resources and it therefore forms part of the firm’s knowledge management activities. This article outlines the reasons why it is important to report intellectual capital. It then describes a methodology, which has been developed to form the basis of intellectual capital reporting. Finally, the article illustrates the methodology using a case example of a Danish firm.

Why disclose intellectual capital? There is widespread and growing frustration with traditional financial reporting as is expressed in, for example, the ‘‘Jenkins Report’’ (AICPA, 1994), the work of the former commissioner of the Securities and Exchange Commission (SEC) Steven Wallman (Wallman, 1996, 1997), and, more recently, Accounting Standard Board (2002), the Canadian Institute of Chartered Accountants (2001), and the Chartered Institute of Management Accountants (Starovic and Marr, 2003). They all argue that the financial reporting system is incapable of explaining ‘‘new’’ resources such as relationships, internally generated assets and knowledge. Disclosing information on such factors is likely to lower the cost of equity capital because it decreases uncertainty about future prospects of a company and facilitates a more precise valuation of the company (Botosan, 1997). It will also enhance stock market liquidity and increase demand for companies’ securities (cf. Healy and Palepu, 2001). It has been suggested that the capital market may be at a disadvantage in several ways if information on intellectual capital is not addressed (Starovic and Marr, 2003) including: J smaller shareholders may be disadvantaged, as they usually have no access to information on intangibles often shared in private meetings with larger investors (Holland, 2001); J insider trading may occur if managers exploit internally produced information on intangibles unknown to other investors (Aboody and Lev, 2000); J increased volatility and the danger of incorrect valuations of firms, which leads to investors and banks placing a higher risk level to organizations; and J increased cost of capital (Lev, 2001). The potential advantages for firms are that in reporting their intellectual capital they not only communicate the firm’s advantages; they can also attract valued resources. This can be seen from Figure 1, which presents findings from a survey among Danish firms that produced intellectual capital statements. Intellectual capital in the management of the firm Information on intellectual capital is relevant to an external audience; however, it can be just as relevant as an internal management tool. Firms experimenting with the external intellectual capital statement quickly realize that the internal management of intellectual resources has to follow suit; and to do this, a management tool is required (see also Bontis et al., 1999; Guthrie, 2000; Marr et al., 2003). The challenge facing firms is to realize how the intellectual resources can be made manageable, and how these in turn are related to the development of the firm. Such a tool should help managers and suppliers of resources to answer some key questions, such as: are intellectual resources increasing or decreasing? What knowledge is there? How is

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Figure 1 Proportion of companies with the following intellectual capital statement objectives

it developed? Intellectual capital statements can be seen as a tool to help organizations to better understand their intellectual resources. But how can intellectual resources become manageable? Intellectual resources comprise of the firm’s knowledge. In a business context this knowledge is used to improve a firm’s innovation capability, processes and performance. However, knowledge is ‘‘intangible’’. Therefore it has to be translated into knowledge resources that can be pointed at so it is possible to say ‘‘this is knowledge’’! Knowledge resources can be described, developed, evaluated and combined in new ways. They can be managed, which means they can be described in an intellectual capital statement. Below we define four types of knowledge resources, i.e. employees, customers, partners, virtual infrastructure, and technologies (see also Marr and Schiuma, 2001). 1. Employees are knowledge resources with inherent attributes such as skills and personal competencies, experience, educations, motivation, commitment, or willingness to adapt. Groups of employees produce beneficial emergent qualities. 2. Knowledge resources based on customers and partners. Especially the relationships to customers, users, and other partners such as suppliers, their satisfaction and loyalty, their referral of the company, insight into users’ and customers’ needs and the degree of co-operation with customers and users in product and process development etc. 3. The virtual infrastructure can be a knowledge resource as it includes procedures and routines. These can be the company’s innovation processes and quality procedures, management and control processes and mechanisms for handling information. 4. Technologies are knowledge based assets as they refer to the technological support of the other three knowledge resources. Focus is usually on the company’s IT systems (software and hardware) such as the Intranet, IT intensity, IT competencies and IT usage. A company’s knowledge management is therefore concerned with the above knowledge resources and their interaction. When the interaction between these knowledge resources is understood, the firm’s knowledge management strategy is clear (Mouritsen et al., 2003; Marr et al., 2004). As illustrated in Figure 2, firms using intellectual capital statements justify this from their increased understanding of their knowledge management strategy, and they point out that a connection can be established between strategy, actions and information. The link between strategy, activities and indicators used to measure them are complex and not always easily understood. It is not always easy to develop a resource-based strategy in organizations. When organizations redefine their strategy, review their activities and align their measurement system, the firm embarks on a process where the whole of the strategy if formed

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Figure 2 Proportion of companies with the following internal intellectual capital statement objectives

as in fact the elements take part in defining each other. What companies develop is a knowledge-based strategy that explains what the firm’s ambitions are, which knowledge resources it has and how they can be strengthened, and measured. The internal and external motives for developing intellectual capital statements should not be separated as they are dependent on each other. They are mutually reinforcing as suggested by Kjaergaard (2003, p. 274) in her analysis of the use of IC statements in an electricity transmission system company, the IC statement ‘‘made it possible for the firm to work actively with its vision and values on a daily basis’’.

Existing accounting practices and intellectual capital Traditional accounting rules have changed over the past decade in acknowledgement of the increasing importance of intellectual resources. In 1998 the ASB introduced FRS 10 as the main standard for reporting intangibles and goodwill, which defines intangibles as ‘‘non-financial fixed assets that do not have physical substance but are identifiable and controlled by the entity through custody and legal rights’’. In 2005, when the international reporting standards replace national rules (for companies listed on regulated markets within the EU), FRS 10 will be superseded by IAS 38. IAS 38 is therefore the proposed international standard for reporting intangible assets. Its definition of intangible assets is very similar to the one used in FRS 10, except it adds that intangible assets are held for us ‘‘in the production or supply of goods and services, for rental to others or for administrative purposes’’. IAS 38 specifies that a company can only recognize an asset if it is: J identifiable; J controlled; J it is probable that future benefits specifically attributable to the asset will flow to the enterprise; and J cost can be reliably measured. These recognition criteria apply to both purchased and self-created assets. If the item does not meet the above criteria, IAS 38 requires the expenditure on this item to be recognized as expense when it is incurred. It also requires the following items to be expensed: Internally generated goodwill, start-up, pre-opening and pre-operating costs, training costs, advertising cost, relocation costs. It is clear from this list that much of what is commonly regarded as intellectual capital would not in fact pass the recognition test. Even if we accept that for the time being intangibles are unlikely to appear in published balance sheets, we are still left with a problem of how to report, measure and manage what are undoubtedly important value drivers in today’s businesses.

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In the UK the operating and financial review (OFR) could be a possible vehicle for identifying the importance of intangible assets. The recent Company Law Review, submitted to the Secretary of State for Trade and Industry in July 2001 and likely to be included in the updated Companies Act 2003, requires all public and very large private companies to produce an OFR. Besides traditional financial measures, the OFR requires companies to include an account of how the company’s intangible assets contribute to its overall value generation and how the conflicting stakeholder interests are balanced. Below we will outline of how organizations could structure more informative statements about their intellectual resources.

The structure of intellectual capital statements The intellectual capital statement can be found in various forms (MERITUM 2002; Mouritsen et al., 2003) and its definition is ambiguous, but there are similarities in practical situations. It can express human capital, organizational capital, and customer capital (e.g. Edvinsson and Malone, 1997; Sveiby, 1997; Roos et al., 1997), and it reports disparate items of financial and non-financial information, i.e. staff turnovers and job satisfaction, in-service training, turnover split on customers, customer satisfaction, precision of supply etc. (Bukh et al., 2001; Mouritsen et al., 2001a). In addition, it also has a substantial narrative part where numbers and text are combined to provide explanation of the strategic direction of the firm. A Danish research project funded by the Danish government between 1998 and 2002, led to the development of the Danish guideline for intellectual capital statements (Mouritsen et al., 2003). This guideline recommends that a firm report on its value creation potential and its strategy for knowledge management, including a specification of which knowledge resources are vital value drivers, through an intellectual capital statement. Here, the intellectual capital statement consists of four elements, which together express the company’s knowledge management. The four elements link users of the company’s goods or services with the company’s need for knowledge resources. They include the establishment of the need for knowledge management, a set of initiatives to improve knowledge management and a set of indicators to define, measure and evaluate initiatives (Mouritsen et al., 2003). The first element is a knowledge narrative that expresses the company’s ambition to increase the value a user receives from a company’s goods or services. Knowledge has to be related to a purpose. The knowledge narrative helps to define what it is that we need to know and thus how knowledge can be directed towards creating a service or a product that has a value to a user. This value can be called the use value, and a set of knowledge resources are needed to create it. The knowledge narrative shows which types of knowledge resources are required to create the use value the company wants to supply. This ambition establishes a narrative because it merges the user’s and the company’s knowledge resources into a whole. It is crucial to tie the narrative together by words such as ‘‘because’’, ‘‘therefore’’ and ‘‘in order to’’. In this way the knowledge narrative shows how knowledge is supposed to lead to improvements for a user. To identify elements of a knowledge narrative, it is useful to answer the following questions: J What product or service does the company provide? J How does it make a difference for the user? J What knowledge resources are necessary to be able to supply the product or service? J How does the constellation of knowledge resources produce the service/product? The second element is a set of (knowledge) management challenges (or business model of knowledge), which highlight the knowledge resources that need to be strengthened through in-house development or through sourcing them externally. The management challenges are enduring challenges that together define the business model of knowledge. They can have different forms such as intense co-operation with innovative customers, great expertise in specific fields or insight into the company’s control processes. Management challenges such as these are relatively enduring over time even if they constantly have to be developed. They usually do not change every year and they are closely linked to the knowledge narrative and

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thus to the individual knowledge resources within the company. The starting point for the management challenges could be the improvement of the existing knowledge resources. But it could also be to introduce new types of knowledge resources that are currently not found within the company. To get an idea of the firm’s management challenges, the following questions could be addressed: J How are the knowledge resources related? J Which existing knowledge resources should be strengthened? J What new knowledge resources are needed? The third element is a set of initiatives that will address the management challenges. The initiatives are concerned with how to compose, develop and procure knowledge resources and how to monitor their size and effects. This might include investing in IT, hiring more R&D consultants, software engineers or launching training programs in company processes and procedures. Vocational and social activities can also be introduced to increase employee satisfaction. These are all, in principle, short-term actions. Comparing one year with the next, initiatives must be seen to work, even if specific types of initiatives are repeated over several years. These are specific initiatives which specific players are responsible for. Somebody hires personnel, somebody launches training initiatives and somebody develops the required procedures and routines. To develop a set of initiatives requires answers to the following questions: J What initiatives can be identified – actual and potential ones? J What initiatives should be given priority? The fourth element is a set of indicators, which monitors whether the initiatives have been launched or whether the management challenges are being met. Indicators allow managers to track initiatives and enable organizations to evaluate their impact. Some indicators are directly related to specific initiatives such as ‘‘training days’’ or ‘‘amounts invested in IT’’. Others are related only indirectly to specific initiatives such as ‘‘number of R&D consultants’’ or ‘‘newly appointed software engineers’’. Indicators can measure:

J Effects – how do activities work? J Activities – what does the firm do to upgrade knowledge resources? J Resource mix – what is the composition of knowledge resources? Together, these four elements represent the analysis of the company’s intellectual capital. The elements are interrelated, and their relevance becomes clear when seen in context. The indicators report on initiatives. The initiatives formalize the problems identified as management challenges. The challenges single out what has to be done if knowledge resources are to be developed. The knowledge narrative also sums up, communicates and re-orientates what the company’s skills and capacity do or must do for users, and what knowledge resources are needed within the company.

An example: Maxon Telecom A/S Maxon Telecom A/S designs and develops cutting-edge mobile telephones for its Korean parent company, which then manufactures the phones. Maxon Telecom is given the basic specification for mobile phones and takes part in an active dialogue on technical specifications and designs. Further, the firm provides competent sparring necessary for its Korean parent company to supply ‘‘communication, anytime, everywhere’’ to its customers. As a sparring partner, Maxon Telecom must be able to compile and exploit the necessary knowledge resources. This can be achieved in many ways and the knowledge narrative specifies which knowledge resources Maxon Telecom considers as necessary to create use value. Highly skilled employees are seen as particularly important because they own the ability to ‘‘play’’ with technology and make new technologies work. These employees must also be

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Table I A summary of the elements of Maxon Telecom’s intellectual capital statement 2002 Knowledge narrative

Management challenges

Initiatives

Indicators

J Product or service: Maxon Telecom develops and designs mobile phones based on cutting edge technology.

J Product development

J Check users’ expectations and satisfaction

J Number of satisfaction studies (and market surveys) conducted J Customer satisfaction with quality J Number of projects ordered in the year

J Improvement of personal skills

J Conduct employee performance reviews J Establish and implement competency development plans J Implement tutor schemes J Implement management training J Implement CASE training J Implement leadership coaching

J Absence J Rate of completion of training needs outlined in the MUS conclusions J Employee satisfaction with course or training initiatives J Number of performance reviews held on schedule J Employee satisfaction J Employees’ assessment of their colleagues’ interpersonal skills and competencies J Staff turnover J Number of employees with competency development plans J Number of employees on job rotation, being promoted or posted abroad J Number of employees who believe they can develop in Maxon, both professionally and personally J Number of employees who see their immediate superiors’ as being capable of motivating them satisfactorily J Number of new employees in proportion to number of tutor schemes

J Ensuring products are on-time

J Launch Microsoft Projects training J Number of projects implemented J Implement project organization on time J Implement teambuilding process J Number of projects kept within the agreed budget J Number of junior project managers recruited in-house J Number of employees approved to work as project managers J Satisfaction with distribution of responsibilities between and within departments J Employees’ satisfaction with the ability to act with speed J Number of project groups with under 16 members J Number of project groups without own project room

J Creating knowledge of and competencies within current and future technologies

J J J J

.

J Use value: Competent sparring to provide ‘‘communication, anytime, anywhere’’. J Knowledge resources: Employees’ specialist knowledge and competencies, insight in users’ and customers’ needs, insight in existing and future technologies and the capacity to run projects.

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Train people in new technologies Introduce roadmap Participate in conferences Being a part of operators’ and development houses’ networks

J Participation in CEBIT and Cannes J Number of co-ordinating meetings a year J Number of departmental managers/technology scouts in operators’ networks J Number of developers in external networks

motivated to become involved in the company’s business, as only then will customers ‘‘and users’’ needs be met. It requires an understanding of mobile phone users’, manufacturers’ and operators’ needs. Maxon Telecom is a development house and therefore has to be at the cutting edge of technology and requires knowledge of future as well as existing technologies. The mobile phone market demands that new developments can be quickly brought to the market. If this is not achieved, communication is weakened which affects the perceived value by the user. As development work is organized into independent projects, the company must be able to run projects so that they finish on time, on budget and at the required quality level. These are the knowledge resources that Maxon Telecom must strengthen through initiatives. Some of the management challenges are about developing existing knowledge resources, such as personal knowledge and project management skills, which deliver ‘‘on-time products’’. Others are about acquiring knowledge that is not found within the company such as monitoring technology development and product development with respect to customers’ and users’ needs. The challenges are addressed in the initiatives launched by Maxon Telecom. The initiatives are designed to establish contact with external parties through communication with end users and through networking and conferences. Initiatives also address the systematic development of the competencies identified as necessary to supply value to users; which includes, in this case, personal and specialist competencies and project management competencies (Table I). The indicators give the company the ability to follow up on how initiatives develop, their effects, and whether Maxon Telecom is ultimately able to create the value they are working for.

Conclusion Experience suggests that intellectual capital statements can be used as a tool for systematizing and developing knowledge management activities. In this sense they may help formulate the firm’s resource-based strategy. The purpose of the intellectual capital statement is often twofold, as it functions as a management tool used internally in the firm and as a communication tool used to communicate how the firm works to develop its knowledge resources in order to generate value. It is interesting to note that this communication has many effects: on the one hand it may attract new resources in form of employees and partners, and in some cases it may also attract customers. In addition, it can function as a management tool, which helps to develop a resources-based or knowledge-based strategy; it can help to monitor its implementation, and therefore allows management intervention so that information (indicators) are used to develop the firm. Measurement in this situation is not a passive act of recording: measurement helps develop the firm’s knowledge about its strategic progress, and it allows actions to be undertaken to change the present towards a better future.

References Accounting Standard Board (2002), Operating and Financial Review, Revision to Guidance, Exposure Draft, Accounting Standard Board, London. AICPA (1994), Improving Business Reporting – A Customer Focus: Meeting the Information Needs of Investors and Creditors; and Comprehensive Report of the Special Committee on Financial Reporting, American Institute of Certified Public Accountants, New York, NY. Amir, E. and Lev, B. (1996), ‘‘Value-relevance of nonfinancial information: the wireless communication industry’’, Journal of Accounting and Economics, Vol. 22, pp. 3-30. Bontis, N., Dragonetti, N.C., Jacobsen, K. and Roos, G. (1999), ‘‘The knowledge toolbox: a review of the tools available to measure and manage intangible resources’’, European Management Journal, Vol. 17 No. 4, pp. 391-402 Botosan, C.A. (1997), ‘‘Disclosure level and the cost of equity capital’’, The Accounting Review, Vol. 72 No. 3, July, pp. 323-49. Bukh, P.N., Larsen, H.T. and Mouritsen, J. (2001), ‘‘Constructing intellectual capital statements’’, Scandinavian Journal of Management, Vol. 17 No. 1, pp. 87-108.

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Bukh, P.N., Rosenkrands Johansen, M. and Mouritsen, J. (2002), ‘‘Multiple integrated performance management systems: IC and BSC in a software company’’, Singapore Management Review, Vol. 24 No. 3, pp. 21-33. Canadian Institute of Chartered Accountants (2001), Management’s Discussion and Analysis: Guidance on Preparation and Disclosure, Review Draft, Canadian Institute of Chartered Accountants. Edvinsson, L. and Malone, M.S. (1997), Intellectual Capital, Piatkus, London. Healy, P.M. and Palelu, K.G. (2001), ‘‘Information asymmetry, corporate disclosure, and the capital market: a review of the empirical disclosure literature’’, Journal of Accounting and Economics, Vol. 31, pp. 405-40. Kjærgaard, I. (2003), ‘‘Constructing a knowledge-based identity: experiences from working with intellectual capital statements’’, Corporate Reputation Review, Vol. 3 No. 3, pp. 266-75. Lev, B. and Zarowin, P. (1999), ‘‘The boundaries of financial reporting and how to extend them’’, Journal of Accounting Research, Vol. 37, pp. 353-86. Marr, B., Gray, D. and Neely, A. (2003), ‘‘Why do firms measure their intellectual capital’’, Journal of Intellectual Capital, Vol. 4 No. 4, pp. 441-64. Marr, B., Schiuma, G. and Neely, A. (2002), ‘‘Assessing strategic knowledge assets in e-business’’, International Journal of Business Performance Management, Vol. 4 No. 2/3/4, pp. 279-95. Marr, B. and Schiuma, G. (2001), ‘‘Measuring and managing intellectual capital and knowledge assets in new economy organisations’’, in Bourne, M. (Ed.), Handbook of Performance Measurement, Gee, London. Mouritsen, J. (1998), ‘‘Driving growth: economic value added versus intellectual capital’’, Management Accounting Reserach, Vol. 9, pp. 461-82. Mouritsen, J. and Larsen, H.T. (2004), ‘‘The 2nd wave of knowledge management: re-centring knowledge management through intellectual capital’’, British Accounting Review (forthcoming). Mouritsen, J., Larsen, H.T. and Bukh, P.N. (2001a), ‘‘Intellectual capital and the ‘capable firm’: narrating, visualising and numbering for managing knowledge’’, Accounting, Organisations and Society, Vol. 26 No. 7, pp. 735-62. Mouritsen, J., Larsen, H.T., Bukh, P.N. and Rosenkrands Johansen, M. (2001b), ‘‘Reading an intellectual capital statement: describing and prescribing knowledge management strategies’’, Journal of Intellectual Capital, Vol. 2 No. 4, pp. 359-83. Mouritsen, J. et al. (2003), Intellectual Capital Statements – the New Guideline Danish Ministry of Sciences Technology and Innovation, Copenhagen. Starovic, D. and Marr, B. (2003), Understanding Corporate Value – Measuring and Reporting Intellectual Capital, Chartered Institute of Management Accountants, London. Wallman, S. (1996), ‘‘The future of accounting and financial reporting, part II: the colorized approach’’, Accounting Horizons, Vol. 10 No. 2, pp. 138-48. Wallman, S. (1997), ‘‘The future of accounting and financial reporting, part IV: ‘access’ accounting’’, Accounting Horizons, Vol. 11 No. 2, pp. 103-16.

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Assessing national and regional value creation Leif Edvinsson and Ahmed Bounfour

Leif Edvinsson is CEO of UNIC. He is the world’s first holder of Professorship of Intellectual Capital, Lund University, Sweden, He is also the world’s first Director of Intellectual Capital, Brain of the Year 1998, Creator of Universal Networking Intellectual Capital and Global Knowledge Nomad. He can be contacted at: Mobile: +46-70-5925078, E-mail: [email protected], Internet: www.corporatelongitude.com Ahmed Bounfour is Developer of the IC-dVALj approach, Associate Professor for Strategic Management Research Programme on Intangibles, University of Marne La Vallee-East Paris, France. He can be contacted at: Mobile: +33 6 07 60 50 74, E-mail: [email protected] and [email protected]

Abstract In the knowledge economy, the value of corporations, organizations and individuals is directly related to their knowledge and intellectual capital. This does not only apply to organizations in the private or public sector but also to entire nations. If intangibles and intellectual capital are important to organizations, they are also important to the productivity and competitiveness of nations as a whole. The question we try to answer is how can we better understand the dynamics of intangibles on a national scale? Keywords Knowledge management, Benchmarking, Intellectual capital

The knowledge economy In the knowledge economy, the value of countries, regions, organizations and individuals is directly related to their knowledge and intellectual capital (IC). Can the new corporate view be translated into a new perspective on national performance? Can the Scandinavian perspective of ‘‘naringsliv’’ as nourishment for life be a clue to the knowledge economy beyond the concept of business? Could there be a new ecosystem or DNA for the knowledge economy? According to the OECD report, Scoreboard 2001 – Towards a Knowledge-Based Economy, the countries with knowledge intensive activities will be the winners in terms of future wealth creation. In that report, 30 member countries are scored according to IC investments such as research and development (R&D), education, patents, ICT etc. Nordic countries score well on this list: J Finland is described as the country with the most rapidly growing investments into R&D. J In Norway several initiatives have been prototyped. One is to understand IC in local communities (e.g. Larvik Kommune) or regions (the Norwegian oil plateau). J Denmark set up a National Competence Council for collaboration between the government and the business community to map the knowledge competitiveness of Denmark J In 2002 the St Paul region in Minneapolis was ranked number one on the world knowledge competitive index ahead of Silicon Valley and Austin, Texas. J In 2003, Dubai was formally inaugurated as leading knowledge village (benchmarked with Singapore). J So called knowledge cities are emerging (e.g. Barcelona) that shape the urban design for the knowledge economy and its knowledge workers.

DOI 10.1108/13683040410524748

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During the 1990s, the research by Paul Romer at Stanford University, USA, has highlighted the exponential value of multiplying knowledge as an exponential value curve, called the law of increasing marginal utility. In other words the more connections, relationships and interactions exists in a network the higher the potential value. It might also be described as 1 + 1 = 11. This is very evident in the case of software development where the value is growing with increased usage. Only investment into knowledge will give us the opportunity to improve the wealth of nations. As such, we need a new map of knowledge assets, a map of regional IC, instead of the old agricultural and industrial plans so often found in regional planning offices. The new corporate longitude The logic of corporate longitude is based on a story from the 18th century. At that time, ships were unable to navigate with any precision from east to west. They were lacking control on an important dimension and consequently many 18th century ships lost their bearings. In the same way that today’s analysts who only concentrate on financial capital do as they are missing out an important dimension of performance. The case of Enron illustrates a recent example of a similar problem in the world of accounting. In the public sector it might be even worse, with an increasing focus on achieving the financial budgets. The result is that public sector organizations are being starved of the assets that will safeguard their future. Extensive cutbacks are robbing them of the crucial nourishment offered by intangibles such as experts, know-how, R&D, learning as well as alliances and networks for social innovations. The solution to the 18th century longitude problem was solved by John Harrison, a watchmaker who developed a tool to help ships to position themselves and therefore understand all the vital dimensions of their journey. In order to get a deeper understanding about the principles of wealth creation, it is essential to develop a similar understanding of the non-financial performance drivers. An approach whereby assets are simply recorded on a balance sheet is far too narrow. A new approach to accounting is necessary to include the intangibles and nonfinancial assets such as knowledge creation, networks, and relationships. The wealth of organizations, as well as the wealth of nations, lies in the space in which human capital and structural capital interact. Currently, organizations, as well as societies as a whole, are like 18th century ships, charting their positions with only one-dimensional navigation tools. Plotting a course solely based on traditional financial reference points leaves them blind to the opportunities on the lateral horizon. Most attention is still devoted to the financial dimension, even in a world where tangible assets of most organizations only represent between 1 and 25 percent of a company’s stock market value. For these assets the organization has CFO and controllers, ERP systems and the whole profession of auditors. But what do we have for the intangibles and intellectual capital? Maybe the customer relationship management systems? In 1991 Skandia appointed Edvinsson as director of IC to address this shortcoming. However, even today it is still an exception. Until sailors could measure longitude, they were frequently lost at sea. The same is the case for our leaders of firms or countries today. The difference between financial and the knowledge based view demands a shift in the way we view the organizations, regions, and countries. We have to take the lateral perspective into account and address value creators such as alliances, networks, cultural context, know-how and other intangibles. Figure 1 is an illustration of corporate longitude as a lateral dimension of intangibles inside and outside the firm’s vertical balance sheet. What is needed is a window for those new value-creating spaces. Value is created in the interaction between people (human capital) and the organizational structural capital such as R&D processes. Nonaka (1994) is referring to this as knowledge creating dialectics or Kenetics. He also referred to them as Ba, which literally means a space for appreciation in Japanese. In Skandia’s case they were labeled Future Center. The Skandia Future Center, established in 1996, focused on the value creation by experiential knowledge exploration. It became an arena where employees could enter into the future and then return to

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Figure 1 The corporate longitude # Leif Edvinsson

the present with new insights. Another such interesting space for renewal was created by the Danish government. In February 2002 the Ministry of Economics launched Mind Lab, which is similar to the concept prototyped at Skandia or the Japanese concept of Ba. Mind Lab is however a center with the aim to nourish knowledge management in the public sector[1].

IC mapping and measurement The 500-year-old accounting system is focused on historical costs and transaction reporting. This backward looking metrics approach leads to growing inaccuracies in the understanding of value creation. Furthermore, it results in misallocation of resources by investment institutions. What is needed is a longitudinal system that allows us to visualize, cultivate and capitalize on these value creating interactions. Some nations are already experimenting with new approaches. Denmark, for example, launched a project in 1998 looking at intellectual accounting that aimed to help transform Denmark from an industry to a knowledge-based economy. In 2000 and 2002, the Danish government published guidelines for intellectual capital statements[2]. In Norway several initiatives are in progress. The local municipality of Larvik has been prototyping both annual IC reports as well as IC-ratings for its activities. In 2002 the Norwegian Association of Financial Analyst has launched guidelines for reporting on knowledge capital[3]. The Invest in Sweden Agency (ISA) was the first national investment organization to apply the latest understanding of intellectual capital to assess and compare national competitiveness and performance in its annual report for 1999. They state that ‘‘Intellectual capital forms the root of a corporation – and of a nation – that supplies the nourishment for future strength and growth’’. Sponsored by the UN Development Programme, Bontis and his colleagues (2002) conducted research on IC in ten Arabic countries. In the study, Bontis quantifies the level of IC for each nation and outlines an IC index, which can be used by each nation to rank themselves against their peers, and indeed to learn from the experiences of other countries. One of the more recent reports on IC on a national level was presented by Pulic (2003) and his team assessing the efficiency in the Croatian economy based on an IC assessment. Most public organizations, institutions, and governments are under increasing political pressure to increase their policy and output transparency. The development of intangible resources is an essential issue for public organizations and governments as it impacts on future growth and employment. In the same way as private organizations, countries and regions must develop innovative approaches, research programs and development, systems of education, fiscal policies and public procurement policies.

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The dynamic value of IC at national and regional level: the IC-dVAlj approach Certainly one way of looking to the longitude of tomorrow lies in considering intellectual capital from a dynamic perspective. As it has been underlined, over the last five years, several interesting initiatives were put in place at the level of nations, regions, other non profit organizations. Most of these initiatives consisted of analyzing existing data, basically at the input level – output level, using existing information. But we need to go further and focus on the organizational and dynamic dimension of socio-economic performance. The IC-dVAlj (Intellectual Capital dynamic Value) (Bounfour, 2000, 2003a) is one approach that defines metrics from a dynamic perspective. This approach has been implemented in different contexts, at microeconomic as well as at macroeconomic levels. Indeed, as far as metrics are concerned, these have to be defined dynamically along four important and interrelated dimensions of competitiveness: 1. Resources as inputs to the production process: tangible resources, investment in R&D, acquisition of technology, etc. 2. Processes. It is through processes that the deployment of a dynamic strategy founded on intangible factors can really be implemented: processes of establishing knowledge networks, and competencies inside and outside organizations; processes of combining knowledge; just-in-time processes for products and services and the whole of the outputs; processes of motivation and training of personnel, processes for building social capital and trust, etc. 3. The building of intangible assets (intellectual capital). These can be built by the combination of intangible resources. Indeed, combining intangible resources can lead to specific results such as collective knowledge, patents, trademarks, reputation, specific routines, and networks of cooperation. For each of these assets, indicators and methods for their valuation can be developed. 4. Outputs. It is on this level that performance of organizations is classically measured, through the analysis of their products and services’ market positioning. Here, one will be interested in indicators such as those relating to market shares, quality of products and services, barriers to entry building, establishment of temporary monopolistic positions. How metrics are calculated according to the IC d-VALj The IC d-VALj defines and measures IC in terms of relative indexes as well as in monetary terms. The starting point is a clear definition of the main components for the four dimensions – resources, processes, assets and outputs. Then a benchmarking process is conducted for these items. Basically we compare the position of a company or a nation to those considered as best performers. The benchmarking exercise leads to calculating ad hoc performance indexes, as well as to a composite index per country, region or community. It is those indexes that are used in this paper. At the corporate level, we usually express intangible assets in monetary terms, hence the possibility of making the link between relative performance indexes and financial valuation. But for communities such as nations, regions or cities, the exercise is more complex. Ongoing research is trying to translate intangible assets of communities into monetary terms (e.g. Bounfour). IC performance at national level This framework has been used to collect benchmarking information on the performance of EU innovation systems using the Innovation Trend Chart data as proxy values (Bounfour, 2003b). Below we will present the initial findings of this initiative. Many data sources tend to suggest that the EU region is lagging behind the USA in terms of efforts – i.e. investment in intangibles – at the input level (RCS Conseil, 1998). The process level refers specifically to the importance of the organizational dimension, i.e. how European companies and other organizations innovate (including new organizational forms for managing and developing their intellectual capabilities). Here, unlike the input dimension, Europe is taking the lead. Since organizational innovations are critical components for building competitive advantage, it is important to note that European companies benefit from a real advance in one

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component of this subject: the modeling and reporting on intangible investment. At the macroeconomic level, by using the Innovation Trendchart data as proxy metrics, we observe that Nordic countries in Europe are outstanding players: Denmark for the percentage of collaborative innovations among SMEs; The Netherlands, Denmark, Sweden for the percentage of Internet home access; and Finland for ICT markets/GDP ratio. At the output level, several studies have stressed the existence of a possible ‘‘missing link’’ between the input effort made and the observed performance. The Nordic countries in Europe also take a leading position in the global comparison (Sweden is the best player in terms of the ratio: percentage of innovating exports on total sales; The Netherlands are the best in class for the unemployment rate; Finland is a good player in new-to-market products, thanks to Nokia’ success). At the level of intangible assets, proxy asset indexes are used to distinguish between structural capital (mainly patents) and human capital. For structural capital, the resulting indexes clearly indicate that again Nordic countries perform best: the number of scientific publications per million. The same applies for two major indicators for patenting: EPO – European Patent Office and US PTO Patent Office indexes. For human capital, data attest better performance for Nordic countries, except for one metric: the percentage of S&E – science and engineering graduates among 20-27 aged population (UK is the leading country here). Finally, using these data as a starting point, we can see that, on average, Nordic countries are ranking well in Europe (Figure 2). This might be related to their good performance at the organizational level but needs further research, particularly in order to understand how these systems function, what makes them unique and how path-dependent they are. Any measurement approach has to take these dimensions into account. Indeed, if a ‘‘naı¨ve’’ perspective were to consider that these countries are the benchmarks for intangibles, the real issue is to document to what extent this might be meaningful for the other EU countries. Could, for instance, a process of ‘learning-by-comparing’’ can be implemented. What is the level of absorptive capacity of the other systems for potential identifiable best in class routines taking into account the difficulties in transferring and comparing practices for managing IC (Marr, 2004). IC performance at regional level The same reasoning can be applied at a regional level. By using different – but limited – proxy data for measuring regional performance in terms of IC in the case of France, a benchmarking index of IC performance could be created. The initial results tend to suggest that two regions are performing particularly well: Ile de France (Paris area) and Midi-Pyre´ne´es (Toulouse region), whereas Corsica is lagging behind. But here again, the real challenge for policy makers lies at the organizational level: what kind of ‘‘learning-by-comparing’’ can be implemented among regions of France as well as with other regions in Europe as well as outside (Figure 3).

Figure 2 IC performance indexes for European countries, according to the IC-dVAlj approach

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Figure 3 IC Performance Indexes for France Regions, according to the IC-dVAlj approach

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Conclusion and implications Intangibles are a major issue at both microeconomic and macroeconomic (community) levels. At community level, several initiatives have been taken, especially in Europe that need consolidation and better development. More research is encouraged in order to better understand the value drivers of regions and counties and how we can better manage them in order to manage for increasing value. Indeed, what we observe now is a strong weakness in the available tools both for statistical reporting and policy making. From this perspective, intangibles are a key driver for producing new ways of viewing the policymaking arena out of the ‘‘traditional boxes’’ of things. This is the main perspective we named: IC for communities. Obviously, the deep change in socioeconomic systems all over the world call for new approaches to wealth creation and beyond that to the social contract building. In these areas, researchers, policymakers are now deeply challenged. It is the role of intangibles – as a perspective – to contribute in dealing with those challenges.

Notes 1 For more information see www.mind-lab.org 2 For more information see www.vtu.dk/icaccounts or download from www.danmark.dk/netboghandel 3 See www.finansanalytiker.no

References Amidon, D. (2003), The Innovation Superhighway, Butterworth-Heinemann. Andriessen, D. (2003), The Value of Weightless Wealth, PhD dissertation, University of Nyenrode, Holland and forthcoming book 2004. Bontis, N. (2002), National Intellectual Capital Index: Intellectual Capital Development in the Arab Region, United Nations, New York, NY. Bounfour, A. (2000), ‘‘Competitiveness and intangible resources: towards a dynamic view of corporate performance’’, in Buigues, P., Jacquemin, A. and Marchipont, J.-F. (Eds), Competitiveness and the Value of Intangibles, Edward Elgar Publishing, London, Preface by Romano Prodi. Bounfour, A. (2003a), The Management of Intangibles, The Organisation’s Most Valuable Assets, Routledge, London and New York. Bounfour, A. (2003b), ‘‘The IC-dVALj approach’’, Journal of Intellectual Capital, Vol. 4 No. 3, pp. 396-412. Bounfour, A. (2003c), ‘‘Intangibles and benchmarking performance of innovation systems in Europe’’, The IPTS Report, May, pp 32-7. Bounfour, A. and Edvinsson, L. (2004), IC For Communities, Nations, Regions, Cities, and other Communities, Butterworth-Heinemann, Boston, MA (forthcoming).

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Danish Ministry of Industry (2001), Guidelines for Knowledge Accounts Copenhagen, Denmark. Edvinsson, L. and Malone, M. (1997), Intellectual Capital, Harper Business, New York, NY. Edvinsson, L. and Stenfelt, C. (1999), ‘‘IC at a national level’’, Journal of Human Resource. Edvinsson, L. (2002) Corporate Longitude, Bookhouse, www.corporatelongitude.com. Forrester, J. (1971), World Dynamics, Productivity Press. Itami, H. and Roehl, Th.W. (1987), Mobilizing Invisible Assets, Harvard University Press. Marr, B. (2004), ‘‘Measuring and benchmarking intellectual capital’’, Benchmarking International Journal, (forthcoming). Mouritsen, J. (2001), IC and the Capable Firm, Copenhagen Business School, Copenhagen. Nonaka, I. (1994), ‘‘A dynamic theory of organizational knowledge creation’’, Organization Science, Vol. 5 No. 1, February. Nonaka, I. (2002), Paper presented at Global Knowledge Forum, Tokyo, 24-25 October. Nonaka, I. and Takeuchi, H. (1995), The Knowledge-Creating Company, Oxford University Press. Pulic, A. (2003), www.vaic-on.net Pasher, E. et al., (1998), IC of Israel, Prototyping report. RCS Conseil (1998), Intangible Investments, The Single Market Review Services, Office for Publications of the European Communities, Kogan Page. Romer, P. (1991), Increasing Returns and New Developments in the Theory of Growth. Stan, D. (2001), Lessons from the Future, Capstone Publishing, UK. Stenfelt, C. et al., (1999), ‘‘IC at a national level’’, Invest In Sweden Agency Annual Report. Viedma, J.M. (1999), ICBS Intellectual Capital Benchmarking System, Paper, McMaster University, Canada, as well as 2001 Journal of Intellectual Capital, Vol. 2 No. 2. Welzl, A. (2001), Intellectual Capital Report 2001, ARC Seibersdorf Research Gmbh, Austria.

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Intellectual capital – does it create or destroy value? Ante Pulic

Ante Pulic is a professor at the University of Zagreb, Croatia, and University of Graz, Austria. Tel: 00385-1-4875 210, Fax: 00385-1-4875 211, E-mail: [email protected]

Abstract Taking into account the transformation in economic reality towards a knowledge economy it seems logical that we treat IC as a resource, equal to that land, physical assets, and financial capital. This means that it is not anymore treated as a cost but as an investment. In order for the new system to be consistent we have to define a new index, namely the value creation efficiency of intellectual capital. Its empirical applications shows that while revenue, profit and GDP may indicate successful performance, IC efficiency may indicate the opposite, that value is being destroyed and not created. Keywords Intellectual capital, Value added, Resource efficiency

Introduction Many books and articles have been written about knowledge and intellectual capital and its role in value creation. As intellectual capital has become such a powerful factor in today’s economic reality, I would like to point out a seemingly common problem. Most economic and financial models treat employees – the prime carriers of knowledge – as a cost and not as a resource. In order to take a step forward it is necessary to define a new status for employees. Employees and their intellectual capital ought to receive the official status of key resource. This means that it should be put on the same level as financial and physical capital. This is not a hard thing to do. If we agree that IC is the key resource of the 21st century and that knowledge is today what once were land, manual work and money, then it would be only natural to give this resource the status it deserves: of an investment instead of a cost. The treatment of employees as investment is the beginning and the end of the knowledge based economy. In the same way, as in the industrial era, where investments were made in plants and machines as the base for value creation, today companies invest in employees, who are becoming the key factor of value creation. This way companies combine the two key resources, financial capital and intellectual capital, which together create value. Rational value creation has been the main goal in all economic era and it is therefore the goal of any modern company, institution, region or nation too. With the same resources a company can create more or less value. Therefore, the key question of the new economy is how do we know whether value is created or destroyed, whether enough value is created and whether it is created efficiently?

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DOI 10.1108/13683040410524757

An index for the new economy Many IC experts agree that traditional financial measuring systems are inadequate for today’s businesses. As the business processes are to a lesser amount based on tangibles, the question arises how to manage not only processes and companies but also regional or national economies in the situation when intangibles are becoming the key factor of value creation? Many methods and approaches appeared during the past 15 years trying to provide an answer to that question (Marr et al., 2003). Below, I would like to comment on just a few. The economic value added (EVAj) methodology can be found on most IC-measuring lists. I find this odd as I do not believe that it is a suitable measuring system for intellectual capital. EVAj focuses on the efficiency of just one resource, capital employed. Therefore this method can not be a valid measuring system for the new economy. The balanced scorecard (BSC) is very popular too and has been applied for quite a long time. Although it seems to me a very useful management tool, I do not find it suitable as a standard measuring system. David Norton, co-author of the BSC, states that ‘‘The BSC is definitely not a measuring system. It is a technique for describing strategy’’ (Daum, 2002). Now I would like to briefly comment on the whole group of non-monetary measurement systems. Even though they might be very useful as a basis for internal management information, on a macro level they pose the problem of comparability and scope. Most of them are operating with a large number of (non-transparent) indicators, at business levels. This makes it difficult, if not impossible, to compare companies. What is required is an index which would allow us to assess business success more objectively. It is therefore our goal to find an index which would be useful to all participants in the value creation process, employees, management, investors, shareholders and business partners. Such an index has to be able to indicate the real value and performance of a company and its units, provide comparison with others and predict future abilities in a relatively objective way.

The solution to this issue can be found in the very essence of economic activity. Traditional, the industrial economy functioned in the following way: the process of production was based on a price forming system, which was based on costs plus the potentially achievable profit in the market. This is the origin of the close relationship between product costs (material and work) and its market price. With knowledge based products this relationship does not exist in the same way any more. The value of a knowledge based product or service is not formed through quantity (e.g. the number of programming lines, number of experiments in laboratories or the amount of money invested in a film shooting). Value is based on the perception of customers. Therefore it is the creation of value and not the production of pieces that is the dominant activity of the new economy. Quantity has been replaced by value. This transformation provides the framework for a new measuring system. In the traditional economy wealth was created by an increase in quantity (e.g. units produced) and therefore the measuring system was based on quantity, with indicators like revenue, costs, and profit. Based on the shift from quantity to value, a new measuring system, with a new index has to be introduced (Table I).

Table I Economy: Measurement system: Measurement unit:

Industry age Quantity Pieces

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On the one side of value creation there is the relationship between customer and the product or service and on the other side is the relationship between created value and resources utilized in creating the products and services. This relationship, between resources and result is what I refer to as efficiency. With this the base for a new measuring system is laid, which considers efficiency of resources in value creation as the new index.

Efficiency of intellectual capital Peter Drucker states ‘‘The most important, and indeed truly unique contribution of management in the 20th century was the 50-fold increase in productivity of the manual worker in manufacturing. The most important contribution management needs to make in the 21st century is to increase the productivity of knowledge work and knowledge workers. The most valuable asset of a 20th century company was its production equipment. The most valuable asset of a 21st century institution will be its knowledge workers and their productivity’’. In order to understand the efficiency of intellectual capital it has to be measured. I take value added as the most appropriate indicator for business success, which is calculated as the difference between output and input. The basic definition is as follows: VA = OUT – IN where: VA = value added for the company; OUT = total sales; IN = cost of bought-in materials, components and services. Value added can be calculated from the company accounts as follows: VA = OP + EC + D + A where: OP = operating; EC = employee costs; D = depreciation; A = amortization. Value added is an objective indicator of business success and shows the ability of a company to create value, which needs to include the investments in resources including salaries and interests on financial assets, dividends to the investors, taxes to the state and investments in future development. After VA has been calculated, the computation of the efficiency of resources – intellectual capital and financial capital – is a matter of simple mathematics. Intellectual capital has two components, human capital and structural capital. All the expenditures for employees are embraced in human capital. What is new about this concept is that salaries are no longer part of the INPUT (Pulic, 1993). This means expenses related to employees are not treated as cost but represent an investment. Efficiency of human capital is calculated as a result: HCE = VA/HC where: HCE = human capital efficiency coefficient for the company; VA = value added; HC = total salaries and wages for the company. Structural capital, as the second component of IC, is calculated as follows: SC = VA – HC where: SC = structural capital for the company; VA = value added; HC = total salary and wage duties for the company. As the equation already indicates, this form of capital is not an independent indicator. It is dependent on the created VA and in reverse proportion to HC. This means that the bigger the share of human capital (HC) in the created VA the smaller the share of structural capital (SC). In some cases SC does not even have to occur – e.g. if VA is less than the investments in HC. It is logical that the efficiency of both, HC and SC rises as the total efficiency of IC increases. Structural capital efficiency (SCE) is therefore calculated in the following manner: SCE = SC/VA where: SCE = structural capital efficiency for the company; SC = structural capital; VA = value added.

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Intellectual capital efficiency (ICE) is obtained by adding up the partial efficiencies of human and structural capital: ICE = HCE + SCE where: ICE = intellectual capital efficiency coefficient; HCE = human capital efficiency coefficient; SCE = structural capital efficiency coefficient I believe that today ICE is for knowledge work and the knowledge worker what once was productivity for manual work and the manual worker. In order to receive a full insight into the efficiency of value creating resources, it is necessary to take financial and physical capital into account. Intellectual capital cannot create value on its own. Therefore we also need information on the efficiency of the capital employed which can be calculated in the following manner: CEE = VA/CE where: CEE = capital employed efficiency coefficient; VA = value added; CE = book value of the net assets of company. In order to enable comparison of overall value creation efficiency all three efficiency indicators need to be added up. VAIC = ICE + CEE where: VAIC = value added intellectual coefficient; ICE = intellectual capital efficiency coefficient (HCE + SCE); CEE = capital employed efficiency coefficient. This aggregated indicator allows us to understand the overall efficiency of a company and indicates its intellectual ability. In simple words, VAIC measures how much new value has been created per invested monetary unit in each resource. A high coefficient indicates a higher value creation using the company’s resources, including its intellectual capital. We therefore have a new way to understand organizational efficiency.

Empirical application of the index Organizational efficiency As already shown all the substantial elements for the calculation of the VAIC index exist in the regular accounting system. For the following empirical applications we have used annual reports. More than 1,000 companies in Europe were analyzed. In many examples the traditional measures indicate positive performance, whereas the VAIC index shows decreasing efficiency. Figure 1 and 2 show the result for Ericsson as an example. According to traditional indicators (Figure 1) Ericsson is doing very well: a rise in revenue, profit and dividend is recorded. However, using the VAIC index the situation is surprisingly different (Figure 2). In 2000 ICE created over three monetary units new value per one unit invested, in 2002 the return was only 2.5. The same fall in efficiency was recorded with capital employed. Considering this information, management cannot be satisfied and instead should be concerned with its performance.

Figure 1 Business results – classic 400 2001 2002

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Figure 2 Business results – new 3,5 3 2,5 2 1,5 1 0,5 0 2000

2001 ICE

2002 CEE

This paradox can be explained in the following way. The production of quantity, as a way of creating value in the industrial era is in total contrast to the new mode of value creation in the knowledge economy. It shows that a company can achieve high revenue, and report profit but that it is not creating value. This is because in today’s conditions of value creation quantity (number of pieces, revenue or profit) is not relevant, but instead the relation between the business result and the utilized resources, the efficiency. A renowned historian refers to such transition as ‘‘dealing with the same bunch of facts as before just establishing new kinds of relationship between them, thereby providing a totally different framework’’ (Butterfield, 1949). This is what intellectual capital efficiency is about. The same data – revenue, profits, and costs – are brought into a new system of relationships, naturally much more complex than before, and new results are received, more objective and more appropriate for the new business reality. National efficiency Something similar is occurring at the macro level. The main criteria for business success of companies are revenue and profit – like in the famous Fortune 500 rankings – but on a national level it is GDP. This means companies do not receive a benchmark and therefore the ability to compare themselves against a national average. Measuring IC efficiency is as important on a national level as it is on a company level. Maybe it is even more important, as laws and policies are made at the macro level which are then influencing company performance as well as the entire economy. Therefore it is vital to establish a common measuring system applicable to all levels of business activity – from a processes level up to national economies. The data for calculating intellectual capital efficiency (ICE) is easily obtained at any national statistics office and therefore it was possible to calculate the ICE on a national level and compare it to GDP. Such analysis was done for all countries of the EU and some others. Figure 3 shows the results for The Netherlands. While GDP per capita was rising from year to year, ICE was falling accordingly. This paradox matches the one found on company level. The traditional indicator – GDP – implies that it is a successful economy but ICE, focussed on value creation efficiency, indicates the opposite. This example demonstrates very well why IC efficiency measures should be introduced on a national level. It sheds new light on the performance of a national economy, which is different from the one provided by GDP, revenue and profit, and because of that it is vital as a benchmark figure in the knowledge based economy. Governments and all parties responsible for the national economies have to pay due attention to the presented results, which has the following message: in order to acknowledge national intellectual capital, its performance has to be monitored. These paradoxes indicate that we do have to accept the fact that our economy has been facing a Copernican change, based on a totally new worldview. For thousands of years people did believe that the Sun circles around the Earth, and that was the accepted reality. No one even

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Figure 3 ICE and GDP 3 2,5 2 1,5 1 0,5 0 1998.

1999.

2000. ICE

2001.

2002.

BDP p.c.

doubted that something could be wrong with that notion until 500 years ago when Copernicus provided a totally different explanation – the Earth circles around the Sun. This shift in worldview was not caused by a change in the natural environment – the movements of the planets were the same all the time – but due to a new interpretation of the existing reality. And this is what we are doing now, through the concept of intellectual capital (as a resource). We are interpreting the existing economic reality of companies and national economies in a new way.

The creation or destruction of value In the closing part of this paper I would like to highlight the benefits, which all economic participants – employees, managers, investors, governments – gain by accepting intellectual capital as a resource and by measuring its efficiency. In order to do that it is best to start with the new economic reality – the knowledge economy – which has changed the perception of value creation. Companies do not produce just products or services but create value. If we compare the production of steel or cars, which were the important products of the 20th century, and software packages nowadays, we can clearly see the difference: the result is not just tons or pieces but incorporated value. Thus a new system has emerged that is based on knowledge. There are different rules for this kind of value creation, new laws and new indicators, which explain and describe reality in a more appropriate way. VA takes over the role which once had financial capital. VAIC and ICE replaces profit and all types of indicators like ROI and ROE in their traditional role as indicators of business success. Value creation per invested monetary unit in intellectual capital is a more appropriate index for the new economy, because it has the value creator in the denominator. Only these two indicators (VAIC and ICE) show whether value has been created or destroyed. As pointed out in the case of organizational efficiency, traditional indicators, such as revenue and profit, created an illusion of success while value was actually being destroyed. Value destruction can happen in the following two ways: 1. If a fall in value creation efficiency occurs. 2. When efficiency is below the average of the environment. A fall in value creation efficiency in comparison to a previous period e.g. the previous year, means value destruction, but I have to make an important remark here. Not every fall in value creation efficiency is devastating. A short-term fall in efficiency caused by investments is natural and can be considered a normal process. But, as a return on investment is to be expected, a fall in efficiency should not last for a longer time period. As already said before, the second type of value destruction is efficiency being under the average. Each company consists of organizational units, subsidiaries, branches or similar

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entities. The individual results of all entities amount to the overall intellectual capital efficiency, which represents the average efficiency of the company. It is composed of efficiencies below company average and those above it. All these entities that perform under average actually destroy value. The reason: they spend more resources for the creation of one unit of value added than it is necessary on company level. Today’s economy is facing a dangerous situation since our outdated measurement systems create distorted pictures of business performance. Many companies, as well as nations, are convinced of their economic progress, while the reality might be entirely different. By using new indicators companies and governments get the chance to receive a more realistic picture of their business ability and gain control over the value creation process. In addition, value added and efficiency of IC reunite the micro and macro level of the economy. We are dealing with measures indicating business success at any level of business activity, from process and units inside the company to regional and national economies. ICE unites two spheres as it treats both, micro and macro level in the same way, using the same database for calculations. In such a way value creation on national level can be monitored by sectors and the ones above or below national average can be identified. Causes can be traced and measures for improvement initiated. The same applies to the economy of regions within a national economy. One unified measure for all levels means that companies will finally receive benchmarks based on the national economy, in other words, they will know how efficient they are in comparison to national IC efficiency average. This will give governments a better understanding of how to support organizations or regions in the national economy. Finally, the shift towards intellectual capital as a resource and its value creation efficiency has also a sociological component. It highlights the importance of employees as value creators and bridges the gap between investors, managers and employees, as well as between organizations and governments.

References Butterfield, H. (1949), The Origins of Modern Science, London, pp. 1-7. Daum, J.H. (2002), Intangible Assets, Bonn. Drucker, P. (1999), California Management Review. Marr, B., Gray, D. and Neely, A. (2003), ‘‘Why do firms measure intellectual capital’’, Journal of Intellectual Capital, Vol. 4 No. 4. Pulic, A. (1993), Elemente der Informationsoekonomie, Vienna.

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Quality focus Bahrain budgets New study offers insight into corporate planning in the Middle East Performance against budget targets is a key indicator of organizational control and planning and there is a wealth of literature on budget practices. To date, studies have focused on large manufacturers, listed companies and Western practices. A new study of 54 companies in Bahrain redresses this imbalance and gives a clear picture of emergent business practices.

Background and benchmarks The study began by surveying the literature to establish benchmarks for the Bahrain companies. The researchers decided to focus on the following areas: J planning of budget; J perception of budget importance; J purposes of budget; J implementation of budget; J participation by managers in deciding budget targets; J variance as a performance measure; and J practices in listed and non-listed companies.

Bahrain companies A total of 146 companies were interested in participating in the survey and were sent a questionnaire which had been trialled with companies not included in the sample. A total of 54 usable questionnaires were returned: 35 from listed companies and 19 from non-listed companies. The companies were in the following industry sectors: banking, investment, insurance, services, industrial and hotel and tourism. Approximately half the listed companies were in investment or services sectors and hardly any in industrial. Approximately half of the non-listed companies were in the industrial sector and hardly any in hotel and tourism. The questionnaires provided data across 16 key areas in the budget cycle starting with whether companies make long-range plans and ending with reasons for failure to achieve budget targets.

Budgeting in Bahrain – planning, preparation, purpose, and participation With only a few exceptions, all companies made long-range plans of between three to five or more years. Approximately half the listed companies made five-year plans and approximately half the non-listed companies made three-year plans. All 54 companies prepared operating budgets but hardly any prepared rolling budgets. Nearly all the companies require their staff to plan budgets according to guidelines.

DOI 10.1108/13683040410524784

There were significant differences in the purposes of budgets. Listed companies ranked improving profitability highest and forecasting lowest but this was reversed for non-listed companies. This is perhaps because listed companies have to be accountable to shareholders who expect profitability to maximize their dividends.

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Significant differences were also observed in budget planning participation. A total of 60 percent of listed companies reported high levels of managerial participation but only 36 percent of non-listed companies did. Public accountability is probably a factor here for listed companies. In contrast, most non-listed companies tend to be family-owned and may therefore prefer secrecy. However, as more and more companies seek listing on the Bahrain Stock Exchange (BSE) this is bound to change.

Budgeting in Bahrain – design, timelines, and communication These three areas have a significant impact on the effectiveness of budget implementation and overall strategy. Just over three-quarters of all the companies had a budget committee composed of senior managers. Companies without a committee had a budget officer who worked closely with the CEO. Across all companies surveyed, 43 percent prepared fixed budgets and 39 percent prepared variable budgets; and 42 percent of listed companies prepared variable budgets. Budgets are most effective over short reporting cycles which assist control for and performance measurement of managers and departments. Most of the listed companies reported quarterly and so did many of the non-listed although 42 percent favor six monthly reporting. This difference is again driven by public accountability as listed companies have to follow the International Accounting Standard for Interim Reporting. Just over half of all companies measured budget performance by department and a third of non-listed companies also used divisional reporting. Budgets determine profit targets and effective communication is required if all staff are to contribute to meeting those targets. Two-thirds of companies reported that budget allocation was secret although they had plenty of information made available when planning operating budgets. There was general agreement that while budget communications were treated cautiously they were generally well received. However, there were significant differences in views of senior management’s leadership of budget implementation. In listed companies there were high levels of satisfaction but in non-listed companies high levels of criticism.

Budgeting in Bahrain – control and performance Budget leadership is connected with who evaluates variances. In the listed companies, department heads working with the budget committee did this. In non-listed companies, it was the preserve of senior management. Nearly all listed companies prepared monthly or quarterly variance reports in contrast to three-quarters of non-listed companies. The way that companies used variance reports revealed that Bahrain managers tended to follow Japanese models more closely than US ones. Budgets were used to measure managers’ departmental performance, identify problems and, as a result, improve the budgets for the next period. There was less emphasis on using variances to allow managers greater control. Companies were asked to rank four reasons for failure to achieve budget targets: inability in our department, poor planning, unrealistic standards and uncertainty. The first two were ranked highest across listed and non-listed companies. The authors of the study argue that this reflects a disparity between the high level of business training available in Bahrain and low levels of uptake by companies.

In the beginning The Bahrain study makes a valuable contribution to budget literature by focusing on the differences between listed and non-listed companies; concentrating on companies selling services as opposed to manufactured products; and surveying practices in a developing country.

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However, the study goes beyond academic relevance and gives a fascinating insight into an economy at a moment of transition. As oil production leads to more foreign direct investment (FDI), local companies will expand and take on board the advanced management accounting common in the West. The wide range of attitudes and practices in areas such as participation, communication and variance reporting highlights what needs to be in place to ensure the success of advanced practices like activity-based costing and a focus on customer profitability.

Comment Adapted from ‘‘Corporate budget planning, control and performance evaluation in Bahrain’’ by P.L. Joshi, Jawahar Al-Mudhaki and Wayne G. Bremser, Managerial Auditing Journal, Vol. 18 No. 9, pp. 737-80. The article reports on a survey of the budgeting practices of 54 medium and large companies in Bahrain. The results of the survey are measured against existing literature on budgeting that is usefully summarized at the beginning of the article. The results are presented in narrative form and in 16 detailed tables. The tables are well organized and easy for nonexperts to interpret. The article is clearly written and easy to follow. It gives a clear picture of differences between listed and non-companies. It will also be of interest to those wishing to establish operations in the Middle East; and to those already working in the region who wish to establish benchmarks and performance measures for their budgeting practices. However, although the article often refers to large and medium companies, it does not provide details of sample companies’ turnover which would have been useful.

Reference Joshi, P.L., Al-Mudhaki, J. and Bremser, W.G. (2003), ‘‘Corporate budget planning, control and performance evaluation in Bahrain’’, Managerial Auditing Journal, Vol. 18 No. 9, pp. 737-50, ISSN: 0268-6902.

KEY READINGS Coming up short on non-financial performance measurement Ittner, C.D. and Larcker, D.F., Harvard Business Review (USA), November 2003, Vol. 81 No.11, Start page: 88, No. of pages: 8 Describes findings from field research conducted with a range of manufacturing and service companies concerning their strategy and performance measurement systems. Gives examples showing how the substitution of qualitative performance measures for more traditional accounting approaches can be counter-productive. Discusses some common mistakes, observing that companies may not link their qualitative measures to strategy or, if they do create a causal model, may fail to validate the links between the chosen non-financial performance measures and financial results. Considers the difficulties involved in selecting performance targets that will deliver long-term payoffs and in developing metrics that have statistical validity and reliability. Recommends a series of steps that facilitate the effective use of non-financial performance measures.

The usefulness of a performance measurement system in the daily life of an organisation: a note on a case study Azofra, V., Prieto, B. and Santidrian, A., British Accounting Review, (UK), December 2003, Vol. 35 No. 4, Start page: 367, No. of pages: 18 Outlines previous research recognizing the importance of non-financial as well as financial measures of performance and provides a case study of a Spanish subsidiary of a US multinational in the car sector which has developed the use of both as a basis for continuous improvement. Explains the research design and theoretical framework, describes the company and its performance measurement system; and analyses in detail the function which this system fulfills and its links with profitability. Stresses that the system was not an ’‘off-the-shelf’’ solution or imposed by head office; and puts its success within the plant down to its practical evolution.

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Power of finance goes beyond counting cash Passage to India The recent trend for major UK companies to relocate their call centers to India is the source of much current concern and debate. Commentators reflect gloomily on the fact that the service sector is no more impervious to harsh economic reality than manufacturing or heavy industry. One lesson that companies have to address, more than ever, in today’s unforgiving and highly competitive global business market is that there are only two ways to make money: to increase revenue or to decrease costs. To meet those global challenges, companies have resorted to cost-cutting strategies which involve people. Downsizing and streamlining, or whatever euphemisms you prefer, have not always benefited organizations: for lean and mean, you can often read skinny and weak. Firms are turning to India with the simple expedient of decreasing costs by employing people at a fraction of the incomes they would receive in the UK. It is one way companies will resort to cost strategies (examining processes is another example), while failing to address the co-ordination of planning, forecasting and budgeting. In other words, finance and accounting processes are being severely undervalued. They are seen as a function of month-end closing and historical focus – something which has to be carried out as a matter of course in running a business – rather than a potential area for competitive advantage. However, finance and accounting should be much more than this. They need to be recognized as value-adding processes in their own right. In that way, they can make their own contribution to the organization’s bottom line.

Book balancing is not enough As it stands, the problem lies with the way that the accounting information cycle works. Under generally accepted accounting principles, books are closed and balanced each month before management, cash and tax reports are issued. This all takes too long in today’s business environment because information reaches management too late to support proactive decision-making. Finance and accounting must therefore move from being part of a historical-information group to a dynamic-information group. They must be able to manage information relating to sources of revenue, the people working for the organization, and the acquisition of goods and services. Ultimately, this process can enable finance and accounting to have a direct effect on management decisions and therefore contribute significantly to the organization’s success. This process can be likened to a movie. The way things tend to work now is that the accounting process provides a succession of snapshots once a month or once a year, like a preview for a new film which is shown before the main feature. A good accounting process is like seeing the full picture. The process provides a full, uninterrupted view of the organization’s changing circumstances. In other words, finance and accounting co-ordinate the information needed to reach this point, evaluate the situation and to see the effect of alternative goals and objectives. Armed with the right information, management can concentrate resources on crucial areas, so that minor surgery can make the business a far healthier one.

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To this end, planning, forecasting and budgeting are all vital. Finance and accountancy can play their part in the smooth running of all three. Both planning and forecasting are – or should be – dynamic processes which should be adjusted at a minimum on a rolling monthly basis.

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Keeping Wall Street happy The same principle applies to budgeting. Sophisticated finance and accountancy practices can enable management to be more far-sighted and to co-ordinate their budgeting with targets lined up through the planning process. On Wall Street, analysts examine performance and accuracy of forecasts. An organization’s share price over the long term will be driven by cash return on invested capital, and the accuracy of the forecast on a 90-day horizon. The costs and activities relating to the actual process of creating a service or product need to be in place. This can be achieved, therefore, by tying planning, forecasting and budgeting into the accountancy process in a way that makes transparent to management the organization’s progress. Armed with this information, goals and objectives can be more readily identified and achieved. For many organizations, the Internet is becoming part of their plans for planning, forecasting and budgeting. Typically, one repository will be maintained, so that all the data are contained in one central database where it can be consolidated and made available to the right people. Planning functions are traditionally bottom-down affairs, but these new tools have made it possible to add a bottom-up element which is more inclusive: with more users in the organization involved, a greater number of talented people have an input. Emerging technology is helping. Internet-enabled processes pave the way for data to be used in many ways, so that managers in the most remote sites of an organization can see income and expenditure at any given moment.

Quick access to data There are other factors that make the Internet-based option attractive. Data input and output are simplified when information is held in a single repository. A total of 80 percent of the time taken to put together an annual budget is spent in collecting and assembling core data. Developments such as relational database technology have simplified the process of keeping information current and accessible. Companies can transfer and share information easily when an authorized person wants it. Paper systems that run parallel to computer systems in most organizations will become a thing of the past. The upshot will be better information sharing and reduced costs. Relational database technology brings with it other advantages. Collective key control is an information system based on the technology. It provides access to information going way beyond the balance of accounts, into such areas as forecasting and the tools for analysis of information. The Internet can be a vital tool. More importantly, however, businesses will face even tougher challenges in the future. A more dynamic approach to finance and accounting might be a crucial factor in deciding whether that future is one that brings success, survival or failure.

Comment Adapted from ‘‘Unleashing the power of finance’’, by B.J. Wright, Strategy and Leadership, Vol. 29 No. 5, pp. 16-20. This article makes some useful points about the way organizations’ strategy for handling finance and accounting is wrongly focused. It would appear that, at best, opportunities are missed and, at worst, practices create real dilemmas. The value of the Internet is emphasized, though the lay reader might find the technical details a bit inhibiting.

Reference Wright, B.J. (2001), ‘‘Unleashing the power of finance’’, Strategy and Leadership, Vol. 29 No. 5, pp. 16-20, ISSN: 1087-8572.

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KEY READINGS Internet reporting: current trends and trends by 2010 (5 October 2002) Jones, M.J. and Xiao, J.Z., Accounting Forum (Australia), June 2003, Vol. 27 No. 2, Start page: 132, No. of pages: 34 Reviews previous research on Internet-based financial reporting and uses opinions from 19 UK experts (names and expertise appended) to assess current trends and predict trends by 2010. Explains the research method and tabulates the opinions collected, broken down into those from academics, regulators, companies, users and auditors, before discussing the main trends identified. Expects more information to be provided in the short and long term with a sharp short-term increase in non-financial information; and various changes to corporate communications and reporting. Suggests that hard copy reports will persist and that users will make more use of the Internet but doubts that they will get direct access to corporate databases. Recognizes that regulation, audit and assurance will be difficult, forecasts some technological developments and identifies more benefits than costs. Compares these opinions with other research findings, comments on them and considers the limitations of the study and opportunities for further research.

Web-based reporting Davis, C.E., Keuer, W.P. and Clements, C., The CPA Journal (USA), November 2002, Vol. 72 No. 11, Start page: 28, No. of pages: 7 Examines the practices of US Fortune 100 companies in relation to the trends and techniques they adopt in Web-based financial reporting. Exhibits examples of cost estimates for Webbased reporting components, and identifies Web-based reporting BSc practices based on the Web sites of the 1998 Fortune 100, in respect of annual reports, quarterly reports, Securities and Exchange Commission filings, financial analysis information and tools, and communication tools. Reproduces screen shots of the financial reporting Web site pages of the Coca Cola, Caterpillar, Texaco and J.C. Penney organizations. Makes the point that as a new medium, the Web is open for the exploration of new ways of achieving traditional reporting objectives.

Focus on books Quality Beyond Six Sigma Basu, R. and Wright, J.N. Butterworth-Heinemann 2003 188 pages ISBN: 0-7506-5561-5 £24.99, paperback The authors of this book, Ron and Nevan, are both associate faculties at Henley Management College, and both have experience in multinational companies. Ron Basu is Director of Performance Excellence Limited and Intec (UK) Ltd., and Nevan is a principal lecturer in management with the Auckland University of Technology. In this introductory book, on Six Sigma, they show how the principles and practices of this method successfully used by large companies can be adapted to fit the needs of any organization. They term their approach ‘‘Fit Sigma’’ to differentiate it from the rest. The book comprises nine chapters and includes a list of references and a six-page glossary at the end of the book. The first half of the book is devoted to introducing the reader to the related concepts of Six Sigma and lean enterprise and the second half for explaining the methodology and implementation of Fit SigmaTM. In chapter one, the authors briefly explain why this new approach Fit SigmaTM. They trace the evolution of Fit Sigma from the advent of industrial

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engineering through total quality management (TQM), Six Sigma, Lean Sigma, and Fit Sigma. They emphasize that Fit Sigma, a management philosophy and an improvement tool, helps to sustain the benefits accrued from implementing Six Sigma and Lean Sigma. A brief history of the quality movement is given in chapter two. W.E. Deming’s 14 points of quality are listed and the works of Dr. Joseph M. Juran, Armand V. Feigenbaum and Phil Crosby are briefly mentioned. However, John Oakland’s work gets a better treatment. It is surprising to note that the coverage of ISO 9000 is based on the information that is dated, as no reference is made to the 2000 revision. In chapter three, entitled ‘‘The enigma of Six Sigma’’, they discuss the essence of Six Sigma; what it is and what it is not, why implement Six Sigma, and the challenges faced in implementing it. The basic calculations are explained in simple terms. In chapter four, three brief case studies are provided outlining the organization’s background, the programs, key benefits accrued and lessons learnt. The companies involved are General Electric, The Dow Chemical Company and Seagate Technology. In chapter five, the attention is turned to the concept of lean enterprise, its impact on Six Sigma, and the relation between the two. It is shown how the variation control of Six Sigma can be combined with the waste control of lean enterprise to form Lean Sigma. In chapter six, the authors explain with the aid of examples why Six Sigma efforts have failed to achieve and sustain results expected. Then they show how these efforts can be combined with balanced scorecard measures and quality award checklist to form a holistic approach of selfanalysis covering all aspects of the business. In chapter seven, attention is focussed on explaining how it can be applied to service organizations, where the needs of customers can be more diverse than in manufacturing organizations. It is emphasized that it is not enough to satisfy customers but it must be affordable to the organization and it must also be consistent and sustainable. In chapter nine, the authors provide brief guidelines for implementing Fit SigmaTM in nine steps that can be customized to the specific needs of any organization. The book is a very good introduction to the basics of Six Sigma and gives an overview of practical considerations required to make its introduction work by making it fit for the purpose by taking into account the organization’s situation. K. Narasimhan Learning and Teaching Fellow, Bolton Institute, UK

Rath and Strong’s Six Sigma Leadership Bertels, T. (Ed.) John Wiley 2003 566 pages ISBN: 0-471-25124-0 £59.50, hardback Handbook In pursuit of achieving the twin objectives of improving customer satisfaction and increasing process efficiency, a number of organizations have turned to implementing Six Sigma methodology. Single authors wrote some of the books reviewed recently on this subject, in this journal. This book is different in that 30 authors (24 from AON Management Consulting and six other specialists) have contributed to this book, which comprises 25 chapters and three appendices. Though the chapters are not grouped into parts, the reviewer has grouped them together in the following paragraphs based on the structure followed by the editor in the introduction to the book. In the first two chapters of this book the historical context, and the why of Six Sigma (SS) are briefly covered. How SS is used in different manufacturing and service industries are discussed in chapter three, and in the following chapter Thomas Bertels, the editor of this book, outlines the various elements of the infrastructure required and defines the various roles needed for getting SS started and organized.

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Chapter five is aimed at the chief executives and senior managers who are necessary to make SS work; and deals with non-delegable issues connected with defining the focus and determining the extent of change desired. In chapter six, it is shown how a combination of lean, a proven method to eliminate waste, and SS can be more effective than either one of them. Chapter seven deals with the topic of bringing together large numbers of people (termed WorkOut by General Electric of America) to improve business performance and to capture collective ideas, energy and wisdoms creatively and translate them into action rapidly. In chapter eight, it is emphasized that SS has to be tailored to each organization and a brief explanation of cultural assumptions of SS are provided. A tool (AON’s organization print) for assessing the readiness for change of an organization is mentioned, but no details are given. In chapter nine, tools (including the Kano model of quality) for developing an understanding of customer needs and wants (even hidden ones) and conducting customer loyalty analysis are very briefly covered. In the next four chapters is provided an overview of the tools, methods, approaches, benefits and risks associated with various elements of SS. The rigorous five-phased data-driven method of DMAIC (define, measure, analyze, improve, and control) is briefly explained in chapter ten. Design for SS is the topic of chapter 11 in which the conceptual and practical underpinnings are discussed briefly and then the five step process – define, measure, analyze, design, and validate – are described. Why and how to create process management, an essential mechanism for linking organizational goals specific process capabilities, is explained in the following chapter. Chapter 13 introduces the concept of balanced scorecard and business dashboard that provides a visual display of process performance and helps identify performance gaps. An overview of typical concerns and guidelines to overcome them are presented in a self-explanatory table. The next six chapters deal with issues involved in preparing for and launching SS. In chapter 14, enrolling the leadership, establishing minimum requirements and selecting the right external consultant, without whose help it is difficult to launch the SS, are dealt with. Decisions required prior to launching and ways of showing visible commitment to SS are briefly covered in the following chapter. Chapter 16 very briefly covers cross-cultural aspects that need to be taken into account to ensure a successful launch. Stabilizing, extending, and integrating SS effort to ensure its continuity and not lose its luster after a few months of launching is covered in the following chapter. Chapter 18 is a very short one in which some metrics are listed for measuring the effectiveness of SS deployment. The key aspect of change management, the soft side of SS, the six principles that the consultants have found to be useful, and six common communication pitfalls are covered in some depth in chapter 19.

The next five chapters cover issues involved in executing projects: selecting black belts and projects that matter; conducting reviews to ensure effective and timely completion of projects; extending the knowledge gained to other projects; and developing a financial model to capture both hard and soft savings. How SS can help develop leadership talent forms the topic of the concluding chapter. The basic SS concepts of variability, data types, and SS quality are very briefly covered in appendix A (nine pages), In appendix B, it is shown how Textured Jersey, UK, a small company with a turnover of £18 million, has benefited from the application of SS. In appendix C (32 pages) an abridged case study is included to give a feel of the rigor involved in a design for Six Sigma (which was covered in chapter 11) project. In this case study two new concepts and techniques (TRIZ analysis and Pugh matrix for short-listing concepts for review) not covered earlier are also briefly covered. TRIZ is a Russian acronym for theory of inventive problem solving. There are 14 interviews with business leaders including CEOs, such as Robert W. Galvin of Motorola, who have implemented SS in their organizations. These interviews give an idea how some companies have used SS to profitably satisfy their customers. K. Narasimhan Learning and Teaching Fellow, Bolton Institute, UK

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The profit zone: how strategic business designs will lead you to tomorrow’s profits Slywotzky, A.J., Morrison, D.J. and Andelman, B. Times Business 1999 ISBN: 0812929004 $25.00 Book Analyses successful companies’ business designs and draws general conclusions about profitability. Makes a compelling and cogent argument that managers should design profitability models, and shows how this can be done. Targets chief executives and general managers at all levels, including brand managers, who are concerned with the profitability of the assets in their care. Suggests new ways to manage brands, both singly and in portfolios. Shows what is wrong with traditional approaches to profit: market share, cost cutting, operational efficiency and product orientation. Substitutes ‘‘customer-centric thinking’’ that orients a firm around the needs of its customers (and potential customers). Furnishes 12 case studies describing companies and how they achieve superior profits. Prompts the reader to analyze his or her own business and develop a new profit model along the lines suggested. Contains plenty of tables and exhibits documenting the profitability of the chosen companies, while an index helps readers to find specific topics.

The ultimate book of business thinking: harnessing the power of the world’s greatest business ideas Dearlove, D. Capstone 2001 ISBN: 184112060X £12.99 Book Forms a surprisingly useful book offering a good introduction to a range of ideas and concepts that all claim to offer some lasting business benefit. Starts with action learning and moves through to the virtual organization. Provides an overview and assesses credibility in terms of practical application.

Events PMA 2004 Conference on Performance Measurement and Management – Public and Private 28-30 July 2004, EICC, Edinburgh, UK Topics to be addressed: Performance measurement and management, including: J measurement in the public sector; J marketing performance; J intangibles and intellectual capital; J designing measurement systems; J people performance; J stakeholder measurement; and J measurement frameworks.

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For more details, contact: Angela Walters, Centre for Business Performance, Cranfield School of Management, Cranfield, Bedfordshire, MK43 0AL. Tel: +44 (0)1234 751122 – ext. 2433, Fax: +44 (0)1234 757409, E-mail: [email protected], Web: www.performanceportal.org/ pma2004.htm

9th International Conference on ISO 9000 and TQM (9-ICIT) (Theme: Best Practices) 5-7 April 2004, Siam-City Hotel, Bangkok, Thailand Organized by the Foundation for TQM Promotion in Thailand (FTQM) and Hang Seng School of Commerce (HSSC), HKSAR Topics to be addressed: J ISO 9000 and TQM best practice; J ISO 9000, ISO 14000, SA 8000 and OHSAS 18001; J 6-Sigma and business process re-engineering; J 5-S, QFD, Hoshin Hanri, and QC tools; J leadership and organizational development; J TQ learning and knowledge management; J business excellence and quality awards; J business excellence in manufacturing and construction; J business excellence in services and education; and J business excellence in public and health. For more details, contact: Sam Ho at [email protected]. Full conference leaflet in MS Word format from: www.hk5sa.com/icit

The 7th International QMOD Conference on Quality Management and Organizational Development This conference has been jointly organized by the City of Monterrey, Mexico, Linkoping University Sweden, and Monterrey Institute of Technology (Tec de Monterrey). It is hosted by the Monterrey Institute of Technology, in Monterrey, Mexico on 4-6 August 2004. Topics The objective of the conference is to provide a forum for discussing the role of quality management and how it will contribute to organizations to face the challenge of improving their competitiveness in order to survive in a global economy Audience The 7th International QMOD Conference will gather participants from the academia, industry, government, service and education sectors interested in the process of implementation of TQM as a strategy to become more competitive. Aims As the conference title indicates, the principal aim of the QMOD conferences has been to provide a unique international forum to exchange knowledge on the multidisciplinary nature of research and practice related to quality management for organizational development. During the years since the first QMOD conference was arranged in China (1997) we have succeeded in balancing the soft side of quality management (the human dimension) with the hard side (tools and techniques) and the result has gradually become well-known. It has been documented in many QMOD papers that the greatest challenge for companies in their continuous search for

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methodologies or roadmaps for successful organizational change and development programs is the design and implementation of a plan which balances the soft and hard side of quality management. It is my belief that this challenge will be one of the biggest challenges in this new century because tools and techniques are still developing very fast especially because of the development of new computer based tools. These tools are becoming more and more user friendly, and at the same time we observe that tools are being successfully developed and applied on applications focusing on understanding and developing people’s motivation and commitment for participating in organizational development projects. The research areas of interest under the QMOD theme are varied and are being tackled by specialists and practitioners in fields such as leadership, business strategy, economics, human resource management, learning and knowledge management, social and organizational psychology, operations management and engineering. At the beginning of the new millennium the greatest challenge is the integration and co-operation between these specialists and practitioners. Our efforts towards integration and co-operation between the different research fields will not only contribute to deepen our knowledge and insight, but also contribute to establish partnership and harmonious co-existence. For more details, Tel: (00 52) (81) 8328 4972, Fax: (00 52) (81) 8358 0771, E-mail: sumi.park@ eki.liu.se, [email protected], [email protected], [email protected] Jens J. Dahlgaard Conference Chair, Linko¨pings University

Focus on the Web iSixSigma www.isixsigma.com/ A quality management resource portal of articles, tools and research to help professionals implement quality practices in the workplace, the information assembled caters to both experts in the field and relative newcomers. The practice of quality is nothing new and compliance with international quality standards is essential for most business partnerships. Aims to keep practitioners up to date on breaking news, tools, templates, methodologies, certification and best practices. Presents three regular ‘‘Spotlight’’ features, which provide more in-depth analysis of current issues, and invites visitors to subscribe to the free, weekly newsletter, packed with articles and jobs. Overall, offers both breadth and depth in the quality management field, with straightforward navigation via direct paths and little requirement to drill down for information.

ASQ Six Sigma Forum www.sixsigmaforum.com/ Run by the American Society for Quality, the Six Sigma Forum is a free to join site focused on the principles of delivering near-perfect products and services. Forum members are classified according to a martial arts style belts scheme depending upon their experience levels. Includes various articles categorized according to the reader’s experience as well as tools allowing visitors to find a member, discuss six sigma, submit an article and look up terms. Interested visitors can also purchase Six Sigma Forum magazine and books.

Quality Digest www.qualitydigest.com/ Quality Digest online provides a wide range of resources on quality news, tips, techniques, provocative articles and is also home to free, searchable ISO 9000 and QS-9000 registered company databases. The site provides an archive to the complete text of Quality Digest magazine plus daily news updates, calendar listings, product announcements and exclusive online columnists. Registration at the site will ensure you receive e-mail updates. Special

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features plus regular columns cater for a range of visitor needs, with all copy written in an accessible and entertaining style. This is an impressive site and the commitment of its contributors is evident.

The Juran Institute www.juran.com/ The Juran Institute’s mission statement is to ‘‘provide clients with the concepts, methods and guidance for attaining leadership in quality’’, and its Web site seems to go some way towards fulfilling this. It is split into six sections: training products, free and fun stuff, consulting, about Juran, hot topic workshops, and contact us. ‘‘Training products’’ contains detailed information on six videos and 14 books, six of which are authored by Dr Juran. ‘‘Consulting’’ is organized into separate practice groups such as manufacturing industry, health care, customer and process assessment, and service industries. ‘‘About Juran’’ includes full details about the Juran Institute, a five-page biography of Dr Juran, executive management, and contact details for offices around the world. There are many articles in the ‘‘free and fun’’ section which can be downloaded (including 30 by Juran), and new ones are added monthly – while the articles are quite old, they are still a useful collection of Juran’ s work. Overall, a very stylish, easy-to-use and informative site.

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Book reviews Catherine Stenzel and Joe Stenzel, John Wiley, ISBN: 0-471-42329-7, 2003, hardback, 331 pages, £32.50 DOI 10.1108/13683040410524766

From Cost to Performance Management Organizations need to manage their overall performance and not just the cost of operations in the knowledge economy of the new millennium. In this book the authors show how to create a cost and performance management system to develop profit and process systems that work with each other. The authors are editors in chief of the Journal of Cost Management, a bimonthly Research Institute of America (part of Thomson Corporation) periodical. They are also co-directors of a Genesis Organizational Diagnostics, a firm that provides cost and is a management consulting service specializing in government, healthcare and education. The book comprises nine chapters, a list of recommended reading, glossary of terms, and end notes. In chapter one, the authors examine the importance of human resources in gaining competitive advantage and the need for more mature ways to manage an organization’s costs and performance in an attempt to create value through better performance. Also examined are the shortcomings of present methods. Conceptual frameworks for indexing the maturity of cost and performance management methods and systems into five stages (‘‘budgetary control’’, ‘‘financial control’’, ‘‘operational control’’, ‘‘strategic control’’, and ‘‘holistic control’’) are also introduced in this chapter. In chapters two, three, and four the conventional components of a cost management system (CMS) and their interrelationships are examined under five categories: 1. financial accounting; 2. managerial accounting;

3. cost accounting; 4. types of costs (indirect, direct, variable, standard, sunk, etc.); and 5. budgeting and standard costing. Also examined are the shortcomings of the conventional cost accounting systems (standards, budgets, and forecasts) to support strategic planning, decision making, and evaluate performance. The authors emphasize that to reflect the actual dynamics of an organization’s activities, inform decision making, and support continuous improvement in cost and process structures more mature frameworks are required, especially for organizations that have invested in high levels of automation and technology, who also need leading indicators. In chapter five, title ‘‘Operational resource accounting: learning new rules and roles’’, the transitional stage two/ three developmental dynamics are dealt with. The authors show nine practical ways to use cost information not just for measuring efficiency but for the ‘‘wise management of valuable assets through optimizing limited resources’’ (p.151). In chapter six, attention is turned to the need for participation in the pursuit of enhancing the ability to learn and adapt to answer the key questions of ‘‘What does the organization wants to be?’’ and ‘‘What it has to become to what it wants to be?’’ The impact of total quality management (TQM), theory of constraints (TOC), activity-based costing, budgeting, and management (ABC), and resource consumption accounting (RCA), their advantages and shortcomings are briefly covered. In chapter seven, the authors explain how organizations in the third stage of their maturity begin to define their external identity and focus on process interrelationships in exploring patterns

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between cost and operational processes. The essential role of reengineering, value engineering, target costing, life cycle performance and costing, lean and agile management, and supply-chain costing and interorganizational cost management are briefly dealt with. In chapter eight, issues involved in stage four of the management maturity are dealt with. In particular, it is shown how to integrate stand-alone cost and performance management systems (for example, the four quadrants of a balanced scorecard) into a comprehensive unified management system to develop deep employee partnership as well as partnerships with customers and suppliers. These partnerships cannot be easily duplicated by competitors and thus help everyone speaking the same

Balanced Scorecard STEP-BYSTEP: Maximizing Performance and Maintaining Results and Balanced Scorecard STEP-BYSTEP: For Government and Nonprofit Agencies

Paul R. Niven, John Wiley, ISBN: 0-471-07872-7, 2002, hardback, 334 pages, $45.00 and Paul R. Niven, John Wiley, ISBN: 0-471-07872-7, 2003, hardback, 305 pages, $45.00 DOI 10.1108/13683040410524775

Successful leading companies in the world have used a number of key success factors in addition to financial factors for a long time. However, Kaplan and Norton (1992) proposed an improved performance measurement system called the Balanced Scorecard (BSC). Now, it has evolved to become a management system of strategic importance. As Robert S. Kaplan opines in his foreword to the first book, Paul’s books explicate the details and processes that can be followed to implement the BSC measurement and management system to turn strategy into action. Paul is a management consultant specializing in performance management (PM) and balanced scorecard. He gained experience as a project leader while successfully implementing it at Nova Scotia Power, Canada, and has developed PM systems for all types of organizations.

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strategic language. The need for multiway feedback for the learning process is emphasized. Chapter nine (the shortest chapter, 17 pages) is devoted to a discussion of the most mature stage (stage five) of the human enterprise, which few organizations have achieved. The need for a conscious and deliberate attention to the integration of moral, needs, and self-identity subsystems of human development is emphasized. The book is easy to read. However, examples applying the concepts showing where on the maturity stage different companies would be placed, and why, would have been more useful. K. Narasimhan Learning and Teaching Fellow, Bolton Institute, UK

Both books contain 14 chapters; however in the general book on BSC the chapters are grouped into five parts and in the book for government and nonprofit agencies the chapters are grouped into four parts. Part one comprising two chapters is similar in both books and is an introduction to performance measurement and the BSC. Chapter one first introduces the limitations of reliance on financial measures of performance and barriers to implementing an organization’s strategy. Then the concepts of BSC are introduced and it is explained how BSC can overcome these limitations. In chapter two, Paul briefly explores the benefits that can be derived from an application of BSC in different types of organizations. As the other parts are distinctly different in grouping and contents they would be covered separately in this review. First, a review of the general book is given followed by the specific book on government and nonprofit agencies. Part two deals with step-by-step development of BSC in five chapters. In chapter three, the rationale for launching a BSC project is considered followed by seven criteria for selecting an organizational unit for its introduction

using a weighted-score method. Strategies for communicating the BSC project and pitfalls to avoid are also covered. Chapter four clarifies the four key components or building blocks – mission, core values, vision, and strategy – to which the BSC needs to be aligned. It also provides tools for determining their effectiveness or developing them. Developing effective performance objectives and leading and lagging measures of performance in each of the four quadrants – financial, customer, internal process, and employee learning and growth – that link to the strategy are covered in detail in chapter five. The critical importance of the cause-andeffect linkages among the four quadrants’ measures and finalizing a shortlist of performance measures are explored in chapter six. Finally, In chapter seven, the importance of aligning organizational plans and initiatives with the BSC and strategy, the critical role of target setting using different types of targets, and prioritizing initiatives are dealt with succinctly. The theme of part three is how to embed the BSC in the management system of an organization; and it is covered in three chapters. The critical aspect of ‘‘cascading’’ of the BSC to align every employee’s action with the organizational goals is covered in chapter eight. In the following chapter, Paul examines the role of BSC in the budgeting process to align spending with strategy. Chapter ten contains a comprehensive review of methods of linking BSC and incentive compensation – both monetary and non-monetary – at all levels. The critical issue of reporting of results in gaining support for using BSC, the use of software packages for reporting, and the need for a champion for owing and updating the BSC are dealt with in part four, in two chapters. The final part, comprising two chapters, deals with BSC in the public and not-for-profit sectors and top ten BSC implementation issues. Part two of the book on government and nonprofit agencies also comprises five chapters, and is titled ‘‘Pouring the

Foundation for Balanced Scorecard Success’’. In chapter three, the rationale for launching a BSC project is considered followed by seven criteria for selecting an organizational unit for its introduction, securing executive support and the roles and responsibilities of the BSC team are considered. The role of training and communication planning in the successful implementation of BSC are dealt with in chapter four. Chapter five identifies the link between the three key components or building blocks – mission, core values, and vision – and the BSC and how to determine if the BSC is aligned with the three components. In chapter six, Paul proposes a five-step model of formulating strategy, which is central to the development and successful use of a BSC. In chapter seven (a comparatively short chapter, eight pages) describes how to reach a consensus on definitions of performance measures, an essential step in overcoming misunderstandings. Developing the BSC forms the theme of part three, comprising two chapters. Chapter eight contains a discussion of graphically describing strategy using a modified form of the BSC perspectives used in industry. Examples from a warfare center, a family access network, and the finance and administrative division of a university are used to explain how to develop strategy maps and maximize their effectiveness. Also covered is the importance of causeand-effect linkages among the four quadrants’ measures. In chapter nine, the attention is turned to types of measures used by public and nonprofit organizations. Input, output and outcome measures to provide leading and lagging indicators of performance in each of the four quadrants – financial, customer, internal process, and employee learning and growth – that link to the strategy are covered in some detail. Ten criteria for selecting performance measures are also provided. In part four comprising five chapters, Niven explains how to maximize the effectiveness of the BSC. The critical aspect of ‘‘cascading’’ of the organizational BSC, through departmental, and operations group

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scorecards, to make employees see the connection between their actions and the organizational goals is covered in chapter ten. In the following chapter, Paul examines the role of BSC in linking budgeting/resource allocation to strategy, and describes a five-step process for achieving that linkage. In chapter 12, the critical issue of reporting performance and the selection of software packages for reporting are dealt with. Chapter 13 contains an interview which gives an idea of how the City of Charlotte, North Carolina, USA, has worked with the BSC since introducing it in 1996.

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The books are easy to read. Each chapter begins with a roadmap (or an introduction to the chapter) and ends with summary and notes (references for further studies). Tables and exhibits used enhance the understanding of the concepts and their application. The book on government and nonprofit organizations includes a glossary of key terms, which is missing from the other book. K. Narasimhan Learning and Teaching Fellow, Bolton Institute, UK

PMA conference announcement Performance Measurement and Management – Public and Private PMA 2004 Conference, 28-30 July 2004, EICC, Edinburgh, UK Following the success of the previous conferences, we are delighted to announce the 4th International Conference on Performance Measurement and Management in Edinburgh in July 2004. The conference theme is performance measurement and management – public and private, and as with the previous conferences there will be a mix of delegates and papers from the academic and practitioner communities. Performance measurement and management is a truly multi-disciplinary field so we thought the conference might be of interest and relevance to you. Below are the details of the conference and the full call for papers can be found at www.performanceportal.org/pma2004.htm

More details about the PMA 2004 conference PMA 2004 is a unique opportunity for the community to meet, network and exchange views. No other event better facilitates dialog in this field of performance measurement and provides the rare opportunity for discourse between academics and practitioners. The conference builds on the success of the previous conferences, which have been running since 1998. Up to 300 delegates are expected to attend PMA 2004 from around the globe, which help to ensure that PMA 2004 will be the leading event of its kind. Traditionally one third of presentations have been from practitioners and contributions have come form a broad mix of disciplines related to the topic of performance measurement and management, including measurement in the public sector, marketing performance, intangibles and intellectual capital, designing measurement systems, people performance, stakeholder measurement and measurement frameworks. In order to engage both academics and practitioners here are two types of submissions Academic Research Submissions and Practical Application Submissions. To submit an extended abstract for PMA 2004 please follow the guidelines set out in the full Call for Papers and e-mail your submission by 16 January 2004. The date by which full papers will be due is 14 May 2004. The conference is organized on behalf of the Performance Management Association (PMA) by the Centre for Business Performance, Cranfield School of Management and will be co-chaired by Professor Andy Neely and Dr Mike Kennerley. As every year the conference commences with a welcome reception, followed by three days of parallel stream paper presentations. Keynote presentations are delivered on each day and additional plenary sessions will be held throughout the event. Confirmed keynote presenters for this year are: Professor Sir Andrew Likierman from London Business School and Professor Chris Ittner from The Wharton School. The principal aim of the conference is to provide a unique inter-disciplinary and international forum for the exchange of cutting-edge knowledge and research about organizational performance measurement within both the public and private sector. If you would like to find out more about PMA 2004 then please visit the conference Web site: www.performanceportal.org/pma2004.htm or contact one of the conference organizers at the address below. Angela Walters Centre for Business Performance, Cranfield School of Management, Cranfield Bedfordshire, MK43 0AL Tel: +44 (0)1234 751122 – ext. 2433, Fax: +44 (0)1234 757409 E-mail: [email protected]

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Note from the publisher During 2003 Emerald developed its corporate publishing philosophy. We did this through discussion with readers, contributors and editors and we would like to share it with you. We believe that our approach to quality makes us different and unique amongst scholarly publishers. It is based on six core principles, which together form our distinctive philosophy:

1. We put quality at the center of our approach to scholarly publishing All papers published by Emerald go through a quality-assured peer review system. All papers published by Emerald are expected to make, in some way, an explicit original contribution to the existing body of knowledge. All papers published by Emerald are accessible to a wide range of students, scholars and practitioners in the fields in which we publish. All papers published by Emerald are beneficial in some way; to researchers, practitioners, or both. J In 2001 we were audited and certified as ‘‘Committed to excellence’’ following a European Foundation for Quality Management self-assessment exercise. J We retained our status as an ISO 9000 certified organization, and our Investors in People (IIP) certification. J More than 30 Emerald journals are listed in the ISI Citation Index.

2. Continuous improvement of reader, author and customer experience We continue to invest in enabling technology to increase efficiency and effectiveness in content provision, customer service and management. We benchmark against others and against our own standards. We are as clear as possible in our policies, measures, targets and achievements and we do not hide shortfalls, but confront and learn from them. J Emerald papers go through a further post-publication ‘‘review’’ which assesses them on readability, originality, implications for further research and practice. We publish this information, and it can be used as search criterion, on the Emerald database. J In 2002 we were judged as providing best customer support by the scholarly library publication The Charleston Advisor. J We provide high levels of dissemination of our authors’ work – nearly one million papers per month are downloaded and read by subscribers to the Emerald on-line portfolio. J In 2004 we will be introducing an on-line submission and peer review system which will speed up the publication process.

3. Internationality We operate in a trans-national world of scholarly ideas and we believe that this should be reflected within our publications. Working with our authors, we set targets for international representation of authors and editorial team members, and measure against them. J In the past six months we have published more than 50 themed issues with a specific international focus. J In the first half of 2003, papers from 60 different countries were published.

4. An interdisciplinary approach We set targets, and ask for, papers and special issues on interdisciplinary approaches, and new/emergent themes. This gives us better, stronger, and more vibrant journals, and a clear leadership position in our industry.

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J In the first half of 2003 we published more than 20 themed issues dealing with interdisciplinary approaches to a subject or industry. J We encourage themed issues on leading edge and innovative research topics, and in the past six months published 35 such issues

5. Supporting scholarly research : the Literati Club We help remove the barriers to publication. We conduct workshops for researchers on publishing issues. We provide help and advice to new researchers. We offer a service for authors whose first language is not English. Our staff regularly present papers at conferences on scholarly publishing themes. J Our scholarly community Web site, the Literati Club, disseminates information about how to write for publication more successfully – we seek to make the process more transparent. J The Emerald Research Register, an online forum for the circulation of pre-publication information is designed to help researchers gain advanced recognition among their peers by publicizing their research at the earliest opportunity. J Each year, we distribute grants to researchers working on improving the scholarly publishing dissemination process, and to encouraging scholarship in the developing world. J We conducted research workshops at 11 universities and conferences, had papers accepted at nine academic and other conferences, and supported six academic conferences worldwide.

6. Integration of theory and practice We ask editors and review board members to focus where applicable on application, and beneficial implication for practice. We do so because this gives a clear message to our core supplier and consumer markets – the applied researcher, the reflective practitioner, the students of business and their teachers, the business and management school. J All of our journals will publish a majority of papers that have a direct application to the world of work. J More than 1,000 university libraries worldwide subscribe to the Emerald portfolio, including 97 percent of the Financial Times top 100 business schools. John Peters Director of Author Relations Emerald

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