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  • 1. THE KNOWLEDGE VALUE CHAIN: FROM ASSET MAPPING TO COST BENEFIT ANALYSIS Edward Truch Henley Management College, Greenlands, Henley-on-Thames, UK edwardt@henleymc.ac.uk Abstract In a knowledge-based economy, where the intellectual capital of an organisation is its most important asset, current accounting procedures are proving inadequate in terms of reporting on intangible assets and providing measures of future profit potential. Another important aspect is the assessment of inherent risks associated with these intangible assets and assurance that sufficient measures are in place to protect them. The objective of this paper is to examine the nature of the intellectual capital of a company, and to review some prevailing models and practical examples of their application. 1.Introduction The transition into the Digital Information Age is bringing about the need for new approaches to the strategic direction-setting of companies. Many of the changes being experienced are paradoxical in nature and require new mind-sets and questioning of hitherto accepted business models. Governments in industrialised countries around the world are focusing more attention on the transition from the post-industrial age towards a ‘knowledge-based’ economy. Many are announcing new policies and initiatives backed by substantial budgets to ensure continued growth of their national economies in the future global marketplace. In this post-industrial era, firms are facing increasing complexity for a number of reasons, two of which are fundamentally altering the competitive context of firms and managers, namely knowledge and technology dissemination (Lowendahl and Revang, 1998). They argue that these global changes, at the societal as well as the individual level, affect strategic management theory and practice in two ways: they alter the relationships between firms and external stakeholders; and they alter the relationships between firms and internal stakeholders. One important effect of the information age is that shareholders are becoming better informed, more critical and increasingly active. City analysts expect more detailed reporting from companies and are becoming more sophisticated in the methods they employ. Thus it is increasingly important for top managers to develop more appropriate tools for managing their intellectual assets effectively and to have adequate reporting measures in place to satisfy their shareholders and potential investors. 2.Knowledge-based Economy 2.1Economics of Knowledge The concept of a ‘knowledge-driven economy’ is by no means new. In 1890, Alfred Marshall wrote “Knowledge is our most powerful engine of production” in his Principles of Economics. Today, we can see a number of processes at work, some entirely new, others that have developed over many years, which together are transforming the way in which businesses and individuals operate. The UK Government’s white paper, Our Competitive Future: Building the Knowledge Driven Economy, calls for a renewed focus on knowledge as the means of improving economic performance. The paper goes on to define a knowledge-driven economy as one in which the generation and the exploitation of knowledge has come to play the predominant part in the creation of wealth. Mid-nineteenth century energy physicists developed what may be one of the great metaphors of all time: that of the closed equilibrium system. This is also the core metaphor of Alfred Marshall’s traditional economics and of much of our management thinking today. Such an approach makes three important assumptions: that the industry structure is known, that diminishing returns apply, and that all firms are perfectly rational (Beinhocker, 1997). Beinhocker poses the question: But what happens if rapid technological or business-system innovation makes producer costs and consumer preferences uncertain? What if we face not diminishing returns (where each additional acre of soybean planted is on poorer land and thus yields a lower return), but increasing returns (where each extra Internet browser sold increases the value of the World Wide Web and thus yields a higher 101
  • 2. return)? What if firms lack complete information, or different firms interpret the same information in different ways? It is important to distinguish knowledge from the traditional factors of production, labour, land and capital (Spender, 1996). Knowledge, it seems, has become the most important or ‘strategic’ factor of production, so managers must now focus on its production, acquisition, movement, retention and application. Spender argues that (i) different types of knowledge lead to different types of economic rent and that firms’ strategies, in the pursuit of these economic rents, will also differ; and (ii) that the firm’s knowledge mix or profile may change over time, being dominated by one type of knowledge at one time and by another type at another time. 2.2Knowledge-based Company According to a study of the CEO’s of large US companies carried out by Karl Wiig (1997), they overwhelmingly agreed that “knowledge is our most important asset”. They also agree that knowledge-based assets will be the foundation of success in the 21st century. Wiig states that progressive managers have recognised that an enterprise’s viability depends directly on (i) the competitive quality of its knowledge-based intellectual-capital and assets; and (ii) the successful application of these assets in its operational activities to realise their value to fulfil the enterprise’s objective. Recent studies provide evidence for the argument that companies that make effective use of knowledge tend to perform better. The recent paper by Marchand et al. (2000) reveals three major factors in the information orientation of a company: (i) IT practices, (ii) information management practices, and (iii) information behaviours and values. A dominant theory of business strategy is that of the resource-based view of the firm (Spender and Grant, 1996). This treats the company and the determination of economic rent as a collection of capabilities. Economic rent is what companies earn over and above the cost of the capital employed in their businesses. This is sometimes referred to as economic value-added (EVA). Economic rent is the measure of the competitive advantage that effective established companies enjoy, and competitive advantage is the only means by which companies in competitive markets can earn economic rents. The opportunity for companies to sustain these competitive advantages is determined by their capabilities. Whilst there are many kinds of capabilities, from the point of view of strategy, the key distinction is between distinctive capabilities and reproducible capabilities. Distinctive capabilities are those characteristics of a company that cannot be replicated by competitors, or can only be replicated with great difficulty, even after these competitors realise the benefits which they yield for the originating company. Distinctive capabilities can be of many kinds. Government licences, statutory monopolies, or effective patents and copyrights, are particularly stark examples of distinctive capabilities. But companies in competitive markets have built equally powerful idiosyncratic characteristics. These include strong brands, patterns of supplier or customer relationships, and skills, knowledge and routines embedded in teams (Lowendahl and Revang, 1998). 2.3Sources of Competitive Advantage In an economy where the only certainty is uncertainty, the one sure source of lasting competitive advantage is knowledge (Nonaka, 1991). When markets shift, technologies proliferate, competitors multiply, and products become obsolete almost overnight, successful companies are those that consistently create new knowledge, disseminate it widely throughout the organisation, and quickly embody it in new technologies and products. These activities define the “knowledge-creating” company, whose sole business is continuous innovation. Organisations possess numerous resources, but it is the resources that are unique, inimitable, and valuable that are central to competitive advantage (Prahalad and Hamel, 1990). An organisation’s knowledge base is one such resource (Matusik and Hill, 1998). Firms increasingly rely on building and creating knowledge as a necessary condition for survival in their respective competitive marketplaces (Nonaka, 1994). Fast changing environmental demands and rapid imitation by competitors make it necessary for even leading firms to continually build new knowledge. Not only must firms be able to create knowledge within their boundaries, but they must also expose themselves to a bombardment of new ideas from outside in order to prevent rigidity, to encourage inventive serendipity, and to check their technological developments against those of competitors (Leonard-Barton, 1995). Competitive advantage is no longer derived from the traditional factors of production of the industrial age, namely labour, land and capital, but increasingly from knowledge (Spender, 1996). 102
  • 3. 2.4Factors of Production Knowledge is an asset unlike any other. According to Day (1998) there are four important characteristics from the point of view of knowledge strategy, namely:  Extraordinary leverage and increasing returns: Most assets are subject to diminishing returns, but not knowledge. The bulk of the fixed cost in knowledge products usually lies in creation rather than in manufacturing or distribution.  Fragmentation, leakage, and the need for refreshment: As knowledge grows, it tends to branch and fragment. While knowledge assets that become standards can grow more and more valuable, others, like expiring patents or former trade secrets, can become less valuable as they are widely shared. The rapid and effective re-creation of knowledge can represent a substantial source of competitive advantage.  Uncertain value: The value of an investment in knowledge is often difficult to estimate. Results may not come up to expectations; conversely, they may lead to extraordinary knowledge development.  Uncertain value-sharing: Even when knowledge investments create considerable value, it is hard to predict who will capture the lion’s share of it. These four characteristics can make investing in knowledge assets particularly risky. Traditional models of industry structure and conduct are an inadequate basis for strategy because they do not help managers understand how value will be created, or who will capture most of it. 3.Auditing Intellectual Capital 3.1Current Accounting Practices Our current accounting practices have been geared to the industrial revolution, where the assets of a firm were vested in land, machinery and capital. The control and safekeeping of shareholders assets is achieved through physical assets inventories and bank balances. These do not apply to knowledge assets, which increasingly represent a major part of shareholder value. According to Sveiby (1998), the traditional tools of financial reporting are quickly losing relevance in a world where the most valuable assets are information, expertise, technology and skill. It is without question nowadays, that knowledge has an economic value that is increasing. The value is more visible in companies that lack traditional tangible values. The important issue from a management perspective is that the present standards grossly understate the value of assets, and therefore give a skewed picture for companies where these are not traditional assets. In addition to these is what Weinstein (1995) has coined the “master competence”: the ability to orchestrate and derive most value from specific competences. Miles & Snow (2000) in describing “the Future.org” refer to this as a “meta-capability”. As we move from the economic era of customisation to one of innovation, so the key meta-capability of delegetion becomes one of collaboration, building a future based on alliances, spin-offs and federations. Brouthers and Roozen (1999) provide a framework for strategic accounting built around the concept of environmental turbulence and differing information needs. For various levels of environmental turbulence, managers have different information needs in terms of the scope, structure and content of information. They describe ‘strategic accounting’ as a new, virtually unexplored area of strategic management. They found that few firms have developed internal systems that can provide the strategic management information needed to make informed strategic decisions. Such a strategic accounting system provides information necessary to perform the following functions: (1) environmental analysis; (2) strategic alternative generation; (3) strategic alternative selection; (4) planning the strategic implementation; (5) implementing the strategic plan; and (6) controlling the strategic management process. In order to fulfil these information functions, a strategic accounting system must contain information that is: (1) mostly non-financial; (2) focused on the future; (3) both internal and external to the firm; and (4) based on realistic projections of the future, not simple extrapolations of the past. 3.2A new approach to intellectual capital The intellectual capital of a company has been variously described in terms of the intangible element of an organisation's assets by authors such as Sveiby (1998) A simple but useful measure is the ratio of market to book value. In the case of a publicly quoted company this is in effect valued by the market daily, whilst for a private company a valuation may emerge in the process of an acquisition or merger. A general characteristic of knowledge-based companies is that the market to book value ratio is considerably higher than for traditional ‘bricks and mortar’ companies. It is not an objective of this paper to examine these differences, but rather to review models and methods for auditing and valuing the intangible asset components. Sveiby classifies the invisible assets on an organisation's balance sheet as: (i) employee competence, (ii) internal structure and (iii) 103
  • 4. external structure. Internal structure includes patents, concepts, models and IT and administrative systems. These are created by the employees and are generally owned by the organisation. Skandia, the financial services company, was one of the first to recognise the importance of its intellectual capital and developed new ways of reporting these aspects of their business to shareholders (Edvinsson and Malone, 1997). In 1991, Skandia made the new appointment of a director of Intellectual Capital in the belief that the company's hidden, intellectual assets were of decisive importance. The company's own research led to a model that has now been widely published. This is based on the formula “Intellectual = Human Capital + Structural Capital”. Edvinsson and Malone define the main components as follows: 1. Human capital. The combined knowledge, skill, innovativeness, and ability of the company's individual employees to meet the task at hand. It also includes the company's values, culture, and philosophy. Human capital cannot be owned by the company. 2. Structural capital. The hardware, software, databases, organisational structure, patents, trademarks, and everything else of organisational capability that supports those employees' productivity - in a word, everything left at the office when the employees go home. Structural capital also includes customer capital, the relationships developed with key customers. Unlike human capital, structural capital can be owned and thereby traded. and even more for knowledge management. For the purposes of this paper the definition provided by Sveiby (1997) is adopted: “The difference between the market value of a publicly held company and its official net book value is the value of its intangible assets”. The intangible assets are also described as the intellectual capital of the company. 4.Auditing Intellectual Capital The auditing of intellectual capital still has many features that are common to the traditional auditing of physical assets. Yet because of their intangible nature, knowledge assets are sometimes difficult to identify – companies often do not know what they know. To fill this gap, techniques are beginning to emerge for the mapping of the knowledge domains and assets within organisations. These can provide information about who holds or owns each major knowledge asset, where it comes from, how it kept, used and renewed, and how it is protected. 4.1Mapping knowledge assets The mapping techniques mentioned above are very much in their formative stages. Earlier attempts by companies to map knowledge assets have in many cases resulted in long and poorly structured inventories that prove difficult to use. This has generally been the result of an approach whereby the organisational structure is used as the reference frame and employees across the whole organisation have been surveyed to identify what knowledge assets they possess and use, and what they feel would be beneficial in the future. This approach has inevitably led to the quite common situation where a major investment in IT infrastructure and new company- wide systems fails to deliver the expected results. In the author’s experience, projects that have been based on strategic alignment of knowledge systems and use the organisation’s key processes as the framework for evaluation of knowledge assets have generally proven to be more successful. This approach has been described as ‘value-based knowledge management’ and is a natural extension of the ‘value-based management’ approach adopted by many companies, which is underpinned by activity-based costing. 4.2Knowledge Inventory An important categorisation of knowledge was put forward by Polanyi (1966) who drew the distinction between explicit and tacit knowledge. Tacit knowledge is personal, context-specific, and therefore hard to formalise and communicate (Nonaka and Takeuchi, 1995). Explicit or “codified” knowledge, on the other hand, refers to knowledge that is transmittable in formal, systematic language. In auditing an organisation’s intellectual capital, one is viewing a dynamic situation with knowledge assets of very different characteristics and shelf-lives. Some can be protected with patents for 25 years or more, whilst others loose their value as soon as they are used, and others increase in value through use. 104
  • 5. Furthermore, value of the intellectual capital may reside in the existing knowledge assets or, as in the case of many firms, in the capability of generating new knowledge assets on a continuous basis. A daily newspaper is a prime example of information that is generated continuously but has a very short shelf life. It follows that a comprehensive audit of the intellectual capital of an organisation must review the knowledge creating mechanisms as well as the existing knowledge assets. 4.3The knowledge value chain A practical approach to mapping the knowledge assets and knowledge-creating mechanisms of an organisation is to identify and map the ‘knowledge value chain’. An inventory of the more important knowledge assets is created by following the main processes in the organisation, and identifying the stages at which key knowledge assets are generated or utilised. A clear distinction is drawn between explicit and tacit assets as these tend to follow different, but interlinked, value chains. Figure 1 below illustrates the principle behind this approach and the 3-dimensional framework that emerges. Knowledge Asset Category C Knowledge Asset Category B Explicit Knowledge Asset Category A Explicit Knowledge Value-Chain Knowledge Value-Chain Explicit Gather - Store - Refine - Transfer - Apply Tacit Knowledge Value-Chain Transfer - Apply Gather - Store - Refine - Tacit Gather - Store - Refine - Transfer - Apply Tacit Figure 1: Knowledge value-chain analysis The main stages of the knowledge value-chain are as follow:  Gather data: includes collecting data to go into the system and contributing to the system  Store data: includes organising information for ready access  Refine data: includes analysis, synthesis, abstracting, interpretation and also retention and disposal disciplines  Transfer information: transferring information to others via sharing, distribution or self service mechanisms  Apply knowledge: (i) putting knowledge to use, for example to perform core tasks, make decisions, set strategy or learn from experience; linking to business processes where knowledge creates value, or (ii) sell or licence the knowledge asset The source and application of knowledge assets falls into the following main categories:  Generated internally and used internally (economic rent)  Generated externally and used internally; licences, data and expertise bought in or outsourced  Generated internally and used externally; sold or licensed In the case of licensing, such as software, there might be an ongoing commitment to renew the asset and this may constitute a potential asset or liability to the company. 5.Knowledge asset mapping in practice An approach adopted by the author in a number of consultancy assignments for companies in different sectors and with differing degrees of knowledge-intensity, from manufacturing to publishing, is described below. This 105
  • 6. method has assisted in forming a picture of the intellectual capital of those businesses and has provided senior management with a tool for making related management and investment decisions. The approach consists of the following mains steps: 1. Strategic review: a top-down review of the business strategy and the core competencies required to deliver the business objects, followed by identification of the critical success factors 2. Process review: bottom-up identification of the key business processes and the knowledge assets they use and/or produce, followed by the development of a knowledge inventory 3. Synthesis: evaluation of the knowledge inventory (step 2) in the context of the core competencies and critical success factors (step 1), and a cost-benefit analysis of current and potential future knowledge assets Where the company did not already have a clearly articulated strategic plan, some additional analysis was carried out to elicit and capture the strategic intent of the management team. In some cases future scenarios were developed using established methods (Weinstein, 1995). In other cases, where for example a balanced scorecard (Kaplan and Norton, 1992) had already been implemented, it was a great deal easier to identify the key core competencies and critical success factors for the business. In mapping the key business processes, it was possible to make use of existing process maps which often formed part of a quality assurance system such as ISO 9000. The outcome of this process produced a clear picture of the organisation’s knowledge landscape and provided a tool for evaluating, managing and exploiting the organisation’s intellectual capital. For many organisations this can lead to a substantial improvement in the benefits derived from major investments in IT systems that have hitherto failed to deliver expected results. 5.1Cost-benefit Analysis The benefits derived from the specific knowledge assets were viewed in terms of the additional value or leverage derived from applying each asset in the key business processes that were identified earlier in the project. Typically value would be derived from new synergies and areas such as:  revenue from new business opportunities;  new products;  new markets and customers;  efficiency gains; deriving more from existing assets; and  cost savings. In the analysis of the respective costs for each knowledge asset the following factors were taken into account:  people, incl. Training;  IT infrastructure;  tools, e.g. special software;  external data;  external experts and consultants; and  other resources. In determining the costs for different knowledge assets it was important to take timing into account as the cost of delivering a particular asset to the business process that it serves depends to a great extent on the timescale within which it is developed or sourced. In some cases it was found to be easier and faster to use relative measures and marginal costs, instead of absolute costs, particularly when the necessary IT infrastructure was already in place. Once the benefits and absolute or relative costs for the key knowledge assets of the business were calculated or ranked, these were plotted on a ‘knowledge-leverage’ grid as shown in figure 2. The chart indicates the possible outcomes for investment in knowledge assets in each of the quadrants. Interestingly, the assets that might provide the greatest competitive advantage were in the top right-hand quadrant. Where these assets are reliant on technological solutions it is likely that in cost terms they will migrate towards the left of the chart 106
  • 7. into the lower cost area, where access to those assets will become more general and, therefore, they will tend to lose their competitive advantage. Prerequisite Potential High to success Competitive Advantage K Leverage / Benefit Potential Efficiency Poor Low Gain Return return Low High Cost of timely delivery Figure 2: Knowledge-leverage grid 5.2Resource Allocation The method described above permitted the managers to undertake better-informed decisions regarding the allocation of resources to the acquisition and creation of knowledge assets. Figure 3 below illustrates this process of evaluating the current expenditure on knowledge assets (box with dotted-line) and re-allocating that budget to the knowledge-assets that had been evaluated as value-generating for the business (box with solid line). A further decision can be taken in terms of where the line is drawn to optimise the spend in this area. This line is shown as the vertical dotted line – ‘value for money’. To the left of this line further investment in seemingly useful knowledge assets will bring diminishing returns. Potentially Available Useful Knowledge Value for Money Future Useful Knowledge Better use of Present existing budget Wastage Current Knowledge Figure 3: Budget re-allocation This approach presents the opportunity for management to generate more benefit from the organisation’s knowledge assets by re-allocation of existing resources without the need to increase the overall spend in this area unless it can demonstrably bring substantial returns. In the case of value-based management, a growing practice amongst major corporations, it allows delegation of such investment decisions to the operational level whilst retaining the rigour and discipline of evaluating each knowledge project in terms of value-added to the business, and ensuring that it is in line with the company’s general targets for ROI. The depth of analysis can be varied and kept appropriate to the complexity of calculating the costs and benefits. The method lends itself to both extremes. Scales can be absolute or relative; carefully and exhaustively calculated, or arrived at through simple voting and ranking, which taps into people’s experience and judgement (tacit knowledge). In practice a surprising degree of congruence between these approaches has been observed. 107
  • 8. The approach can also be used to identify the assumptions underlying the valuation of knowledge assets and, therefore, can provide a method for regularly re-evaluating them as well as assessing risks to the asset value. Equally, the method can help identify opportunities for deriving additional value from existing assets. This can lead to a knowledge portfolio approach. Some assets may have contingent value, depending on whether they may be used in the future. For example, tracking a potential acquisition target over a period of time creates a knowledge asset that may never be used. An extension of value-based knowledge management could be to introduce a probabilistic approach in calculating present and potential future benefits by applying the principles of options valuation. This method could provide a means of measurement that is based on the additional revenue stream generated by an asset and future cash flows can be discounted to calculate NPV. Other benefits of the value-based approach are that skills and tools are identified. This helps in developing a KM strategy and plans which cover skills and training needs, confidentiality and access issues. Indeed, this method can provide a framework for the whole KM process. Another issue is maintaining knowledge assets. Refresh rates are identified and strategies for developing and maintaining knowledge assets, analogous with maintenance of physical assets such as buildings and machinery. The difference is that knowledge assets can actually increase in value with use, as mentioned earlier. 5.3Intellectual capital performance indicators Whilst the value-based knowledge management method described above serves as a decision-making tool for managers, a different approach is required to measure the overall performance of the business in terms of efficiency in generating and using its intellectual capital. The method adopted by Skandia (Edvinsson and Malone, 1997) employed a portfolio of performance indices covering the following areas:  customer focus;  process focus;  renewal and development focus; and  human focus. 6.Conclusions Evidence confirming that firms with a clearly defined knowledge management strategy tend to perform better is beginning to emerge. A key factor is a consistent approach that sets out company-wide rules of engagement for evaluating, developing, sharing and investing in the intellectual capital of the firm. A process-led approach that applies the principles of value-based management to knowledge can provide a useful framework. An operational model of the organisation’s knowledge value-chain has been used to develop a knowledge inventory that supports the valuation and management of knowledge assets, both tacit and explicit. Whilst an intranet that captures explicit knowledge is a common starting point for companies that are developing a formal knowledge management system, it is the creation and sharing of tacit knowledge that can bring most competitive advantage. The value-based approach examined in this paper can provide a means for evaluating future plans and ensuring that a new KM system is developed in the areas that will bring most benefit. Further research to fully evaluate the outcomes of value-based knowledge management could make a valuable contribution to the understanding of this important area of strategic management. Bibliography Beinhocker, E. D. (1997) McKinsey Quarterly, 1997, 24-39. Brouthers, K. D. (1999) Long Range Planning, 32, 311-322. Day, J. D. and Wendler, J. C. (1998) McKinsey Quarterly, No.1, 19-25. Edvinsson, L. and Malone, M. (1997) Intellectual Capital, HarperCollins, London. Kaplan, R. S. and Norton, D. P. (1992) Harvard Business Review, Jan-Feb 1992, 71-79. Leonard-Barton, D. (1995) Wellsprings of Knowledge: Building and Sustaining the Source of Innovation., Harvard Business School Press, Boston. Lowendahl, B. and Revang, O. (1998) Strategic Management Journal, 19, 755-773. Marchand, D., Kettinger, W. and Rollins, J. (2000) Sloan Management Review, 41, 69-80. Matusik, S. F. and Hill, C. W. (1998) Academy of Management Review, 23, 680-698. 108
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