Unfortunately I was not able to quote either Mary or Henrik Martin, the CEO of Intellectual Capital Sweden, in the article, despite the fact that they both gave me terrific interviews, in order to avoid the appearance of conflict of interest: I’ve been talking to both of them about becoming a licensee/practitioner of the IC Rating method, which I think is one of the most sensible intangibles rating systems I’ve seen so far.

Jim Ludwig of Integral Input made a very thoughtful response to my posting Account for Intangible Cost, Not Value

I agree with Jim wholeheartedly that there are many aspects of intangibles that cannot be measured and an obsession with measurement can be counterproductive (like counting calls completed by a call center rather than customer satisfaction). The work of our IC Rating network is actually all about non-financial measures.

However, we should not ignore the measures that we do have–including intellectual capital investment. I think that we would accomplish a number of things if this kind of measurement would become popular. First, it would help managers and boards of directors to face up to the fact that they are already investing a lot in intangibles. This would force them to recognize the need to develop intangibles management capabilities. It would also help all of us learn more about the dynamics of intangibles management. Right now, no one can say what a “normal” level of investment is in systems or training or external relationships.

But Jim is right to ask about the next step: We can measure cost but can we measure return in a traditional, mathematical way? The short answer is no. Much of knowledge work occurs inside of people’s heads and, for the foreseeable future, our heads will not have gauges on them to show how effectively we are thinking. The path from cost to return goes from tangible to intangible and back to tangible, when the business process makes money or not.

I like to use the analogy of the fact that intellectual capital expenditure is like pouring money into a closed tank or a black box. You cannot see what is going on inside the box and you hope that money will come out the other side. It is our job as managers to learn how to discern what is going on inside the box, improve it and increase the flow of money out of the business.

We like to use stakeholder interviews (inside and outside the company) to determine whether the investments made are getting the desired results. Stakeholders are in a good position to, as Jim suggested, “evaluate” or assess the strength of the underlying intangibles. Some of the ways that they can be assessed include current performance, readiness for the future and risk. Thanks to Jim and Henrik Martin for their input–keep the conversation going!

It’s a topic I’ve written on before (most recently in discussing Denise Caruso’s book, “Intervention”), but Giberson boldly goes where I didn’t dare in suggesting that “Science … has the raw material for a new religion.” But then he asks some hard questions of a scientifically rooted religion:

What would this new religion be like once it became institutionalized? After all, if religion fills a genuine human need, something has to fill the hole created by its passing — something that appeals to billions of people.

Could we be sure, for example, that this new scientific religion would not give rise to the extremism and aberrant behavior that plague conventional religions? Would concern for the diversity of life, for example, inspire vegetarians to blow up slaughterhouses, and run the local butcher through his or her own meat grinder? Would reverence for the cosmos reinvigorate astrology? Would appreciation for natural selection bring eugenics back out of the closet? In other words, if science dismantles the traditional religious content that people use to satisfy their impulses — many of which are quite passionate — will we really be better off?

Great questions. The questions remind the reader that religious exercise isn’t just about getting the facts. They suggest that those who insist on literalism in religion miss the point, as if strict literalism among a group of human beings is either possible or desirable.

So rather than attacking religions, I’d prefer to see biologists (such as PZ Myers) and other scientists approach religion as an evolutionary phenomenon. Clearly, religion is itself an important evolutionary adaptation for the survival of our species. The religions in the world today exist because they are the ones that enabled cultures to survive. Religions have been successful in coordinating activities and building foundations for trust for millions of people across the globe. And they have done this without requiring the laity to have Ph.D.’s or IQ’s over 150. Whether the stories today’s religions tell are “true” in the scientific sense is irrelevant; what can’t be disputed is that these religions have enabled cultures to survive and civilizations to thrive where others have failed.

Religions will continue to evolve, but they won’t follow a rational or scientific path. Religions are also unlikely to completely overpower the human propensity for “extremism and aberrant behavior.” So before rushing off to take scientific communion, consider this: if survival in nature depends on making rational, scientifically founded decisions, how did we ever come to be?

It is not surprising that the organizers of the conference turned to two accountants to explain the “state of the art” of intangibles in the firm. It was a natural decision. We rely on accountants to provide objective information about our organizations. Who better to help us understand this new “asset” class that makes up 80% of the valuation of the average company and fuels competitive advantage?

But the problem is that accountants have not been able to answer this question. Accounting was designed 500 years ago to track the movement of tangible goods. The system worked well throughout the industrial revolution because it provided a way to keep track of the full value chain of a tangible business—from construction of a factory to purchase of raw materials, creation and sale of finished goods, and collection of accounts receivable.

The value chain of an intangibles-intensive business, however, is much less visible in traditional financial statements. The intangible assets used to create services and knowledge are not on the balance sheet. So the first time a service may hit the financials is as revenue. Costs related to the delivery of a service or creation of a knowledge product are not tracked directly. They hit the income statement as operating expenses. So the cost of building intangibles is mixed in with the cost of operating both the tangible and intangible sides of the business.

At the National Academies, Baruch Lev asserted that the best way to develop standards for intangibles reporting would be to work industry by industry to develop models of what he calls the “structured input-output information on performance of the major drivers of enterprise value.” He supplies two examples of this kind of value chain analysis for the pharma/biotech and telecom/internet industries.

Lev’s argument mirrors those of many others when confronted with the challenge of capturing intangibles in accounting—“we need to understand intangible values before we can account for them.” I think that this argument misses the point. Companies (and their accountants) are not in the business of “valuing” assets.

Think about it. When a company builds a new manufacturing plant, the analysis is not around the value of the plant. It is about the expected cost and return. No one around the table says, “this plant will have a great re-sale value.” The important questions are about how to use the plant to create revenues and profits for the company. The accountants book all the investments and expenses at cost.

Treatment of intangibles should be the same. Managers, accountants, boards of directors and investors should not ask the value of intangibles but, rather, the accumulated cost and expected return. This argument was made very effectively in a Melbourne Institute Working Paper, Measuring Intangible Investment, by L. C. Hunter, Elizabeth Webster and Anne Wyatt.

I stood up at the National Academies conference and asked a question about this. I’m not sure the panel had thought about the issues in this way before so I would like to pose it again and, hopefully, open a conversation about where to go from here:

Aren’t we ignoring a hugely important set of information that is already in every accounting system: the cost of the investments that companies make every year in their intangibles?

Corporations around the world pay to hire people and train them. They pay to develop business processes, implement software (sometimes five times the cost of the software license itself) and perform R&D. They invest in their brands and customer relationships.

If we use macroeconomic data as a guide, the annual investment in intangibles now surpasses tangible investments in the U.S. But, with the exception of R&D, spending on intangibles is not broken out. It passes through the income statement where it is mixed in with true operating expenses.

Couldn’t/shouldn’t every company prepare a report of these intangible investments? It would detail out all the “expenses” that are in the current year’s financial statements that are actually “investments” in the company’s future that are expected to provide value beyond the current year? Accountants are used to this distinction between current costs and future investments; they would just be applying that distinction to create a supplementary report.

The income statement would not be changed. GAAP would be respected. But a company’s stakeholders would have a better view into the long term thinking and investing of its management:

• How are they preparing their people for the future?
• What are their key processes and how are they building them?
• What is their investment in innovation and research?
• How much do they invest in their brand and customer relationships?
• Are they investing in key partnerships?

I would call this something like the “Intellectual Capital Expenditure Report.” It would provide critical information that should be available to managers, boards of directors and investors. Once you get this data over a series of years, you could begin to look at the relationship between spending on intangibles today and increases in revenues and profits in future years. You could also create industry consortia that collect and provide benchmarking data to their members.

I think that having good information on the cost of intangible investments would be a boon for managers and investors alike. Do you agree? How can we get this going? I hope to hear from you by email or through comments on this entry.

However, it is worth reading the analysis that led them to this conclusion. Their examination of the largest 150 companies in the world showed that after growing at 3% from 1970 to 1994, their total market capitalization grew at 11% per year through 2004, even taking into account the bursting of the internet bubble in 2001. They then separate the companies into two groups: “labor-intensive” and “thinking intensive,” looking at net income per employee. It probably won’t surprise you that the thinking intensive companies had much higher income per employee. (Note that this data is in the Introduction to the book which is available as a free download)

The authors go on to state that “almost all of today’s companies…were built primarily to mobilize their labor and capital assets—not the intangible assets that enable profits per employee to rise to levels never seen before.” And further that this model leads to “massive, unnecessary, unproductive complexity.” They also imply that many of the companies that have succeeded at this game have done so more by intuition and luck than by deliberate strategies.

The authors’ focus on complexity reflects their focus in their data and in their suggestions on the largest companies in the world. But that does not reduce the value of their recommendation that organizational design and innovation be a primary focus of business leaders in the coming years. Unlike Gary Hamel and Bill Breen, who made the same recommendation in their recent book The Future of Management but stopped short of suggesting how to accomplish this, Bryan and Joyce explore in great detail what they call “ideas” for the reader’s consideration:

• Backbone Line Structure
• One-Company governance
• Dynamic management
• Formal networks
• Talent marketplaces
• Knowledge marketplaces
• Motivating economic behaviors
• Role-specific performance measurement
• Organizational design as strategy

I found that many of the recommendations would only be relevant to the mega-corporation. No surprise as that’s McKinsey’s market. Not every company has the same complexity of challenges that need complex solutions. Nevertheless, this is a valuable contribution to the field of intangibles.

There were two panel discussions on the role of government around intangibles. Many of the presentations were rich with data, and I recommend them to those interested in the macroeconomic aspects of intangibles.

Douglas Lippoldt, Organization for Economic Cooperation and Development (OECD) made a clear case for governments and organizations like the OECD to focus on intellectual assets as:

• They are central to value creation, economic growth and competitiveness in a modern economy.
• Continued shortfalls in measurement and understanding of intangibles has implications for decision making
• IA relationship to innovation, as inputs and outputs needs to be understood
• There are significant possibilities to leverage these assets for acceleration in development

R&D was the focus of presentations by John Jankowski, Science Resources Statistics Division of the National Science Foundation, and Steve Landefeld, Bureau of Economic Analysis at the Department of Commerce. Landefield explained the significant shift in how research and development gets done today versus the way it was done in the 1950-70’s. Today, more research is done at the corporate level (although not just in large companies) while less basic research is done at the corporate level; basic research has moved to academia. The focus of R&D today is much more on IT, services and is global. These changes speak to the need for new approaches to measurement of R&D, an effort that is currently underway.

Ahmed Bounfour, Paris-Sud University, gave a dense overview of activities in different regions of the world (other than North America). Nir Kossovsky, Steel City Re, explained the role of reputational risk in the value of intangibles.

Kenan Jarboe, Athena Alliance, presented a detailed estimate of the U.S. government’s spending on intangibles of $204 billion in 2006. Of this, $122 billion was in R&D. The remainder was in development of human, reputational and organizational capital. Jarboe also outlines the beginning of an intangibles policy agenda including expanding definition of investment tax credits from capital to intangible assets. He also identified many measures which will help support the growth of markets for intangibles, such as registries of security interest in intangibles.

All in all, The National Academies conference on Intangible Assets was a great start to what I hope will be a new chapter in the U.S. focus on the resources that will make or break our collective future. But there is still much work to do. Stay tuned here for lots more ideas and information.

This was the discussion of the day closest to my experience and practice so I was especially interested in these presentations.

I recommend the discussions by Laurie Bassi, McBassi & Company, and James Malackowski, Ocean Tomo, whose companies are encouraging market development for intangibles. McBassi offered data on the value of investment in human capital. Malackowski’s firm made its name by developing public auctions of patents and is now developing investment units tied to licensing rights. The work of companies like this will provide an important validation to markets and managers of the value of intangibles in business.

Baruch Lev of New York University’s Stern School, reported that “shares of intangibles-intensive companies are systematically undervalued, causing excessive cost of capital as well as suboptimal investment and growth.” Lev rejects the value of many intangibles indicators and advocates “structured input-output information on performance of the major drivers of enterprise value.” The challenge to this is, as Lev admits, that this type of analysis would need to be done industry by industry and, as such, would take years to develop.

Ron Bossio, Financial Accounting Standards Board (FASB), explained that FASB’s priorities are around international convergence and joint projects with the IASB and completion of codification of US GAAP. As previously reported late in 2007, FASB will not work directly on the issue of intangibles. He ended the discussion with the prediction that the challenge of intangibles disclosure will not be solved for the foreseeable future.

I asked Lev, Bossio and the others on the panel about cost. In my own work, I keep coming back to cost and I am beginning to see it as the potential answer to this dilemma. Companies are already spending millions on intangibles. Accountants know how to count costs—they are counting the cost (I would call it investment) in intangibles and putting most of it on the income statement. Why don’t we start creating management reports about intangibles spending and use the information for greater transparency and learning? Our economy has already changed. We are already in an intangibles-heavy economy. We cannot afford to ignore a powerful information source in the form of annual investment data in intangibles.

The introduction to the day’s proceedings was made by Cynthia Glassman, Under Secretary for Economic Affairs at the U.S. Department of Commerce. Ms. Glassman’s remarks distilled lessons from the 2008 Report of the Secretary’s Advisory Committee on Measuring Innovation in the 21^st Century Economy.

Irving Wladawsky-Berger, IBM and MIT, gave one of the best presentations of the day. He gave a thoughtful but entertaining view of the importance of intangibles, saying the “moment of shift” was in the mid-1990’s with the rise of the Internet. He also predicted that most innovation will be in market-facing technology, which reminded me again of Lean Solutions, the book which I discussed in my post on Manufacturing’s Intangible Future. This book is a great introduction on focusing on the enterprise from the consumption/market perspective.

Wladawsky-Berger pointed out that so much of the work in information technology done to date was in the back office, where you are dealing with machines and products. In market-facing solutions, you are dealing with people and services—a much more complex and intangible task. This is also an important reminder of why relationship capital—networks, relationships and brand—will continue to grow in importance.

For the economists in the audience, Wladawsky-Berger connected intangibles with three concepts from Adam Smith:

• Division of Labor: The new frontier is the study of business processes, learning to break them down into components. This is the focus of IBM services. Wladawsky-Berger used an inverted pyramid to explain the size of this challenge. He put technology at the narrow bottom of the inverted pyramid—the wide part of the pyramid at the top represents the broad array of processes built on that foundation.

• Invisible Hand: Increased integration and accelerated change will lead to increased convergence, unpredictability and long-tail events (made me think of Taleb’s The Black Swan)

• Moral Sentiments: He pointed out that moral sentiments in a digital economy are embodied in social networks, collaborative innovation and corporate social responsibility.

Wladawsky-Berger concluded by emphasizing that the bottom line is that talent is more important than ever.

Another presenter, Charles Hulten, University of Maryland, asked the question, “What do companies really do?” His answer focused on design, technology, innovation and marketing. His talk was based on the paper he wrote with Janet Hao that was published by the Conference Board on Intangible Capital and the “Market to Book Value” Puzzle. Hulten took a different tack on taxonomy than that used in the intellectual capital community; i.e., human, structural and relationship capital. He identified:

• Structural: related to innovation, human resources and organization
• Value of Output: stock market, securitization (here he also referenced the recent BusinessWeek’s work on brands)
• Value of Inputs: value at cost, Tobins Q and the cost-value link

Note that Hulten’s focus on cost is on macroeconomics—how much are we spending economy-wide? The question of cost at the enterprise level was discussed later in the day (and in my post on Intangibles and the Firm).

He identified some economic characteristics of intangibles (for all you economists out there) which are:

• Not market transactions
• Invisible, hard to count
• Non-rival (use by one person does not prevent use by another)
• Have value that is appropriable only if from a commercial investment (the rest of the value diffuses as reduced cost and increased total factor productivity)

These concepts are examined in Hulten’s paper with Corrado and Sichel in 2006 on Intangible Capital and Economic Growth. One of the interesting data points he cited was that in 2003, the total investment by businesses in fixed assets was $1,077 billion versus $1,226 billion in intangibles. Even though intangibles investment has already surpassed tangible investment, we are all still just figuring how to count it!

The discussion of the challenges and approaches to macroeconomic measurement of intangibles was greatly strengthened by the presentations of perspectives from not only the U.S., from Carol Corrado, The Conference Board and Brent Moulton, Bureau of Economic Analysis, but also from Jonathan Haskel from Queen Mary College, University of London, and Kyoji Fukao of Hitotsuboshi University and RIETI. I recommend the individual presentations for more detail but thought I would highlight a couple points that struck me.

Corrado pointed out that many of the expenditures in intangibles are co-investments in IT. This emphasizes the role of technology as a catalyst for change in organizations as well as a tool for accomplishing that change. Process improvement, increased employee competencies, improved customer service, are all inter-related. This comment was also interesting in light of Wladawsky-Berger’s presentation based on his experience at IBM on the role of intangibles in business.

Using the approaches developed by Corrado, Hulten and Sichel in 2006 on Intangible Capital and Economic Growth, it appears the intangibles investment in the UK and Japan is much lower than in the U.S. But then Fukao dug into the numbers. He pointed out that one component of the calculation of investment in organizational structure is the CEO’s time commitment to corporate strategy. Data shows that, in the U.S., CEOs spend 20% of their time on strategy (versus 9% in Japan). Further, CEOs in the U.S. earn about 10 times more than their counterparts in Japan. So 20% of U.S. CEO compensation will far outreach 9% of Japanese CEO time.

Another difference in the calculations was in the differing role of formal versus on-the-job training. The U.S. tends to use formal training for employees. Japan relies more heavily on informal training. So the U.S. calculation under-counts Japan’s investment of 9% of the average worker’s time in on-the-job training.

These two factors lead to higher calculation of the U.S. investment in intangibles—but I was left wondering whether the U.S. calculation is valid … Another demonstration of the challenges ahead on measurement of intangibles.

For those of us that have been working in the field, it was a gratifying moment to hear the keynote from Senator Jeff Bingaman (from my home state of New Mexico) challenging the audience to help the Congress and our nation in general understand this critical issue—and develop recommendations that can translate into good policy, where necessary, to support the intangible strength of our economy.

Many of the participants were economists from the U.S. government; a few academics and a small number of consultants and business people attended as well. You can scan all the presentations yourself, if you’d like.

In this and following posts, I thought that I would add my two cents on some of the content. Remember that my experience and interest is at the organizational level, so my comments reflect that bias. I’ve broken the notes into sections for each session of the day.