Driving growth: Economic Value Added versus Intellectual Capital

Management Accounting Research, 1998, 9, 46 1-482 Article No. mg980090 Driving growth: Economic Value Added versus Intellectual Capital Jan Mouritsen" This paper compares and contrasts Economic Value Added (EVATM)and Intellectual Capital (IC) as two technologies of managing oriented towards encouraging growth. The analysis suggests that EVATM and IC contrasts greatly. EVATM is a financial management system based on radical delegation and 'empowerment' and which therefore directs attention to the results created by managers. Based on financial micro-theory, EVATM is a performance measure that attempts to account more properly for the cost of capital, but more than that, it is also a management control system which seeks to create radically independent business units and minimize corporate staff. IC is a different control system concerned to encourage endogenous growth implemented via loosely coupled sets of non-financial measurements that become strong via stories and metaphors about the post-modern firm in the postmodern world. Here, based on theories of organizational knowledge and competence development, emphasis is put on mobilizing white collar productivity and creativity based on some form of evolutionary economics or resource-based theory. While EVATM looks to managers as the movers of change, IC seems more systematically to promote the creativity possessed by employees. 0 1998 Academic Press Key words: Economic Value Added; Intellectual Capital; organizational learning; knowledge; management; control; organizational development; shareholder value; competence. 1. Introduction Where d o corporate growth a n d value creation come from? T h i s question is obviously important to managers of business firms a n d to politicians who attempt to create strategies a n d policies for their firms a n d countries. Although growth a n d (financial) value creation may not b e t h e only possible objective for the management of the future, in the contemporary World this is often t h e case. Growth a n d value creation, however, d o n o t come automatically, a n d a set of mechanisms have to b e mobilized in firms o r at political levels to support them. T h e r e has to b e a technology of managing which points out the parameters a n d justification of the path towards the future. As previously, managers h a d to learn about discounted cash flow (Miller a n d Rose, 1990)) today there seems to b e to other options for this e n d found in Economic Value Added (EVATM) a n d Intellectual Capital (IC). T h e y are both presented as potent technologies of managing which promise a golden future if applied properly, * Copenhagen Business School, Howitzvej 60, DK 2000 Frederiksberg, Denmark. Accepted 5 September 1998. 1044-5005/98/040461+22$30.00/0 01998 Academic Press 462 J. Mouritsen just as they are both rooted in practice-for EVATMto the point where it has been trademarked.’ EVATMis said to produce ‘a higher standard of living, greater overall productivity and competitiveness, and a better functioning of the equity market’ (Copeland et al., 1994, p. 3-4). Likewise, IC is claimed to find and express how ‘the new source of wealth is not material, it is information, knowledge applied to work to create value’ (Edvinsson and Malone, 1997, p. 3). Both EVATM and IC are thus concerned with wealth creation. They share a commitment to crafting a technology of managing which can point out relevant assets to be managed, and they are both concerned to somehow attach the prospects of the future of firms, capital markets and countries directly to the management of the firm. However, while EVATM proponents appear to be concerned with concrete and explicable ventures and want to put the prospects of the market into singular cash flow digits, the proponents of IC are more concerned to point out the firm’s competence-bases for future earnings omitting specific cash flow calculations and concentrating on multiple non-financial digits to help implementing a particular vision of the future. EVATM is presented as a new and potent technology of managing which helps firms enhance shareholder value creation (Rappaport, 1986; Wenner and LeBer, 1989; Copeland et al., 1994, Landesman, 1997; Stewart, 1991). It is built around a piece of calculation which reorganizes the balance sheet and the income statement in such a way that the capital base of the firm is accounted for and matched to a specific cost of capital unique to the firm which takes into consideration risk. EVATM’s concerns with driving growth appear to be closely attached to the balance sheet and the income statement although in a re-engineered form. It describes possibilities of growth on the basis of existing markets, products and technologies as it seeks to estimate a future on the basis of cost and revenue structures already put in place. In contrast, IC is concerned to account for the firm’s future prospects in a much more organizational mode. It is concerned to lay out its competencies which represent drivers of growth as potentialities (Brooking, 1997; Edvinsson and Malone, 1997; Roos and ROOS, 1997; Roos et al., 1997; Stewart, 1997; Sveiby, 1997; Johansson, 1998; Johansson et al., 1998). It is not concerned with the growth found in present markets, technologies and products, but it is rather focused on mobilizing internal, foundational capabilities and competencies useful for growth in a long-term perspective (cf. Wernerfeld, 1984; Hamel and Pralahad, 1994, Roberts, 1998). Here, organizational capabilities and competencies constitute the specific bases-organizational routines-for competitiveness built up over a long period of time and realized in a multitude of products and technologies over time. Growth and value creation are not a matter of particular products and markets but of the broad organizational knowledge, unique to a firm, which allows it constantly to adapt to changing conditions. In this paper, IC will be mobilized as a possible angle from which to problematize the power of EVATM.The paper starts by an interpretation of EVATM not along its EVATM is trademarked with Stern, Stewart and Co., a New York based consulting firm that calls itself the EVA company. It explains on its web-site as follows: ‘EVATM Economic Value Added is the financial performance measure that comes closer than any other to capturing the true economic profit of an enterprise. EVATM also is the performance measure most directly linked to the creation of shareholder wealth over time. Stern Stewart and Co. guides client companies through the implementation of a complete EVATM-based financial management and incentive compensation system that gives managers superior information and superior motivation to make decisions that will create the greatest shareholder wealth in any publicly owned or private enterprise’. ~ ~ ~ ~ Driving Growth 463 accounting and financial measurement characteristics, but rather related to its character as a management control mechanism. Then IC is introduced to craft a perspective from which EVATMcan be problematized, and in the last section, EVATM and IC are compared and conclusions are made as to the character of EVATM. 2. EVATM: corporate governance as the financial management of capital EVATM is a technology of managing that attempts to underscore value creation and growth through focusing on the deployment of financial capital.’ Minimally, EVATM is a performance evaluation system which emphasizes ‘net operating profit after taxes less a charge for the capital employed to produce those profits’ (Stern et al., 1994, p. 52); or in other words: “EVATM is the ‘residual income’ left over from operating profits after the cost of capital has been subtracted” (Stern, 1994, p. 49). It makes the cost of capital explicit, and it attempts to make certain changes to the balance sheet to make the capital base more in harmony with a cash flow perspective on capital c o n s ~ m p t i o n .EVATM ~ is said to be ‘superior to accounting profits as measures of value creation because (it) recognizes the cost of capital and, hence, the riskiness of the firm’s operations’ (Lehn and Makhija, 1996, p. 34; Copeland et al., 1994, pp. 153 ff.). It directs attention to the possible different risk profiles of the elements of the assets in the balance sheet and allows a different cost of capital to be used for each, just as it allows different premiums for risk related to the various business segments of the firm’s operations, to the relation between borrowings and equity, and even possibly to different risk profiles of investors using CAPM models to support this. EVATMis thus a performance measure which highlights the value added beyond the cost of capital of the firm’s periodic income, and the present value of the firm’s future EVATMs represent the firm’s Market Value Added (market value less the cash provided by investors and lenders). EVATM is thus a performance measure which provides a decision criterion (value beyond and above cost of capital) and it ties in neatly with the firm’s Market Value Added and thus with value to shareholders, or Shareholder Value. Although it can be debated whether EVATMis ‘new’, whether the relevant capital base can be found or whether it is possible actually to compute the cost of capital, EVATMis more than a piece of c a l c ~ l a t i o n It . ~also provides a system of management or government which, if implemented, crafts managers’ work anew. As a management system, EVATM‘consists of those financial policies, procedures, methods and measures that guide a company’s operations and strategy’ (Stern et al., 1994, p. 41)) ’Proponents of EVATM know about the possible benefits of non-financial ratios (Copeland et al., 1994, p 98.) but they just consider these secondary to the financial statements and balance sheets because each non-financial measure is isolated. 3Stern and colleagues suggest that the conventional GAAP may have to be changed on 164 items to achieve this, although in practice, 5 to 10 adjustments are often adequate (Stewart, 1994). 4EVATMis a more detailed performance measure than say ROI and ROE, and it appears to have certain advantages such as (1) it allows uniform profitability objectives across business units where e.g. the ROI-objective is dependent on previous levels of ROI for the individual business unit, (2) as a dollar-measure, improvements in EVATM will always improve the firms bottom line, while increasing ROI may be accomplished by reducing the business selling off sub-ROI projects, (3) a complex and heterogeneous set of interest rates may be applied to different assets and thus account for different forms of risk. EVATM does not sort out all problems, however. One issue is that of book value and depreciation as elements to the problem of finding proper bases to which interest rates should be related. 464 J. Mouritsen and therefore ‘EVATM is a financial management system. It is a framework for all aspects of financial management decision-making that are anchored by the incentive compensation plan’ (Stern et al., 1994, p. 52). It is concerned with the operations as well as the strategies of the firm and is not an attempt merely to describe its financial situation. It is more importantly a system which transforms corporate activity including managers’ jobs; it re-crafts the whole organizational structure and the role of the manager in it. This is a large agenda and it is legitimated by a broad analysis of the new conditions of competition existing in the 1990s. Stern et al. (1994, p. 32) argue that the need for a new governance structure is in place today because ‘the information revolution, along with the pace of technological change of all kinds and the rise of a global economy is leading to major changes in the structure and internal control systems of large organizations’. It is the need for ‘empowerment’ legitimated by increased competition and rapid change which propels technologies such as EVATM;and in addition there are behavioural problems with current control systems which because they are based on conventional accounting and budgeting procedures that allow ‘sandbagging’, ‘lowballing’ and other forms of window-dressing which create and maintain an unhealthy budgeting game. EVATM is aimed to ‘eliminate altogether the need for subjectivity in the financial management (and incentive) system’ (Stern, 1994, p. 70) which would reduce such games by making expected performance less a matter of internal budget standards than of external market-based value added r e q ~ i r e m e n t s .EVATM ~ thus promises a lot. But in order to do this, it needs a set of behavioural effects which require the firm to be transformed through radical decentralization, and more ‘empowerment’ of local business unit managers. EVATM thus calls for a transformation of the firm, it also calls for a new alliance between manager and shareholder, just as it promotes the market as the arbiter of all corporate problems (Glassman, 1997). It is not merely a new piece of calculation. This means at least, that EVATMrequires a strict organizational structure built along business units. Secondly, the manager has to simulate him or herself as a particular kind of distant owner, and thirdly, EVATM creates and lauds managers as heroes. These are important dimensions of the politics of EVATM.Let us take them in turn. Radical ‘empowerment’ For EVATM to work, the firm has to be (re)organized strictly in business units to allow ‘empowerment’. HQ has to be very lean as the large strategic planning departments that once reigned there are to be dismantled. Strategizing has in large measure to be located with business units, and EVATMtherefore replaces other kinds of co-ordination and planning. Or to use Stern et al. (1994, p. 42) formulation, ‘the widespread corporate practice of using different financial measures for different corporate functions creates inconstancy, and thus considerable confusion, in the management process ... With EVATM, all principal facets of the financial management process are tied to just one measure, making the overall system far easier to administer and understand’. There is one rule: the manager has to produce and implement projects with a 5Minimally, this implies that budgets are irrelevant and that the CAPM model will help reducing discussion of targets. Relevant financial targets are those which exceed the cost of capital as defined by after tax risk-adjusted performance expectations. These are found in the capital market, at least in principle. Driving Growth 465 positive EVATM,because this generates value. Such a game may be appealing since it crafts in a radical form the responsibilities that the manager has to perform. However, such a scheme is not without its contradictions. In ‘conventional’ management control systems, the financial responsibilities are typically but one managerial technology, as there are also strategic planning, operational planning and all sorts of other top management interventions which contextualize the financial responsibilities (Anthony and Govindarayan, 1995). Compared to this, EVATMstands out as a most singular technology of managing which purports to take into account all management issues at one time. While it may do so at the intellectual level, it possibly does not do it in empirical situations. As Zimmerman (1997)) for example, points out, EVATMdoes not concern itself with possible synergy between business units because of this radical form of ‘empowerment’. Neither do other more conventional performance measures, one may add, but here it must be emphasized that they to a certain degree are contextualized by numerous ‘adaptations’ found in strategic plans, operational plans, capital budgeting procedures etc., each of which tend to make each of the other measures relative and relational. They are implicated in a management form which not only includes many other kinds of paper-work, but also many other agents, such as H Q staff and top managers (Anthony and Govindarayan, 1995). In addition, it may be argued, as does Simons (1987)) that firms existing in uncertain circumstances in terms of technology, markets and competition, will be more likely to use several kinds of information systems and communication devices simply to get some grasp of, how changes will affect the firm. Here, singular information systems may not be adequate. Therefore, EVATM’s insistence on a governance structure deploying only one kind of ex post information may be problematical. EVATM’s concern for simplicity and clear guidelines is laudable, but perhaps the structuring it posits exaggerates the rationality and simplicity that complex corporate systems find themselves in. EVATM, however, insists on such simplicity. It insists on crafting organizations on such an agenda, and it therefore insists that EVATMcannot merely be a calculative technique that can help identifying what firms’ organizational entities are worth; it first has to change the firm, and then, possibly, it is possible to calculate the value added. Or to put it differently, for EVATM to work, organizational structures may have to be changed, managerial responsibilities have to be renegotiated, and a host of information providing mechanisms have to be abandoned and replaced by a single EVATM.Therefore, is not merely a calculative technique; it is also, and perhaps more importantly so, an organizational change scheme. The firm has to be adopted to the technology rather than the other way around. The simulated equity owner In continuation with the first point, EVATM attempts to transform the outlook on business of the manager. It seeks within a highly decentralized management system to ‘simulate the feel and pay-off of ownership’ (Stern et al., 1994, p. 40). EVATM aspires to ‘make managers into owners’ where ‘pride in one’s work, sensible risk taking, and, above all, accepting responsibility for the success or failure of the enterprise are among the attitudes that separate owners from mere hired hands’ (Stewart, 1991, p. 223). EVATMis a monitoring system that would want to persuade managers not only to create results but also to install a certain ‘consciousness’ of ownership even if managers are not in fact owners. It is the bonus plan and 466 J. Mouritsen compensation scheme6 which drive this merging of interests. It is obviously debatable just to what extent managers’ and shareholders’ interests actually differ, but leaving this aside the consciousness of ownership is a strange one imported from the abstract agent moving in capital markets. The anonymous spectre of cash flow interests more than the prudent innovator in Schumpeter’s models of capitalist development (Schumpeter and Clemence, 1989). In a sense, contrasting to Schumpeter’s owners, EVATM’s owners do not really care for the firm, but only for its cash flows. Obviously, some care for the firm has to be in place to ground cash flows, but the precise kind of consciousness of ownership that would support this, is down-played in EVATM.Therefore the consciousness of ownership devised by EVATM may or may not have anything to do with the well being of the firm as a firm, i.e. products, people, innovation and all the other issues that together constitute the realm of a business organization. EVATM entertains an idealized version of the firm, based on the government mechanisms envisaged by finance theory. This is also why Stewart (1991) and Copeland et al. (1994) talk much more about establishing proper cost of capital indexes than about how to evaluate the relevance of corporate strategies. Therefore, the consciousness of ownership that EVATM proposes may be inappropriate to govern a business organization; at least it is partial. The consciousness of ownership is also relevant to EVATMin a different, although related, way. EVATM’sbonus plans are wholly concerned with managers and they only marginally suggest how managers could or should use EVATM to produce commitment and engagement with ‘ordinary’ employees. Their presence is minimal. Although some mentioning is made of ‘motivated employees’ (Stern et al., 1994, p. 32)) the role of employees is completely marginalized, except form situations where some foremen have been equipped with certain localized EVATMS . In effect, the only agents we meet are those equipped with EVATMs;others do not count as ‘assets’. Relevant assets-and thus drivers of growth-are those for which cash has been paid. Therefore, the hero of EVATMis the manager who is seen as omniscient and capable of crafting all necessary initiatives to find and implement projects with positive EVATMs.The manager is assumed to have the insight that provides certainty about the future. This is also why the manager is the only one to benefit from bonus schemes via the rule of ‘simulated ownership’. The lack of strategy This leads to the third point about EVATM: it is not concerned with corporate strategy at all. EVATMis thought to be forward-looking but upon reflection it is clear that EVATM’s strategies are truisms. EVATM is expected to work through three possible actions. The first is to ‘increase the return derived from the assets already tied up in the business’; the second is to ‘invest additional capital and aggressively build the business so long as the return earned exceeds the cost of that new capital’, while the third is to ‘stop investing in, and find ways to release capital from, activities that earn substandard returns’ (Stern et al., 1994, p. 40). These solutions which - 61t is a Bank System which simulates long term interest (three years) as managers are compensated for not only their present performance but also for their ability to maintain a certain result over three years. If this is not possible, the original compensation will be reduced. Likewise, the compensation plan creates targets based on the general development of the capital market to reduce compensation which does not accrue form the manager’s own efforts but from uncontrollable external events (Stewart, 1991, pp. 235 ff., Stern et al., 1994, pp. 43-45) Driving Growth 467 are EVATM’sstrategies merely say how certain changes in financial ratios come about. Note here, that such imperatives could also easily apply to a performance management system based, say, on RONA The recommendations would be similar. Therefore, EVATMdoes not help us with a specific theory of how firms grow under the conditions of ‘the information revolution, along with the pace of technological change of all kinds and the rise of a global economy’, as Stern et al. (1994, p. 32) would like us to think. At least not beyond providing a new government structure based on ‘empowerment’ where managers are put in to think, but they do not suggest what managers should think about specifically. EVATM is concerned with the question: ‘do we like the effects of our decisions?’ more than with ‘how do we know what to propose?’ or ‘what competitive power should we aspire to get?’, or for that matter ‘how does a decentralized business unit have to work to produce EVATMs?’. Thus, EVATMpresents itself as a strategic evaluation tool, but it does little to help devising the strategies themselves. In effect, the strategies proposed by EVATM refer to black boxes where its replacement of input-oriented corporate strategizing by wholly output-oriented performance measures is in place. Therefore EVATMtakes on more responsibility than is typically accorded to performance measurement systems. It omits attention to the possible timelags that may exist between strategic manoeuvres and their results. The connections between strategic vulnerabilities and financial vulnerabilities over time are most likely complex and unique, and ‘good results’ may be rooted in strategic moves made in earlier periods. Thus, EVATM not only down-plays the relationship between strategy and financial performance. It also is silent on what kind of strategy is relevant under the circumstances of change and disruption that are said to make it a relevant solution. Therefore, EVATMdoes little to sort out the relationship between accounting and finance measures and the firm’s business, operations, competition and strategies beyond the ‘manager’s best estimate’ (Rappaport, 1986, p. 77) where the strategies remain silent and attention is given primarily to the manager’s estimate of their cash flows. Here, it differs from the various kinds of strategic management accounting which propose particular relationships to be made visible to support the firm’s competitiveness. Bromwich (1 990) proposes to model product attributes financially, Shank and Govindarayan (1 993) focus on interfirm value chain analysis, Cooper and Kaplan (1 99 1) direct attention to the firm’s cost of infrastructure and delivery system, and Colville (1991) shows among other things accounting’s involvement with competitor analysis and industry analysis. Here, the financial realm is oriented towards particular business issues. EVATM is not. Therefore EVATM’s idea of strategy is wholly ex post, and it may provide a set of decision criteria, but it does little to actually focus on what is important about the conditions of uncertainty and disruption where EVATM is thought to be a superior performance management system. This is where Intellectual Capital (IC) presents an alternative. It has a vision of how strategic possibilities are realized. ~ 3. IC: the economy of creativity in human capital, customer capital and organizational capital The interest in IC is argued as follows by Robert Reich (1991): 468 J. Mouritsen Members of the accounting profession, not otherwise known for their public displays of emotion, have fretted openly about how to inform potential investors of the true worth of enterprises whose value rests in the brains of employees. They have used the term ‘goodwill’ to signify the ambiguous zone on the corporate balance sheets between the company’s tangible assets and the value of its talented people. But as intellectual capital continues to overtake physical capital as the key asset of the corporation, shareholdersfind themselves on shakier and shakier ground. Robert Reich here argues for a competence theory of the firm where the specific organizational routines, processes and procedures are attributed the power to generate growth. Tangible assets, albeit important, are not decisive. More important is the ‘value of the talented people’ that are valuable because they are part of an organizational system. Such a competence theory (Wernerfeld, 1984; Itami and Roehl, 1987; Grant, 199 1, 1996; Hamel and Pralahad, 1994; Roberts, 1998) suggests that organizational competence is a gradually built, historically forged and always placed in the uneasy position between discursive and tacit understanding of organizational rules of conduct. It directs attention to internal processes within the firm and not merely to external markets and competition. Robert Reich also suggests that presently there is no good model to represent IC in figures, numbers and digits. Although the implicit assumption that it is easy to represent tangible, fixed assets in accounting systems is wrong, he correctly suggests that there are new challenges for investors and shareholders who want to understand a firm’s growth and value creation potential. Or, more precisely, he is almost right. Some firms, practitioners and consultants are beginning to experiment with IC statements. They are developing and extending the boundaries of external financial reporting particularly by introducing non-financial elements to this report, such as employee satisfaction, customer satisfaction, time and quality. More precisely, they are introducing elements to financial reporting which are not solely based on the firm’s financial database, because a substantial part of the new ‘non-financial’ measures are expressed in monetary terms but not exclusively via the financial database such as for example market share, expenditure to employee development programmes per employee, marketing expenditures per customer or I T investments per employee. Such key ratios are non-financial because only part of them are located in the financial database. The general IC model Although writers on IC differ about the specifics of IC reporting, they typically mobilize three dimensions which extend the idea of financial reporting beyond the conventional financial statement. They generally talk about human capital (which leaves the firm during the weekends), organizational capital (procedures, manual and administrative systems) and customer capital (customer-loyalty, product-brands and corporate image). Stewart (1 997)) for example, calls these human capital, structural capital and customer capital. Human Capital, for Stewart, is that what thinks; or with his own words ‘[mloney talks, but it does not think; machines perform, often better than any human being can, but do not invent ... [The] primary purpose of human capital is innovation-whether of new products and services, or of improving in business processes’ (Stewart, 1997, p. 86). Of structural capital Stewart says that it is ‘knowledge that doesn’t go home at night ... [I]t belongs to the organization as a whole. It can be reproduced and shared ... technologies, inventions, data, publica- Driving Growth 469 tions,. .. [and] strategy and culture, structures and systems, organizational routines and procedures ...’ (Stewart, 1997, p. 108-109). Concerning customer capital, Stewart comments that like human capital, it cannot be owned by the firm but it is crucial because it is ‘the value of its franchise, its ongoing relationships with the people or organizations to which it sells... [like] market share, customer retention and defection rates, and per customer profitability’ (Stewart, 1997, p. 143). Sveiby, among the leading writers in this field, divides IC into three similar dimensions: employee competence, internal structure and external structure (Sveiby, 1997, pp. 10-1 1): ‘Employee competence involves capacity to act in a wide variety of situations to create both tangible and intangible assets. .. Internal structure includes patens, concepts, models, and computer and administrative systems ... The external structure includes relationships with customers and suppliers. It also encompasses brand names, trademarks, and the company’s reputation or image’. Again, an attempt is made to inscribe phenomena that may be said to be capital, but is not reported in the conventional financial reports. It is more concerned with the organizational processes that make up the firm as an ongoing accomplishment when people put tangible assets to use. Edvinsson and Malone (1997, p. 11) suggest a distinction between human capital and structural capital where the former comprises the ‘combined knowledge, skill, innovativeness and ability of the company’s individual employees.. . it also includes the company’s values, culture, and philosophy. Human capital cannot be owned by the company’. In contrast, structural capital is ‘hardware, software, databases, organizational structure, patents trademarks, and everything else of organizational capability that supports those employees productivity ... [It is] everything left at the office when the employees go home ... Unlike human capital, structural capital can be owned and thereby traded’. Here, IC is conceptualized as people and ‘everything else’. A fairly broad definition which, however, captures the basic point that firms thrive on IC rather than financial capital. If they in combination make up the firm’s market value, according to Edvinsson and Malone, the IC part is increasing as we approach information society, or as Robert Reich suggests: The Economy of Creativity where people rather than ‘things’ are decisive growth drivers. Brooking (1 997, p. 13) distinguishes between market assets, human-centred assets, intellectual property assets and infrastructure assets. Market assets comprise the ‘potential an organization has due to market-related intangibles’ (Brooking, 1997, p. 13) which are important because they provide a competitive position in the market place such as branded products, customer loyalty, distribution channels, contracts and advertizing. Human-centred assets ‘comprise the expertise, creative and problems solving capability, leadership, entrepreneurial and managerial skill embodied in the employees’ (Brooking, 1997, p. 15) such as psychometric data on individuals about their ability to live with stress. Such assets are said to be important because they are expensive (to train, hire and sustain), have rights (to leave employment, be sick, go on holiday etc.) and possess knowledge important to the firm. Infrastructure assets are ‘those technologies, methodologies and processes which enable the organization to function’ (Brooking, 1997, p. 16) including corporate culture, risk assessment procedures, management systems, databases, communication systems etc. Such assets are said to be important because they bring order, safety, correctness and quality into the firm. The last of Brooking’s IC assets are the intellectual property 470 J. Mouritsen assets which include ‘know-how, trade secrets, copyright, patent and various design rights’ (Brooking, 1997, p. 14) which are legal mechanisms to protect the firm’s assets. There are differences between the wordings proposed by these writers. However, they share a concern to try to depict an area for reporting and for management which is beyond the realm of financial management. Although they share with EVATM the view that value creation is at stake-and possibly even shareholder value-they do so by adding complexity to reporting and calculation. In direct contrast to EVATM which looks at the bottom line in terms of cash flows, IC looks at additional areas of representation which cannot be constructed (‘easily’) as a bottom line figure. Edvinsson and Malone propose to see IC as the sum7 of human and structural capital both of which have an open ended definitions, or as Edvinsson and Malone (1 997, p. 185) suggest: ‘Is this a definitive list? Hardly’. There is no set formula for the inclusion of measures. They are inspirational and have to be invented in situ. This is why measures can only be examples. They are never an integrated model. Sveiby says this clearly: ‘The measurement system that I propose does not present a full and comprehensive picture of a company’s intangible assets; such a system is not possible’ (Sveiby, 1997, p. 150). An IC statement is a set model; not a set calculation that arrives at a digit for the worth of a firm’s IC. It is headlines-employees, organization, customers-for a possible extended reporting on a firm’s situation beyond the narrowly financial. These loose headings are then be applied and used in each organizational situation and filled in with digits, often non-financial digits.8 IC statements are not definitive. Their idea of calculation is open-ended as they neither present an exhaustive list of what measures to apply, not do they in any systematic sense present a mathematical mechanism to integrate the disparate measures. In addition, they do not agree on the list of headings to be included in the IC balance sheet. In a sense, IC statements are not very powerful technical media.’ Why, then, be interested? Competence and organizational learning IC statements are more concerned with a broad idea of competence development. They are concerned to ‘understand’ the huge difference sometimes seen between firms’ book values and market values and suggest that this is the case primarily for knowledge intensive firms. The strategic management of employee- and customer-relations is at stake here (Klein, 1997; Prusak, 1997) where knowledge-workers’ efforts are central. IC statements are concerned to underscore and visualize knowledge creation, since by their existence they direct attention to priorities. Managers should, under the regime of ICY be concerned to develop individuals (human capital), 71t is not clear why this is a sum. For Edvinsson and Malone it appears very important to pretend that IC adds up to a bottom line. They even introduce the idea of an IC index which through a complex calculation is made to look strong and mathematically rigorous (pp. 179 ff.; Roos et al. (1997) pp. 78 ff.).) ‘Proponents of EVATM will not disregard the importance of non-financial metrics (Copeland et al., 1994, p. 981, but they will subordinate them to financial calculations. This is an important contrast to IC statements but EVATM would argue that they summarize the effects of IC. ’There are hints at investments in IC in the form of capitalizing R and D and brands also in ‘conventional’ financial accounting literature. Other than this the valuation of IC is left to the market, but this is a ‘problem’ since the firm quite possibly has more insights into internal capabilities than external market participants. Driving Growth 471 develop internal structures (organizational capital) and develop relations to customers (customer capital). As such IC-just as EVATM-is a technology of managing which sets a mindset for the management of the firm. While EVATM’smindset is cash flows, IC’s mindset is organizational learning and competence enhancement (Nonaka and Takeuchi, 1995; Allee, 1997; Lank, 1997). IC: some empirical stories about effects IC is an invention mobilized in and for practice. Although space does not permit a systematic discussion of Table 1, it illustrates a set of empirical examples of firms’ work with IC. The stories are based primarily on the statements of those responsible for IC in each of the firms, who may exaggerate IC’s effects. All the stories have been confirmed by them.” The table illustrates that in these 10 firms, IC statements serve various ends. In spite hereof, however, the stories also share a concern, namely the role of ‘relationships’ either to employees or to customers. They share a concern to augment the propensity for people to engage in the creation of certain values that derive from a particular relationship between firm and customer, namely that motivated and ‘empowered’ employees engage directly with customers, solve their problems, and thus constitute the customer basis as a long-term project through high retention rates. In effect, the story of IC in one of decentralization to employees, one where employees are called on to directly interact with customers in flat organizations, where uncertainty and dynamic conditions make the pretence of top-management omniscience absurd (Bartlett and Ghoshal, 1997). In a sense, the mobilization of IC serves to persuade employees and customers to form an alliance where they constantly decide to align their conduct with each other. Top-management is, in the story, partly removed from developing the firm’s concrete strategies vis-)l-vis its environment; top-management is there, the story goes, to facilitate local deployment of creativity and knowledge in the pursuit of white collar productivity. Examples of IC measures in these 10 firms are illustrated in Table 2 which shows that IC statements do not produce a straightforward bottom-line. As illustrated by Table 2, the numbers in IC statements are often non-financial. The list is open ended. It dramatizes some of the mechanisms which are called on by top-managers to stage the issue of ICY namely an economy of creativity where individuals’ creativity counts. The numbers hinted at in the table are used to stage an agenda to improve employees’ satisfaction and qualifications, and to augment customer-satisfaction, just as measures of process-efficiency are presented. But all are partial; they are decoupled; and different firms use different parts of the template represented in Table 2. So, there is no definitive list of measures to be used, and there is little emphasis on retrieving a grand bottom-line to suggest whether a firm’s IC is increasing or not. Often, moreover, concrete IC statements are organizationally specific and developed uniquely at the particular firm. However, the experiences of Skandia, a Swedish insurance and banking company may illustrate how an IC statement may work. Skandia’s IC statement is built along the model reproduced in Fig. 1 (see Edvinsson, 1997, Edvinsson and Malone, 1997). Fig. 1 visualizes in a sketch a set of interrelated forms of capital: It is a set of boxes 10 A closer analysis of this data will have to await a forthcoming publication. P Table 1 T e n IC statements 4 t 4 PLS Consult Rambmll Firm characteristics, and main effects of IC. ICs Intellectual Capital statement. A Danish consulting firm in the managementrstrategy area which has experienced tremendous growth the recent years. Its IC has been credited that this growth has been possible with a reasonable order and perspective A Danish engineering consulting firm which has developed an IC to underscore the breadth of the firm’s objectives. These involve a humanistic view on people and an aspiration for a musical tone in work-life. A Swedish insurance A Swedish consulting company that credits firm in the its IC with managementrstrategy its tremendous area that not only growth over recent produces an IC to years. Skandia is to develop its known internationally own strategy and for its IC make it broader to statement. include a variety of policy issues. Why Intellectual Capital statement IC .? IC helps developing and maintaining the firm’s competencies focusing on employee profiles. IC helps realising the firm’s employee philosophy where employees’ engagement and satisfaction are prioritised. IC helps focus the firm’s competencies so that tommorrow’s conditions for value creation will be met through decentralised creativity. IC is used to support the firm’s long-term process through developing the customer- and produce basis for the firm’s future. IC helps securing motivated and competent employees compared with a future that requires flexibility. What measures are in the Intellectual Capital statement? IC focuses on measures concerning employee profiles re. age and qualifications. IC is a comprehensive reporting of measures re. Employees, customers, production and effects via a version of the T Q M model. IC is very broad but makes a priority of the financial effects of technological competence. IC focuses in particular on measures re. employee- and customer profiles. IC contains a detailed account of employee profiles and a human resource accounting statement. Skandia Consultus Telia ? A Swedish telecommunications firm that uses IC to increase awareness of the relationship between employee development and corporate strategy. 3: cont. 2 5vl B Table 1 (continued. What are the Intellectual Capital statement? IC creates attention about the firm’s long term strategy convening competence development. IC helps locate the firms’s culture with middle managers and employees. IC supports a strongly increased efficiency and attention to the firm’s mission. IC helps craft a systematic strategy concerning customer portfolio. IC makes employees conscious about the needtomake them ‘employable’ in a firm under constant change. How is the work with Intellectual Capital statements organised? IC is organized via top management. IC is organized via the personnel department. IC is organized via the accounting department. IC is organized via top management. IC is organized via the personnel department. What kind of information can not. be published? What is measured has to be revisable and auditable; and nothing should be published which can be relevant for competitors. Nothing is to be published which is confidential or has an interest for the competition What is published has to explain the firm’s mode of operating, but items of direct relevance for competitors have to be exempted. Too much of direct strategic interest to competitors should not be disclosed. IC has to show possible partners and employees what the firm is but nothing of relevance to competitors should be disclosed. cont. . U 2. w C, ci 0 P 4 w Table 1 (continued. ABB Sparekassen NordJylland Firm characteristics, and main effects of IC. ICs Intellectual Capital statment . A SwedishrSwiss industrial conglomerate that uses IC to focus employee development and empowerment and to develop co-operation with suppliers and and customers. A local Danish bank that uses its IC to create loyalty among employees, customers and owners. A Swedish airport A large Swedish operator which uses bank which uses its IC to focus IC to straighten a human resource relationships with accounting customers. perspective on employee development relationships to corporate strategy. What measures are in the Intellectual Capital statement? IC focuses on employee satisfaction, staff related matters and time. IC focuses on employees’, customers’ and shareholders’ view of the firm. IC is concerned with employee profiles and costs. IC focuses on customer- and employee satisfaction, sand on training and ecology. IC focuses on fairly few indicators re. employee profile age, formal training and length of employment ., and a bit about revenues. Internal and external stakeholders look at the firm in a long-term perspective. Employee identity has been crafted which connect them closer to the firms’s interests. Employees have been made ready for change in acknowledging a need to become more marketoriented. The business press and to a certain degree customers have shown interest in the IC statement. Productivity and What are the motivation Intellectual Capital statements’s effects? sharply increased. Luftfartsverket Sparb an ken W M Data A Swedish computer and facility management consulting firm that uses its IC statement as one medium to communicate with the capital market, potential customers and the business press. cont. . Table 1 (continued. How is the work with Intellectual Capital statements organized? IC organized from top management. IC organized via innovation department. IC is organized via the personnel department. IC is organized via a particular IC department. IC is organized via the accounting department as a report from the normal wage administration system. What kind of information can not. published? Inform about issues that put employees to the centre. The firm’s specific strategy is not to be revealed, but but the firm’s ambitions as to its role in society has to be emphasized. Nothing is to be published which can be traced to the specific individual. The firm’s specific strategy is not to be revealed, but the firm’s ambitions as to its role in society has to be emphasized. IC has to interest the capital market or possible customers. U 2. w 0 ci 0 476 J. Mouritsen Table 2 A template for IC measurements and representation ‘That what is’ (statistics) ‘That what is done’ (internal key ratios) ‘That what happens’ (effect ratios) Employees Length of employment Formal education and training Expenses for training and education Share employees with personal development plan Number of training days per employee Expenses for training and education and training per employee Employee satisfaction Employee turn around ratio Human resource accounting Value added per employee Customers Distribution of revenues on markets and products Marketing expenses Number of customers per employee Marketing expenses per revenue Administration expenses per marketing expense Customer satisfaction Customer loyalty Share customers with long relations Technology I T investments Share of internal to external I T customers PCs per employee Computer expenses per employee I T qualifications I T licence Processes Expenses per process Distribution of staff on processes Investments in R& D and infrastructure Throughput time Product development time Time to organizationally and administratively fit new organizational units Errors Waiting time Quality Company reputation The Skandia Stow ! A f h I islikeatree. Partofitisvisible-itsJFvfiuits-and part of it is hidden - the roots. Ifyou only concentrate an theJFvits and ignore the roots, the tree will die. For a tree to be able to grow and continue producing, one has to see to that the roots get their nourishment. . Financiaicawl i ! ~ n t e ~ l e d ~ c a1 p i ~ Figure 1. Skandia’s system of Intellectual Capital. Driving Growth 477 which are related by lines and thus indicates that it is possible to construct market value by somehow aggregating or integrating the boxes in a set of logical steps from the bottom and upwards. However, in fact there is just one mathematical relationship namely that market capital is the sum of financial capital and IC. Even if it is difficult to explain this relation in detail," it is important to note that the rest of the relations in this model are simply not specified. All other possible forms of capital are reported with a variety of non-financial indicators put side by side which do not sum up to any number that can be related to the other capitals and neatly summed up in measure of market capital." Examples of measures of human capital include statistics on education and employee satisfaction. Structural capital is measured by customer capital, which may be expressed in terms of repeat business or customer satisfaction, and organizational capital, which in turn is innovation capital expressed for example in the form of business from new services, and process capital measured e.g. by staff per transaction, and administrative cost per account. These measures are quite mundane. Nothing strange or new about them, and they certainly are not presented as a new bottom-line which truthfully reflects the earnings potential of the firm. IC is here justified by a visualization that pretends a set of logical relations which are hinted at and espoused rather than defined and shown. It is partly the pretence of mathematical rigour that makes the visualization of the model strong, and it is partly the visual resemblance with a tree which suggests that what is below is epitomized in what is at the top. The tree is namely central to the Skandia story. As the quote in the box one says, the tree is fruit and roots. IC is concerned with the roots: The story is one of a benevolent gardener that minds the long-term future of his plants and the whole constellation of trees and flowers vis-&is each other. It is a narrative mode of explaining the value of the firm (in contrast to EVATM which is a paradigmatic mode of inquiry; see Boland and Schultze, 1996). Its particular translation to Skandia is not presented. It remains a good story which, if it works, will motivate people to be creative for the better of the firm; not managers only; most certainly employees at large. 4. Comparing EVATMand IC: where does value come from? As illustrated above, EVATM and IC suggest very different drivers of growth and value. They are both intellectual technologies oriented towards the future, but they capture the future in two different ways: EVATMtries to calculate it; IC tries to hope for it and visualize it. EVATM is directly concerned with cash flows; IC is directly concerned with competence enhancement. Table 3 illustrates some of these differences on four important issues. Firstly, EVATMis a bottom-line indicator which focuses on total factor productiv11 There is ambiguity here because the market value is also said to be influenced by intellectual capital, therefore the precize relationships between market value, financial capital and intellectual capital is probably much more complex. The irony is that the market value is taken at face value and that the financial capital is determined from the accounting rules currently in place which leaves intellectual capital as a residual. But this just contradicts its espoused power because, if relevant, the measure of intellectual capital would influence market capital. 12 Recently, Roos et al. (1997) (chp. 4 and 5) suggest what they call a second generation IC statement which attempts to reduce the number of indices reported by aggregating certain measure. Their result is still embryonic. The pretence of rigour is there, although it is more a system of applying subjective weights to certain IC indices and through this constructing a weighted average that a system of 'pure measurement'. 478 J. Mouritsen Table 3 EVATMand IC compared EVA^^ IC The financial Financial calculations and riskrepresentation measures integrated in an investment indicator. There is perfect information about the future cash flows of chosen projects. Financial and non-financial calculations organized in a loosely coupled sets of indicators. Information on knowledge production is always provisional, fragile and tangential. The drivers of growth Future growth is somehow a reflection of the development of individual, organizational and customer capital. Growth drivers are internal and located in the interplay between tangible and intangible assets. Future growth is a reflection of the capital and cost structure of the firm. Growth drivers are expressed as P & L and balance sheet ratios. Growth is determined by the external market. The grounds The calculation justifies robustness in Calculations have to be aligned with for policy policy recommendations. strategy to justify robustness in policy recommenrecommendations. dations. Capital and assets Capital is a stock against which assets Capital is a process towards an depreciate value. Investmentshave aspired future against which assets useful lives. accumulate value. Investments are never-ending and self-reinforcing. ity. Here, cash flows are integrated and aligned with a cost of capital derived from the capital market. There is little attention to or acceptance of loosely coupled sets of information which are contained in accounts of the type preferred in IC whose sets of measurement are hardly an exhaustive list and carry no pretence of being a full reflection of the IC increments which accrue to the firm from period to period. EVATM claims access to (near) complete information used by the omniscient manager who deploys his or her individual skills for the benefit of an owner and a manager simulated as a stock owner. ICYin contrast, claims all knowledge to be provisional and in the process of becoming something new as new knowledge aligns itself with other assets in a spiral of development that cannot be predicted. Such a logic of discovery is concerned with knowledge-destruction and re-application to new and more appropriate ends. Here, if there is an implicit model of a simulated owner somewhere, it would not be the one preoccupied with financial returns (alone) but more likely one resembling Schumpeter’s entrepreneur who improves the business because the products and services will make more sense. The simulated owner is here the entrepreneur, while for EVATMit is the portfolio manager with no specific interest in the business. It is entrepreneurial capitalism vs. financial capitalism (Spybey, 1984). Secondly, for EVATMgrowth and value creation are reflections of the past-present in terms of known cost-revenue and cost of capital structures which more or less presume that technologies, products and markets are known. As a strategic mode of thought, EVATM via its calculations has to be short-term. It is concerned with cash flows which, however, can only be determined with adequate level of certainty in known activities. Prediction requires experience, which in turn requires conditions to Driving Growth 479 be stable. This is obviously a paradox given that EVATM’swhole justification lies with dynamic markets and technology. In addition) this stability is reinforced by the centrality of cost of capital. For this to be stable, the firm has to stay in its industry and it has to be in the position it has taken up for a while. Otherwise the measure of risk (beta) in the CAPM model would simply change and thus be a variable. But this is not the case for EVATM. Cost of capital appears to exist prior to the EVATM calculation. This is a very important assumption of stability. This point also illustrates why the future is mediable by ‘managers’ best guesses’. The manager has simply been elevated to the hinge between the past and the future based on his or her experience. T h e manager is the omniscient hero. Managers and shareholders count in value production. Employees only marginally. In contrast) IC presumes that the firm will change in terms of concrete technologies) markets and products and that capability and competence are more fundamental in a reflection of present-future. Future growth requires organizational development concerning individuals) processes and customers. The effects of such organizational innovations cannot be expected to be predictable in cash flows with any accuracy. Rather than applying a logic of justification to show that investment in IC development is appropriate) firms that do this hope for and bet on its appropriateness. Employees are here much more presented as the heroes who through empowerment programmes below the level of management are provided the opportunity to mind the firm’s business and not only their own. Employees are here perhaps often with a good dose of rhetoric termed the real assets of the firm. Employee development is a cornerstone for such firm in their search for the future. It is suggested that managers cannot know the future and to a substantial degree it has to be crafted by employees and customers in partnership. Thirdly, for EVATM the consistency of the financial model itself justifies the correctness of its result and that it will lead the firm towards growth and value creation. It is claimed to be ‘sound micro theory’. For IC this is different. The ground for policy recommendations is purely related to the implementation of strategy envisaged elsewhere. While EVATMevaluates (and provides the incentives for action) a logic of justification strategy defined elsewhere) IC implements strategy) but a very loose one dealing with the transformation of corporate identity) capabilities and competencies rather than with particular products, markets and technologies. This is also where the intellectual commitments of EVATM and IC show themselves more clearly. In being concerned with the capital market and thus the present values of choices concerning products, technologies and markets, EVATM is massively a theory of the firm black boxed into the straight jacket of idealistic micro economic theory. Rather than exploring the corporate modes in which wealth is created, EVATMembarks on an abstract analysis of corporate activities modelled on the simplistic desires of capital markets that lack attention to the sweat, sacrifices) uncertainties) politics and simple conflicts that make up organizations. EVATM is a vehicle to promote an impoverished model of the firm constructed for other kinds of economic analyses than the one executed around EVATM.This is the financial model of the firm with its emphasis on abstract governance structure. In contrast) IC subscribes to competence theory and possibly to some form of evolutionary economics (Nelson and Winter, 1982) as it attempts to understand specifically the basis for the development of organizational routines as regimes of knowledge substituting previous regimes of knowledge. There is a heightened attention to the processes of discovery, ~ ~ ~ ~ 480 J. Mouritsen and the organizational tuning is here set on organizational knowledge and development. Fourth, the idea of capital differs greatly between the two approaches. EVATM’s calculations are concerned to identify tangible assets as a stock, or rather with the cash outlays that make up the assets the firm has. These assets, some of which may be intangible such as R& D, are then depreciated against their useful life. This is done to attempt to provide a cash basis for the calculation of the profits that go into the EVATM calculation. For ICY in contrast, capital is a process which may, if successful, augment rather than depreciate assets being used. IC’s capital is orientated towards crafting a future where it is both medium and outcome: It will be in its augmentation leverage other assets’ increased by its use; and it will productivity. These differences are important. They illustrate two managerial technologies both of which claim to be able to lead firms into the next century with prosperity for all as result. EVATM is primarily rooted in a type of theory which says that firms compete mainly on their products which translate into immediate cash-flows which can be inserted into a financial model to calculate EVATM and shareholder value (see also Rappaport, 1986, and Landesman, 1997). ICYin contrast, is not rooted in a theory of products and time-bound competition but in a theory of organizational competencies as pivotal for long-term growth and value creation. Products are secondary to competition and therefore as products reflect the link to cash-flows it is impossible, or at least not very interesting, to calculate present value of individual action and projects. The future is a qualitative project brought about by heavy use of numbers, figures and digits which are made relevant for their ability to construct talk and direction towards a metaphorically formulated strategy. Numbers are important if they can help implementing a future yet unknown. The theory of the future of IC merely posits that if white collar productivity and creativity can be elevated, then the future of the firm will probably not be in jeopardy. ~ ~ ~ ~ 5. Conclusion From the perspective of ICYEVATMis a very sorry representation of the future. From an IC perspective, if it is possible to calculate in a net present value of the effects of organizational action over the long run, then the strategies proposed cannot be very interesting, they must be conservative, and most likely they will miss the point about how post-modern markets function. Therefore, according to proponents of ICY EVATM may generate results, but very uninteresting ones that cannot be of strategic value to the firm. EVATMis concerned to create a bottom line; IC cannot se a bottom line but rather a set of interrelated sets of talk structured by loosely associated sets of figures, digits and visualizations. EVATM sees growth as a reflection of current products and technologies and cost of capital; IC sees growth as the outcome of skilfully managing the relationship between tangible and intangible assets. For EVATM,strategic recommendations are produced directly from the net present value calculations; for IC strategy has to be rooted in hopes for a better future emphasizing the need to increase white collar productivity and creativity. EVATMsees capital as a stock which has to be depreciated properly and associated with risk-adjusted interest rates to calculate Driving Growth 481 performance a n d net present values; IC sees capital as a process where t h e augmentation of intangible capital may increase t h e productivity of t h e network of complementary capital. T h e r e are many differences between t h e two accounts of growth a n d value creation. T h e y are simply diametrically opposed in terms of the role of calculation. F o r EVATM,calculations cut through organizational mess a n d rearranges it in such a way that all good a n d all b a d are related i n a final proposition as a digit. T h i s may involve a complete reorganization of the firm. 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