Realising the true value of KM

An intangible standards approach to ROI

Intangible resources are what make up the true value of any organisation, yet they are almost uniformly ignored by established accounting procedures. Ken Standfield describes how the International Intangible Management Standards Institute has worked to address this imbalance, and outlines the importance of intangible assets to any attempt to measure the return on investment of a knowledge management project.

You know the problem...

You have a project that does not result in your organisation downsizing or reducing costs. It should, however, result in increased productivity, revenue and sustainability. But how do you prove your business case, when all senior management looks at is firing staff and cutting costs? You need new methods, new tools and new ways of thinking that lead to a breakthrough in management science and valuation. You need international intangible standards and intangible management.

The International Intangible Management Standards Institute (IIMSI), after 15 years of research and development, is the world’s first organisation to be able to objectively identify, classify, measure, report and manage intangible value in such a way as to create reliable and objective financial measures. These measures can be used to comprehensively compare intangible value in different industries so that investor confidence is safeguarded and there is a reduced chance of fraud, misrepresentation or ‘creative’ accounting.

Intangibles cannot be efficiently or effectively identified, managed, measured or reported using conventional management techniques and methods. To equip executives with the required skills to manage value according to the new rules of the intangible age, the IIMSI has created numerous international intangible standards. At present there are in excess of 30 international intangible standards, representing a completely new strategic framework for managing and reporting intangible value.

Intangible management is defined by the Intangible Foundations Standard as “the concepts, methodologies and tools required for comprehensively identifying, consistently classifying, objectively valuing, scientifically managing and financially reporting the impact of intangible transactions on long-term and short-term organisational financial performance and sustainability” (IIS1001.D1). Intangible transactions are defined (IIS1001.D22) as non-financial transactions that result from the use of knowledge assets, relationship assets, emotional assets and time assets.

The standards approach to ROI

A new language is required to explain intangibles because the old rules of conventional management, when applied to intangibles, typically create the opposite outcome of what is expected. International intangible standards represent the first consistent attempt to describe the new language of intangibles in a totally structured and logical manner.

In order to effectively calculate the return on investment for any project today, it is helpful to be aware of IIS2001 – the intangible operating structures standard. As IIS2001 makes clear, there are three levels of resources organisations actually work with to which the subject of ROI is applicable:

Level 1 resources

A machine that produces ‘widgets’ could be classified as a level 1 resource. L1 resources involve financial transactions that result from legal property rights. A legal property right is defined (IIS2001.D1) as the right of an entity to own, otherwise control and protect an item of identified value (as evidenced by a financial transaction). As the organisation owns the widget machine (having paid for it) it becomes an L1 resource.

Level 2 resources

Trademarks, patents and other forms of intellectual property are level 2 resources. L2 resources represent legal intangibles (also referred to as ‘hard’ intangibles). Legal intangibles are defined (IIS2001.D2) as ownership rights that are conferred by an Act of parliament, or by a national or international agreement that creates legal ownership in the represented form of an applied intangible competitive right. Represented form is defined as the explicit output that results from the process of converting a portion of an L3 resource into an explicit L2 resource.

Level 3 resources

Knowledge, satisfaction, quality, reputation, expectations, emotions, relationships and other ‘soft’ intangibles are examples of level 3 resources. L3 resources represent competitive intangibles. Competitive intangibles are defined (IIS2001.D3) as the source from which L1 and L2 resources are created, maintained and enhanced over time. In other words, L3 resources are the source of value creation for all organisations. Without L3 resources, organisations would not exist. Unfortunately, conventional management science has focused almost exclusively on L1 and L2 resources and has done its best to ignore L3 resources. Knowledge management, intellectual capital management, emotional intelligence and other similar fields are attempting to reverse this inherent flaw in how executives manage value and how governments govern.

Getting specific

To measure return on investment for any project, it is vital to understand that L3 resources create L2 resources and L1 resources (IIS2001.R1).

The IIMSI Resource Classification Scheme (IIS2001.D6) states that within each of the three levels above there are six classification categories:

Asset;
Expense;
Liability;
Capital;
Revenue;
Profit/loss.

To correctly determine return on investment you need to understand exactly what resource levels are involved and what classifications of resources are used. Without this knowledge, you will not have any success at scientifically determining return on investment for any project.

At present, executives and managers understand L1 assets, liabilities, capital, revenue, expenses, and profit/loss exceptionally well – our finance and accounting system has traditionally been built on this knowledge. Of L2 resources, most people understand intangible assets in relation to intellectual property, but the understanding tends to stop there. Few people have thought about L3 assets, liabilities, capital, revenue, expenses and profit/loss. Considering that competitive advantage is primarily gained or lost through L3 resources, it is essential to develop a far greater understanding of soft (L3) intangibles than of hard (L2) intangibles.[1]

Ownership issues

When determining ROI it is important to consider the blind spots our society has created due to the concept of ownership. L1 resources are subject to legal property rights (enforceable actions in a court of law) and are created through contract law. L2 resources have ownership attributed to them due to Acts of parliament. L3 resources are not subject to the principle of ownership as conventional management understands it, which to some extent explains why L3 resources have been ignored in the past. An employee’s knowledge can be leased through an employment contract, and the organisation may own the intellectual property that an employee produces during office hours, but the employee’s knowledge (what is inside their mind) cannot yet be transferred (science fiction films like ‘Johnny Mnemonic’, ‘The Matrix’, ‘Exchange’ and ‘Existenz’ address the possibility of this in the future). In other words, the ability of a person to create knowledge cannot be owned by a firm, it can only be hired. Due to ownership issues, therefore, your KM projects may be worth far more than you realise.

ROI and intangible finance

Intangible value comprises the majority of the value of most firms in operation today. The Knowcorp 500 represents the top 500 firms in the US economy, ranked by intangible value. For an organisation to be ranked in the Knowcorp 500, it must generate more than $2,000m in intangible value. Every month, the IIMSI analyses data on the Knowcorp 500 and publishes the results. The Knowcorp 500 for March 2002 generated market capitalisation of $14.46trn. Of this amount only $4.07trn (about 28 per cent) was book value – the rest was attributed to intangible value.

Some of the outstanding firms in the Knowcorp 500 have significant intangible management factors. An IM factor is an intangible finance measure (IIS6001) that defines how $1 of book value relates to a firm’s intangible value. For example, Pfizer (ranked 3rd) had an IM factor of 12.76, meaning that for every $1 spent on L1 resources, $12.76 in L3 value was generated. The Coca-Cola Company (ranked 13th) had an IM factor of 10.44, meaning that for every $1 spent on L1 resources, $10.44 in L3 value was generated. Similarly, SAP (ranked 51st) had an IM factor of 16.61; Sadia (ranked 68th) had an IM factor of 70.88; the Colgate-Palmolive Company (ranked 77th) had an IM factor of 60.71; and Infosys Technologies (ranked 277th) had an IM factor of 19.83. The highest figure was attained by Dow Jones & Co. (ranked 412th), which demonstrated an IM factor of 118.60. The IM factor offers an indication of how financial wealth fluctuations and intangible value can be connected.

Another useful intangible finance measure is the intangible value-to-sales metric, or IVTS (IIS6001.D60), which represents how $1 of sales translates into intangible value on average. For example, Microsoft (ranked 2nd) has an IVTS of 10.26, meaning that for each $1 of sales, Microsoft generates $10.26 in intangible value. Ranked 170th, eBay generated an intangible value-to-sales ratio of 19.16. The highest performer in the IVTS race was IDEC Pharmaceuticals Corp (ranked 250th), with an IVTS metric of 33.16. The intangible value-to-sales metric shows how each dollar’s worth of intangible value relates to gross revenue.

Downsize? Maybe not

Intangible finance (IIS6001) consists of over 60 new ways in which to measure stock market performance. The two methods outlined above are therefore not conclusive.

One prime factor that influences ROI on a KM project is intangible value per employee (IVPE). IVPE shows the average contribution to intangible value per employee in the organisation. The greatest IVPE was attained in March 2002 by Stilwell Financial (ranked 476th), which achieved an IVPE of $185m per employee. In second place was IDEC Pharmaceuticals (ranked 250th) with $18.3m, followed by Fannie Mae (ranked 34th) with $15.6m.

If these firms were considering projects that led to downsizing, they should think again. Such firms actually have a great incentive to apply KM practices to further increase their intangible value per employee.

Better understanding intangibles

By now you should have a broad understanding of what intangibles are, what levels and sublevels they encompass, how they interact and how to determine their value according to the intangible finance standards. What is missing is an understanding of what intangibles look like on an operational level.

Forget intellectual property – that is a L2 resource (a hard intangible) and the output of the implementation of various L3 resources. The Intangible Foundations Standard defines an intangible as any event that creates or modifies perceptions or expectations of the future behaviour, value or relevance of an individual, group or otherwise constituted organisation (IIS1001.D2). It is little wonder we cannot own L3 resources, as these are the softest of all resources – they are expectations and perceptions.

ROI and intangible economics

Knowledge management concerns itself with matching capabilities to market opportunities. According to intangible economics (IIS7001), as soon as a consumer generates a ‘want’, they look for the expectation or perception of that want being satisfied by a relevant product or service, at an affordable price (the Law of Want Creation – IIS7001.L5). The Law of Satisfaction (IIS7001.L6) notes that it is not the product or service the customer is actually interested in; rather, it is the satisfaction of a personal image, expectation or perception that is important to the customer. This explains why the cheapest restaurant on a street will not attract all the customers – in visiting a restaurant, a consumer is looking for far more than just food. More concerning is the Law of Want Escalation (IIS7001.L7). This law states that as soon as a customer satisfies the specific expectation they created (in IIS7001.L5), they will escalate the complexity of their desire and expectation to a higher level at a specified rate (known as the escalation rate). The escalation rate can be very high (as in the case of computers and other technologies) or quite low (in the case of food). The escalation rate is therefore the rate at which current perceptions and expectations are increased over time until inversion occurs (IIS7001.D20).

Inversion occurs when typical products and services can no longer satisfy customer wants in their current form. Only a fundamental breakthrough in technology will be sufficient to re-ignite spending and consumption in that area, as customer wants have exceeded the market’s ability to satisfy them. According to intangible economics, it is inversion that explains economic recessions, depressions and the boom/bust cycle. The Law of Economic Stability (IIS7001.L8) states that “harsh economic conditions” only occur after poor management practices and a fundamental ignorance of the value of intangibles. This law states that economic stability is only possible when organisations focus on satisfying continually escalating and inverting wants. Products and services are a way in which this law can be satisfied, if (and only if) the organisation can disengage and re-engage in escalated production processes.

When assessing ROI metrics, weight must be given to the role of the project according to the principles and laws of intangible economics. If these principles and laws are violated, the project may have little chance of yielding the expected returns.

ROI and intangible accounting

Intangible accounting has been viewed as one of the most significant developments in business since the dawn of accounting theory some 500 years ago. Intangible accounting is the long-awaited and much needed update to conventional (financial) accounting.

Accounting seeks to provide information regarding the amount of resources an organisation has, how those resources were financed and what results were achieved by using them. Unfortunately, this process ignores non-financial (intangible) transactions. There are four categories of L3 resources that intangible accounting deals with:

Knowledge resources;
Relationship resources;
Emotional resources;
Time resources.

Each of these resources can be an asset, liability, revenue or expense. It is the interaction between intangible assets and intangible liabilities that creates intangible capital. It is the interaction between intangible revenues and intangible expenses that creates intangible profit (or loss). Intangible accounting is specifically designed to measure, value, report and manage L3 resource transactions. It is an essential consideration for anyone looking to measure ROI.[2]

ROI and cost quality

When calculating ROI it is essential to understand how your project impacts on the cost structure (increases/decreases) of the organisation. According to the cost quality standards (IIS4002, IIS4003 and IIS4004), a change in expenses will lead to a change in intangible performance, which will lead to a change in revenue. The aggregated effects of a change in expenses and a change in revenue will lead to a change in profit.[3]

Summary

Intangible management is a collection of more than 30 new developments in management science, from intangible accounting to intangible economics and intangible finance. It is a crucial consideration for any business looking to calculate the return on investment from a KM-related project, and I hope that this article has offered some insight into some of the most important issues relating to the application of international intangible standards.

Ken Standfield is chairman of the International Intangible Management Standards Institute. He can be contacted at: kensl@standardsinstitute.org

References

1. See chapter 4 of Standfield, K., Intangible Management – Tools for Solving the Accounting and Management Crisis (Academic Press, May 2002) for more details.

2. For more in-depth analysis of intangible accounting and intangible reporting, see chapters 1-8 of ibid.

2. See chapters 9-16 of ibid.