Chapter 32. New Measures of Prosperity

Thomas Monahan and Stephen A. Stumpf

Defining and Measuring Economic Value

There is little debate over the need to enhance measurement systems to better capture "value" when analyzing firms. Recent innovations in economic value measurement, such as value-based management or Economic Value Added (EVA) systems, focus on using past financial performance data to forecast future cash flows (or adjusted profit tied to a firm's operations). These measurement systems define capital in financial terms alone. Defining capital in this way has enormous consequences on the reported, and hence perceived, value of an organization. These measures also highlight what the organization's leadership should focus on to develop its internal performance measurement systems. Consequently, these performance measurement issues impact both internal and external reporting for firms.

The failure of many companies in the digital (dotcom) industry has put pressure on organizations and the investment community to better understand, define, and measure the elements of economic value. This pressure adds to the existing demand for measurement systems to more accurately assess the value of organizations in industries that require few physical assets to function successfully, such as software, knowledge, and professional service firms that predate the digital industry by decades.

The efficacy of basing value on management systems that rely on financial capital alone is coming under increased scrutiny. Many business leaders agree that a better understanding of the root causes of value creation is needed and the factors considered as part of the performance measurement system need to change. This is supported by the significant growth in firms that are using some form of Kaplan and Norton's Balanced Scorecard approach to measurement.^[1]

Given the growth in a service- and knowledge-based economy, four kinds of capital are critical to understanding value creation: financial capital, human capital, intellectual capital, and social capital.

Financial Capital

Financial capital is defined as the financial strength of a firm in providing assets (physical and intangible) to generate future cash flows for investors. In this measure, value (future cash flows or operating profits) is tied to the level of asset investment and past financial performance of the firm. For an agriculturally based economy or one in the early stages of industrialization, assets and cash flows are generally tied to the physical nature of property (land, plant, equipment, inventories). In this environment, a measurement system that focuses on financial capital works well, since the survival of the business is often predicated on raising sufficient resources to acquire or control productive assets that lead to cash flow. Given the evolution of the world economy over the past few decades, the primary and overarching focus on financial measures of economic value is disturbing.

Human Capital

Human capital is the competencies and capabilities of the workforce (employees, managers, and executives). Organizations seek the highest quality of human talent they can afford, and they often invest in it to maintain and improve the capability of that talent. Individuals try to improve the value of their human capital through education, practice, and work experiences. The "war for talent" experienced by many firms in the late 1990s epitomizes the value that employers and prospective employees place on human capital.^[2]

This change in focus, however, has not led to important changes in the measurement and analysis systems used to report a firm's economic value. For example, as industries shifted to more complicated manufacturing processes in the 1960s, the development of people was considered a key to success—more emphasis was placed on training employees and the development of the organization's human capital. This contributed to a movement by behavioral scientists to move the expenses for wages to an asset account, since human capital was considered a key to future value and therefore met the definition for being classified as an asset. It was thought that for business to value human capital appropriately, it would have to be reclassified on financial statements and measured accordingly. This change in accounting treatment never came to pass due to the uncertainty surrounding the benefit period from human capital. Many behavioral scientists still consider this omission to be a major flaw in U.S. corporate reporting systems.

Intellectual Capital

As business became more sophisticated and moved into complicated financial, technological, and service arrangements, the importance of intellectual capital (ideas) moved to the forefront. Intellectual capital existed previously (just as human capital existed before it became a common business term), but it was not frequently talked about as part of the capital of a business to be measured and reported to investors and other stakeholders.

Proprietary technologies, copyrights, patents, and trade secrets are intellectual capital, just as books, libraries, and other electronic depositories are guardians of intellectual capital. Intellectual capital has increased in importance as the knowledge needed to conduct business has deepened and as the intellectual prowess and technology necessary to solve complex business problems has increased. To the extent that one can sell intellectual capital (e.g., sell a patent to a competitor or sell ideas to a client), it is an asset of the firm. As industries embrace the internal changes necessary to make contributions in a knowledge and service economy, the creation of intellectual capital takes on significant importance. Knowing which ideas to value and selecting them from large volumes of information available to everyone via the Web is critical.

Companies with minimal assets and a relatively small workforce, such as Microsoft, use their intellectual prowess to develop ideas that lead to significant cash flow. Industries with heavy investments in assets, such as pharmaceuticals, are relying more on their pipeline of ideas for generating future value than on the size of their asset base or number of employees.

Social Capital

A fourth form of capital, social capital, consists of the breadth, interconnectedness, and diversity of those with which one or the organization has meaningful relationships. Wayne Baker^[3] puts forth a series of arguments that focus on achieving success in business through developing and leveraging social capital. He argues that it is not what you know, but whom you know that is critical in a knowledge and service economy. Social capital involves the development and leverage of relationships in the conducting of business.

The driving force behind the value creation may shift from intellectual capital to social capital for industries dependent on relationships between firms. How does one determine the value of a professional services firm? Certainly not by its financial assets. Even cash flow is close to meaningless as clients this year may not be clients next year. The ability to sustain a flow of clients is based on relationships more so than any other form of capital. Most firms have difficulty measuring this internally and it certainly is rarely reported to external constituencies.

Four Forms of Capital

Clearly new and broader value drivers are emerging and our measurement systems are struggling to adjust to this changing environment. Examples abound where knowledge based firms in consulting, software creation, and financial services are focusing on developing human, intellectual, and social capital as ways of creating value for their customers and clients. Think of how professional service firms maintain relations with past employees (alumni) through formal network channels, or how universities work intently on developing close relations with alumni.

Toward Interdisciplinary and Integrated Measures

While we have an understanding of what is meant by human, intellectual, and social capital, difficulties involved with developing measurement systems to capture the value of these investments remain. Yet, being able to measure and effectively manage these forms of capital in the future can provide a huge competitive advantage to firms. There have been recent attempts to isolate social capital by focusing on these types of relationships in developing new measurement systems. For example, activity-based management (ABM) is an attempt to measure cross-functional processes in attempting to identify and manage cost drivers across functional areas. The Balanced Scorecard is an attempt to help businesses focus on the relationships among customers, processes, financial, and innovation measures in managing their operations. Enterprise resource planning (ERP) focuses on managing operations across functions to efficiently allocate resources across the firm. Customer relationship management (CRM) focuses on managing the business-to-customer relationships in an attempt to highlight the importance of this aspect of the firm's capital. Many organizations are realizing that measuring and managing staff development, idea generation, and relationships will be an essential element of their future success. These same firms have been frustrated by the resistance experienced from many employees when implementing systems that focus on new forms of measurement.

In order to aggressively implement new performance measurement systems that emphasize process (relationships) rather than functions or outcome measures, two initiatives must take place. First, major efforts must be undertaken that focus on unlearning principles that employees have worked with for years. Second, employee development programs must be drastically altered to focus on the importance of relationships and social capital in cross-functional decision making as compared with functionally focused decision making. When this happens, different measurement systems can then be adopted to support interdisciplinary approaches to decision making. These systems will be able to focus more on the importance of human, intellectual, and social capital and a firm's ability to measure and manage relationships that help contribute to firm value.

Learning and Unlearning: The Need for Both

Following the publication of Peter Senge's book The Fifth Discipline, much has been written about the learning organization. A recent guide for managers highlights what organizations can do to put learning into action.^[4] Based on David Garvin's work, we define a learning system as one that creates, acquires, interprets, transfers, and retains knowledge, and is purposeful in modifying its behavior to reflect new knowledge and insights. Systems need to learn quickly in a knowledge-based society. Garvin's "litmus tests" of a learning organization are that the organization can say yes to the following questions (taken from his book Learning in Action: A Guide to Putting the Learning Organization to Work) and provide meaningful examples in support of each yes.

• Does the organization have a defined learning agenda?
• Is the organization open to discordant information?
• Does the organization avoid repeated mistakes?
• Does the organization lose critical knowledge when key people leave?
• Does the organization act on what it knows?

The heavy focus on learning (akin to a heavy focus on financial capital) can lead to unintended consequences. Just as it is unlikely for an organization to believe that it doesn't want to earn more money, it is difficult for the organization to believe that it doesn't want more learning. More is always better. Yet, sometimes, less is more. Libraries, disk space, digital files, and Web sites expand at rates well beyond an organization's capability to use, manage, or service the information. Systems need to be able to unlearn just as they need to be able to learn. Early organizational change theorists referred to this as unfreezing. Current ideas and structures need to be dismantled to create an environment ready for new ideas and change initiatives.

To unlearn, a system must destroy, dispose of, ignore, hide, or replace some of the knowledge that has been learned, and purposefully modify its behavior to reflect that of which it has let go. Our litmus tests for an unlearning system follow:

• Does the system have a defined unlearning agenda? (Products to be de-marketed, information to be expunged, key players to be replaced, MIS indices to be changed, business models to disregard, consultants to terminate, bankers to replace.)
• Is the system open to unlearning some of its accepted concepts, frameworks, and premises? (What ways of thinking no longer apply that need to be expunged? What old paradigms might be discarded? What is highly successful today that will be an inhibitor to change tomorrow?)
• Does the system use repeated mistakes to diagnose underlying learnings so as to unlearn them? (If we continue to do this, what is it that we must unlearn to stop doing it?)
• Does the organization derive benefit from the knowledge it loses when key people leave? (Now that "they" are gone, what "idea space" has been freed up? What can we do differently now that a "barrier" has been removed)?
• Does the organization act on what it destroys, disposes of, ignores, hides, and replaces? (Having let something go, does the organization eliminate costs and burdens?)

Functional or Interdisciplinary: A Time for Change

There is a "battle" taking place in companies that is centered on an interdisciplinary and relationship orientation versus a functional or departmental perspective in measuring performance. Built upon the need for specialization and division of labor techniques required in industry over the last century, the functional or departmental perspective to decision making has served industry well.

Academics have contributed to this functional focus in business by developing a level of expertise in functional areas that was extremely useful to solving business problems. Academic research thus supported tremendous growth in commerce. Journal articles became so specialized and discipline-focused that few academics had interest in reading, never mind conducting, research across disciplines. Having deep knowledge in a narrow specialization became the "ticket" to gaining prominence in one's field and gaining exposure in the most respected academic journals.

Business appreciated and benefited from the sophisticated functional research produced by the academic community as it helped them deal with the complex issues being addressed in the finance, accounting, strategy, and marketing functions. In recent years, however, businesses have begun to change their approach to decision making. Understanding processes that go across functional areas is becoming critical to implementing quality programs. Interdisciplinary approaches to management decision making require a different mode of thinking. Industry is changing the basic techniques it uses to conduct business, yet performance measurement systems remain unchanged. It is clear that capturing the richness of relationships among processes, functions, people, and customer groups is critical in creating value for firms and that our traditional measurement systems are not focused on capturing this type of information.

Businesses are investing billions of dollars in new systems to support interdisciplinary decision making. These systems require massive changes in the way employees use data to manage their sub-businesses—requirements that will not be met unless these managers are willing and able to unlearn much of what they believe is the foundation of their success. In making these investments, firms have underestimated the degree of commitment employees have to the functional models they have used for years. This continues to be reinforced in the practitioner literature and many executive education programs. For example, the authors reviewed the curricula of the top-ranked MBA programs in the United States and Europe and found that although there are many individual efforts aimed at increasing the cross-functionality of curricula, the majority of courses are based on a functional excellence model. Many academics believe that moving toward a more interdisciplinary model undermines functional excellence. Consequently, the basic educational structure to which future business leaders are exposed is still tied to functional knowledge and delivery rather than to interdisciplinary decision making. While functional excellence will remain important to a firm's success, the functional area managers must be able to embrace interdisciplinary perspectives, since most strategic decisions involve elements across functional areas. Even when using materials that are multidisciplinary, such as case studies or simulations, the discussion is influenced by the instructor's functional background. Team-based instruction using faculty with different functional backgrounds rarely takes place in business schools or executive education classrooms.

The difficulty involved with driving this different approach into the education of future leaders cannot be overemphasized. It will take a huge "unlearning" initiative within business schools to enable this new decision-making process to take hold. It will also require dramatic changes to the measurement systems used in industry to evaluate and reward employees.

Performance Measurement Programs for Today (the Future Is Too Late)

Many companies have begun to move towards relationship-based reporting through initiatives such as ABM, Balanced Scorecards, and ERP systems. Many of these initiatives have failed; others have progressed more slowly than anticipated. We propose the following reasons for the limited success of initiatives whose intention is to offer a more thorough measurement and valuation system. We also offer recommendations to increase the probability of future success.

First, in many of these implementations firms have not directly addressed the unlearning process, which has undermined their ability to create change. Formally applying the litmus test for unlearning and following the implied recommendations in these questions will help firms address this shortcoming.

Second, it is imperative that firms change their evaluation and reward systems when they move toward focusing on other forms of capital, particularly relationship management (i.e., social capital). If firms continue to tie their evaluation and reward systems to functional-focused performance measures, employees will continue to complain that they need the "same information" in order to run their business. Educate employees as to why the four forms of capital (with emphasis on relationship management in service industries) are so critical to value creation, and then reward employees for supporting progress towards creating value along each of the four capital types. Part of this education system must involve a formal process to help employees understand the unlearning process. Without this, firms will continue to experience a lack of success with change management programs.

Third, more measures must be developed to capture the essence of human, intellectual, and social capital, and these must be included in a firm's reports, as required by the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB). Human capital measures might include educational level, training and development expenditures, library and digital knowledge resources, and e-learning opportunities. Knowledge measures might include copyrights, patents, software development, knowledge-online systems, e-learning capability, and various presentations and distributions of what has been learned and unlearned. Relationship measures might include customer and employee retention; alumni networks; meetings and conferences attended that are designed for relationship building; and collaborations and partnerships with suppliers, buyers, and other stakeholders.

Human capital, intellectual capital, and social capital are as critical to the future value of an organization as are its profits, yet these forms of capital are not meaningfully captured in current external reporting requirements. Granted, these measures are less objective (in many cases) than dollar estimates, yet they can provide analysts with a more complete picture of value drivers than what we currently require in GAAP reporting. Kaplan and Norton's Balanced Scorecard provides an effective framework to begin experimenting with a new form of reporting of these social capital measures.

Fourth, major curricula revisions must be implemented in business schools and executive education programs to better prepare participants for the interdisciplinary world they will be facing. The unlearning element of change can be significantly streamlined if business executives begin their careers open to opportunities for creating firm value through adaptive problem solving that uses interdisciplinary methods and leveraging relationships, as opposed to a near total focus on functional and financial excellence.