Intellectual capital

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TECHNICAL MATTERS

Intellectual capital Indra Abeysekera draws on a Sri Lankan study to explain how firms can improve their performance by turning uncontrollable circumstances to their advantage.

When Sri Lanka’s government agreed a permanent ceasefire with rebel forces on February 22, 2002, it stopped a civil war that had ravaged the nation for 19 years.

The conflict had important implications for Sri Lankan businesses. It created an uncontrollable commercial environment characterised by, among other things, a reduction in foreign direct investment, the exodus of skilled labour and the depreciation of the Sri Lankan rupee.

During the war, businesses became used to this instability. Similarly, in the transition from war to peace, many companies adjusted to uncontrollable forces by using them in their own favour.

They did this by driving performance through intellectual capital (IC). Two forces influence the value and nature of IC: uncontrollable (external or market) and controllable (internal). In Sri Lanka, the former include inflation, interest rates and government policies. For example, a large portion of GDP was allocated to military purposes in the war. This served to fuel inflation, increase interest rates and limit growth, which all combined to reduce consumers’ disposable income.

I held interviews with 17 of the top 30 companies listed on the Colombo Stock Exchange in 2001 and again this year. I also analysed the annual reports of all 30 between these times. I found that some successful firms overcame uncontrollable and difficult conditions by strengthening relationships with their stakeholders. For example, the Ceylon Tobacco Company and Lion Brewery of Ceylon, whose products attracted high excise duties, negotiated with the government to reduce these levies. The firms pointed out that these had made their goods so costly that consumers were moving towards illicit alternatives that didn’t attract duty.

The government was happy to reduce the

INTELLECTUAL CAPITAL CATEGORIES AND ITEMS Internal capital Processes Systems Philosophy and culture Intellectual property Financial relations

External capital Brand building Corporate image building Business partnering Distribution channels Market share

excise rate on products on which it had been losing revenue to piracy, while the two firms kept their places in the top 30.

Other firms had a strong position in wartime, but they took it for granted.

Colombo Dockyards, which benefited from the war because it produced gun boats, was ranked 17th on the exchange in December 2001, but it had lost its ranking by the following December. The peace deal had eroded its market share.

Although the company’s tangible asset position hadn’t changed dramatically, its IC set had been altered, which in turn affected the business’s performance.

Because firms compete on IC items rather than tangible assets, they need to think ahead and consider a variety of scenarios for creating and capitalising on IC items that could improve their performance. At least Colombo Dockyards is now collaborating with overseas companies in order to reach other markets and diversify its activities.

Unlike the external forces described above, the internal forces that affect IC are largely controllable. They exist within, or depend on, a company’s internal, external and human capital.

Investors’ knowledge of a firm’s controllable IC contributes to the

Human capital Training and development Entrepreneurial skills Employee safety Employee relations Employee welfare Employee know-how

difference between its market value and its book value. The IC value drivers varied among the firms in my study. I defined these as the IC items that most affected a business’s performance and, therefore, its market value. As we have seen, IC value drivers are influenced by uncontrollable environmental forces.

For example, the main IC value driver for Colombo Dockyards in the war was employee know-how, because the firm had a guaranteed market share, courtesy of the government, and its aim was to build the best vessels. After the war, business collaboration became a more important driver. It’s vital for companies to identify their core value drivers, both current and future, so that they can focus on monitoring their performance.

As well as having one or more core IC value drivers, the firms I studied had complementary value drivers. It’s equally important to identify these, because they have a synergic effect on the core drivers.

Lastly, there may also be contradictory drivers that have a dampening effect on the other two.

Brand names and distribution channels are the core IC value drivers for Nestlé Lanka. Brand names allow it to distinguish its foods from those of its FIN A NCIA L July/August 2005 M A N A GEM EN T

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Intellectual capital

THE INTELLECTUAL CAPITAL GRID

Intellectual liability competitors, while distribution channels allow consumers to access its products.

Customer satisfaction and patents are complementary drivers. On the other hand, a deterioration in industrial relations can be a contradictory driver.

The intellectual capital grid (see panel) is a way of mapping a firm’s core, complementary and contradictory IC items. The Y axis depicts the business’s performance resulting from a given item.

The X axis depicts intellectual assets and liabilities. The company should aim to shift all of its IC items to the top-right “champion” quadrant. This will allow it to perform better through its intellectual assets. IC items become intellectual assets when their probability of increasing the firm’s future market value is greater than 50 per cent. They become intellectual liabilities when their probability of decreasing a firm’s future market value is less than 50 per cent.

The high performers in the study positioned some of their IC items in the “runner” quadrant. This may be done deliberately, but the intellectual asset can become a liability. Firms such as Singer Sri Lanka actively encouraged staff turnover. The types of skills they required changed over time: owing to the rapid expansion of their markets after the war, some needed more staff with marketing skills and fewer with admin skills. Even if the existing staff could be retrained, these firms preferred to bring in new knowledge through recruits who had been exposed to the best practices of other organisations. Although high staff turnover can damage a company’s market value, the injection of new knowhow can improve its long-term prospects.

Businesses also need to address issues relating to IC items in the “average” quadrant. For example, training is widely

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Industrial disharmony

Business

Employee know-how

CHAMPION performance

RUNNER

LOSER

seen as having a positive effect on a company’s market value. But, if courses are not directed towards improving business performance, they may have no bearing or even a negative effect. This factor was neglected by most firms in the study. They rarely audited their training, taking its effectiveness for granted.

The “loser” quadrant should clearly be avoided, since IC items here are detrimental to performance. An example of this is industrial strife, resulting in a loss of working time to strike action etc.

In some companies, trade unions had a major influence on performance. The highest-performing firms consciously created and maintained good industrial relations. On the other hand, companies such as Ceylon Brewery, which fell out of the top 30 during my study, had poor relationships with their unions and suffered work stoppages as a result.

The firms I interviewed were strongly aware of the value drivers that should be in the “champion” quadrant. Some used the “runner” quadrant to improve their performance. Most hadn’t given much thought to the items in the “average” quadrant. A few had items in the “loser” quadrant and assumed that these were the result of uncontrollable forces.

We can determine whether an IC item is a business performer, an intellectual asset or an intellectual liability by measuring its attributes. A positive attribute outlines the extent to which a firm has made the most of a given item,

Brand

Intellectual asset Training programmes

AVERAGE

while a negative attribute outlines the extent to which an item has been neglected. For example, the number of customer complaints (negative) and customer commendations (positive) are attributes of customer satisfaction.

Few firms consistently measured the performance of their IC items. Where they did, they measured either positive or negative attributes, but not both.

Since capital markets aren’t perfectly efficient, firms should inform investors and other stakeholders about their IC value drivers to reap the full potential of IC value creation. My study shows that they need to turn uncontrollable forces in their favour and explore win-win situations with their stakeholders. Since uncontrollable forces change constantly, it’s important that companies regularly analyse possible scenarios and position their IC items in a way that will improve their current and future performance.

Using the intellectual capital grid to map their IC items allows firms to audit their present position and work out how they can reach their desired position over time. Although it could be argued that the change in uncontrollable forces experienced by businesses in Sri Lanka resulted from extreme circumstances, there are important lessons here for businesses around the world. F M

Indra Abeysekera ACMA is a lecturer in the department of accounting and finance at Macquarie University, Sydney.