The new New Economy Analyst Report – July 06, 2001
Juergen Daum’s new New Economy Best Practice service
©2001 Juergen Daum. All rights reserved.
News categories: the New Economy Economics, enterprise and business strategy, strategic enterprise management and business performance management, value based management
In 1997 three major business books had been published with nearly the same message:
· The source of value has shifted from tangible to intangible value
· It is not financial capital and tangible assets that represent the main value drivers, but intangible assets such as human capital, relationships with business partners and a company’s capabilities to innovate
It was a book of Thomas A. Stewart (an editor of Fortune Magazine) titled “Intellectual Capital”, a book with the same title from Leif Edvinsson (the world’s first director for Intellectual Capital at the Swedish financial service company Skandia) written with Michael Malone (a journalist), and finally the book from Karl Erik Sveiby titled “The New Organizational Wealth”:
Around the same time, empirical economic analysis revealed, that at the begin of the 1990s in deed the source of value creation in the industrialized economies has shifted from tangible to intangible assets. In 1982 the value of tangible assets, reported on the balance sheet of Standard & Poor 500 companies in the U.S. on average made up still most of the market value of these companies. To be exact, 62% of the market value of S&P 500 companies in the U.S. in 1982 was covered by the value of tangible assets. In 1998 this ratio has been totally turned around: only 15% of the market value of S&P 500 companies was represented through the value of their tangible assets, 85% was the portion of the market value that was assigned to intangible assets (see figure 1).
Figure 1: In the last 20 years the source of value has shifted from tangible to intangible assets with the turning point at the begin of the 1990s
All three books were demonstrating how value is created today and what can happen, if an organization is able to unearth the full potential of its intangible assets: wealth creation at an before unseen speed and level. But the authors also explained, what will happen if the underlying new economics are neglected: The power of the new value lever “intangible assets” is the same in the other direction. If management does not understand the new logic, value will be destroyed at an before unseen speed and level.
What are these intangible assets that have gained that much importance in recent years ?
These are knowledge and relationship based assets like the value of the relationship to the people or organizations a company sells to (customer value), the value of the relationship to organizations or individuals through which a company sells or is doing business with in general (business partner network value), the R&D pipeline of new leading edge products that will increase a company’s market share and will generate new revenue and free cash flow in the future (R&D pipeline or innovation capital), a highly skilled and talented work force which is committed to the company (human capital), leading edge business processes, organization structures and a corporate culture that help to convert individual knowledge and skills of employees into relationship value and innovation capital which the company owns when employees go home (structural capital).
The interesting thing now with knowledge based intangible assets and knowledge based products is, that they behave differently from traditional industrial products and tangible assets from an economic point of view. For example the economic law of decreasing returns, which applies to tangible assets based business, does not apply to knowledge based businesses. Why ?
The main reason is the lack of “scarcity” of knowledge based assets. In contrary, scarcity is a typical characteristic of tangible assets.
In a typical tangible asset based business the return will increase if you invest further into this business - but only to a certain level, then it will decrease. For example, if you are a farmer, who owns a piece of land (your tangible asset), you can increase your return, by employing more workers or by investing into better agricultural machinery. But at a certain point in time, you will not be able to increase this return again – the other way round: it will decrease, relatively. The reason is, that there is a scarce asset called “land”, which can’t be used in parallel for different purposes. You can only use it once to plant corn or to plant potatoes – not both at the same time. With knowledge based assets, for example a book or software, this is totally different: it can be copied limitless and can be used and read by as much people as like to read it.
Knowledge based products therefore typically have very low variable costs (the printing costs of the book, the CD on which a new software application is shipped etc.) but high fixed costs (the R&D costs, or better investment, that are necessary to create the first copy). This effect in combination with the global integration of the world’s economies (which leads to tremendous economies of scale because you can spread your high fixed costs across a larger customer number from all over the world) and in combination with new communication technologies such as the Internet (which allows much simpler distribution of knowledge based products and lower sales costs – for example downloads of software anywhere worldwide as a self-service) leads to dynamic network effects and increasing returns and a wealth creation potential unseen before (see figure 2).
Figure 2: The new Economy Economics: the combination of all three factors is leading to dynamic network effects and increasing returns
Management Challenges with Intangible Assets
In order to better exploit the full potential of existing intangible assets and to enable an organization to constantly built new intangible assets, management has to do two things:
· Adapt structures and business processes (create appropriate structural capital), in order to enable the organization to make it’s people more productive and to better leverage relationships to suppliers in order to built sustaining value for customers and to built customer capital. I will come back to this topic in a later issue of “The new New Economy Analyst”. To get already a clue, please see the case study about Cisco in my presentation “Business Management in the new New Economy” (a link is located at the end of this report).
· Improve management and “steering” tools – that is: improve the management system
Why are traditional management systems not sufficient any more ?
In the old days you could look at a balance sheet and P&L for the essential information needed to run a business or to make investment decisions. But financial information today can tell you only 15% of the story, keeping in mind, that 85% of the market value of companies, that refers to intangible assets, is not reported in financial statements. At SAP, which is the company I work for, less than 10% of its market value is reported in its financial statements. And this is typical for knowledge based businesses and increasingly also for traditional companies, where knowledge and intangible asset based activities have become the main value drivers.
Therefore, management and investors need today a much broader, keener perspective into both financial and non-financial issues, into tangible and intangible assets. That is the reason, why financial accounting is not enough anymore to serve as the basis for the management system.
But including information about non-financial success factors into your management reports is not enough. The nature of intangible assets is, that there is no direct relationship between them and a financial outcome. If you invest into R&D, that does not mean that you will increase revenue and return. Only if your R&D investments lead to leading edge competitive products and only if you are able to sell those products on a larger scale, for example globally, you can cover your R&D investments and make money.
Figure 3: There is only an indirect relationship between intangible assets and a financial outcome
So only through activities and initiatives which combine different intangible assets (for example by combining your R&D efforts with marketing expertise to make sure, that you develop the right products, and by combining your development efforts with the distribution and sales capabilities of your own organization and/or those of your business partners) financial value will be created. And this is the role of strategy to provide such a strategic recipe for value creation. With today’s dominance of intangible assets, strategy has become more important.
Thus, a strategic management system is needed,
that help organizations to tie together those different activities and to focus
them into one direction. And because intangible assets have only a relative
value, this value is very sensitive and dependent on market perception and
changes in customer preferences, technology changes and the like. The value of
intangible assets is very much dependent on external influences. Therefore the
new management system has to institutionalise that such external changes
trigger internal changes of the companies strategy and trigger also related
change management activities. This is what modern strategic enterprise
management is all about: companies have to manage strategy as a continuous
process, so that strategy can be adaptive to changing
conditions change and resource allocation
can follow suit (see also the new New Economy Analyst report about “Beyond Budgeting”).
As has to follow accordinglythey execute such
strategy-setting tasks again and again on a monthly or even weekly
basis, they need a good strategic enterprise management system that allows them
to do that very efficiently (see figure 4).
Figure 4: Strategy has to be adapted continuously
How to proceed ? – Cook book for the CFO
If you are a CFO or Corporate Controller, that is someone who is usually responsible to keep a company’s management system up-to-date and improve it, you should
1. Facilitate a common understanding of corporate strategy among the members of the management team. If they do not agree, your company has no strategy, because there can be only one, and one focus for your organization
2. Establish a consensus of opinion about the company’s value creation system: Where are your core competencies? How do you want to create value for customers using these competencies? Which tasks do you leave to others (and outsource them) etc?
3. Implement a strategic and operative monitoring system based on this value creation system (a monitoring system that both tracks implementation of strategy and the efficiency of your “operations”, which is your value creation system)
4. Establish a process of continuous evaluation of business risks through rolling forecasting and analysis, because risk associated with intangibles is much higher than compared with a more traditional tangible assets based business (because of the relative value and dependence on external influences)
5. Implement internal and external communication and reporting processes. Only if managers and investors understand how a company is creating value and how successful it is, they will be able to contribute through appropriate action (managers) or further investments (investors)
6. Facilitate understanding of the dynamics in the business system (enabling for systems thinking in management). This will probably become one of the most important management disciplines in the future. Because intangibles are very much dependent on other intangibles and are linked with each other in a highly dynamic way, managers can either cause tremendous value creation or destruction by some “minor” action that trigger very powerful dynamics in the business system. To get a better understanding and feeling about such dynamics is therefore very important (see Figure 5).
Figure 5: An Example for a “Systems Thinking” exercise
This report is the shortened version of Juergen Daum’s presentation “Business Management in the new, New Economy” at SAP’s European mySAP Financials conference in Basel, Switzerland, June 25/26, 2001.
More about this topic and other New Economy issues in my forthcoming book "Intangible Assets oder die Kunst, Mehrwert zu schaffen: Erfolgreiche Unternehmensführung im Zeitalter des Intellectual Capital" ("Intangible Assets or the Art to Create Value: Successfull Enterprise Management in the Era of Intellectual Capitalism").
More about about New Economy Economics and Management Best Practice in general, and about other related topics will be continued here in this new New Economy Analyst reports. To subscribe for Juergen Daum’s free-of-charge e-mail push newsletter click here.
©2001 Juergen Daum. All rights reserved.