To achieve sustained profitability, today’s companies must pay greater attention to non-material production factors. This approach calls for new management and reporting instruments that model and comprise the entire enterprise value creation system.

· Growing importance of non-material production factors

· Focus on intangible assets in difficult times

· Increasing demand for a holistic approach

· From financial accounting to business accounting

· Transforming cost accounting into an enterprise management system

· From financial statement reporting to business reporting

· Combination of old and new success factors

In difficult economic times, “hard” topics like cost efficiency and profitability come to the fore. But companies and their managers must exercise caution: too close a focus on the bottom line can prove shortsighted, and all-too-ambitious attempts to “trim the fat” from costs may cut out vital muscle as well – a fact which they may not recognize immediately.

Simply studying the profit and loss statement or the balance sheet won't reveal the factors behind sustained financial success that have become decisive in every industry in our modern economy: intangible assets in form of human capital, business relationships, brand recognition, ideas, expertise, corporate culture, power to innovate, and public reputation.

Growing importance of non-material production factors

Over the past decades, companies have invested increasingly in the preparation of their operative activities and processes used to supply customers with products and services. They have accelerated investments in research and development, brand building, establishing customer relationships, staff training, and information technology. These expenditures were primarily reported as costs, but their investment character helped add non-material value. Such intangible assets do not appear on any balance sheet, yet potential investors or buyers when evaluating a company consider them.

One clear indication of the trend is that the portion of a company’s book value compared with total market value has decreased on average from 60 percent of in the early 1980s to only 20 percent at the end of the century. That means that of the productive factors of a company that are reflected in its market value, only one fifth is still captured and reported through its accounting system that serves as the foundation for external corporate reporting and for internal management control.

Focus on intangible assets in difficult times

20 years ago, when a much smaller portion of the value creation potential of an enterprise has been ignored by the corporate accounting and management systems, also the probability was much smaller to cut into “productive flesh” through a cost cutting program. That is because a cost focused approach recognizes only those items and activities, that are reflected in the accounting system. Today’s cost-cutting measures pose therefore a much greater risk of inadvertently ignoring and destroying resources potentially important to the company’s future or the activities that create and maintain these resources.

In addition, empirical studies have revealed that investments in traditional industrial assets, that is in physical assets, just return their cost of capital, but do not create value added. Our service-oriented and knowledge-based economy of today creates added value, that is returns beyond the costs of capital, primarily through innovative work in strategic management, product and market development, and by creating unique relationships with customers, business partners, and other stakeholders, such as employees. But to make this possible, managers have to develop the capability to assess the expected return on investment in R&D, employee training, information technology, brand enhancement, and other intangible assets and compare these returns with those of physical investment in an effort to achieve optimal allocation of corporate resources.

But that is exactly the problem: Today, most business enterprises do not have the information and monitoring tools required for the effective management of intangibles. So investing in these new type of management systems may become an important tasks especially during an economy slowdown.

At the beginning of the 20th century, industrial mass production served as the motor to generate value; this required more complex cost accounting, beyond the abilities of previous accounting practices, to enable management to control and optimize the efficiency of these new value creation processes from an economic perspective. In the same way, we must now expand accounting and controlling systems to a new level, to enable companies to optimize, manage and report on today’s new value creating activities and processes – for example in the area of strategy management, in the product innovation and commercialization process as well as in the creation of relationships with customers and business partners.

Increasing demand for a holistic approach

The true value of intangible assets becomes apparent only within a specific context. Investments in human capital – such as additional training – generate reduced costs or increased revenues only when combined with such other factors as reengineered business processes or the availability of appropriate information systems. Investments in product development will lead only to a market share that is able to return these development costs plus a profit if the company disposes of relationships to potential customers and marketing partners for these new products that allow a fast commercialization before competitors are able to catch up.

Therefore, the entire enterprise value creation model within which the intangible assets are created and – in particular – utilized must be taken into account. In this process, it is important to develop a strategy for bundling all of a company’s sources of value creation potential into a single “recipe for adding value.”

From financial accounting to business accounting

Only a consideration of the entire system enables you to decide if, for example, you can post investments in product development as assets in accounting. Baruch Lev, an expert in accounting for intangible assets and a professor at the Stern School of Business of New York University, recommends that you capitalize such expenditures as soon as you have information confirming that they lead to positive and secured economic results¹. But you can do so only when in the framework of the product development process information on marketing and customer relationship processes can be accessed, analyzed, and verified with tests as early as possible . Accordingly, accounting must become more closely geared to these new value creation processes, just like classic industrial cost accounting and the traditional income statement had to be closely linked to production processes in order to report product manufacturing costs /costs of goods sold.

It follows that the traditional financial accounting process must be built up into an extended business accounting function that reflects the company’s specific business model. In addition to manufacturing costs, financial statements should separately identify the costs of all relevant value-creation activities such as in product development, investments in human capital and employee competencies, market partner network building etc. Expenditures, which provide investment character, could be capitalized as assets, as recommended by Baruch Lev, as soon as the sustainability of the created potential is secure. Depreciation can start, when revenues are generated from these investments. This would increase the transparency of the income statement, because expenses with investment character do not distort it any more. In addition, companies would be able to report more precisely on their return on investment, because the equation would include all investments – no matter if they are of tangible or intangible character.

Transforming cost accounting into an enterprise management system

In addition, traditional cost accounting must be expanded into an enterprise management system that spans the entire spectrum of the enterprise value creation system and that focuses not only on cost efficiency, but takes into account at the same time the company’s effectiveness in meeting market and stakeholder expectations.

This approach encompasses ongoing strategy management, a process that helps to control the enterprise’s “value creation recipe” and, by means of strategic programs, to adapt it continuously to new market conditions; corporate performance management, that optimizes total enterprise performance across all economic subsystems and value creation activities; and business controlling, which helps control and continuously optimize the individual value-creating activities per se in such areas as product development, supply chain management or customer relationship management, as well as resource management processes in human capital, finance or information technology management.

Figure 1: The Tableau de Bord – the management information system that helps to control and optimize total enterprise performance

The major element in such a control system is a comprehensive yet compact set of metrics and key indicators – the so-called Tableau de Bord (see Figure 1). This scorecard, which enables the systematic monitoring of performance and risk in the company’s overall value creation system, is a cornerstone of the new enterprise management system. In addition, companies need management processes that permit quick and efficient exchange of background knowledge between individual managers to ensure optimal usage of this information. Such processes include a strategic management process that establishes continuous, strategic dialog throughout the company and thus ensures that the company remains a nose ahead of external developments that could harm its intangible assets based competitive position. Companies must also have a process for performance management that optimizes the exploitation of existing assets in order to achieve short-term profitability goals. Both “enterprise management processes” need to be linked with operational management processes through clearly defined checkpoints (see figure 2)².

Figure 2: Management processes as an organizational framework that supports management dialogs throughout the enterprise to optimize continuously trade-offs and increase enterprise total factor productivity

From financial statement reporting to business reporting

Moreover, traditional external corporate reporting, based nearly exclusively on financial statements, must be expanded into a more comprehensive business-reporting framework. The objective: to provide investors and other external stakeholders with a better insight in the enterprise and, by giving them an overview of all value-creating activities from an economic view-point, to enable them to better assess true potential and the company’s ability to achieve sustainable results from this potential.

For example, in addition to financial statements, companies could publish supplemental information on business strategy and business models, along with operational and intangible key performance indicators via so called supplemental corporate reports. Working groups of the U.S. Securities and Exchange Commission (SEC) and Financial Accounting Standards Board (FASB) have suggested this approach, and the “intellectual capital statements” proposed by the Danish government represent a similar step. Thus, the same concept that is used for internal enterprise management, as described above (“Tableau de Bord”) can be used as well as a basis for external corporate reporting. It might be less detailed than the internal performance reporting systems and some information will be excluded from the external reports for competitive reasons.

In addition to the one way corporate reporting process, management needs to initiate and maintain with important external stakeholder groups a continuous active bi-directional dialog in order to get and keep them engaged for the enterprise: stakeholder relationship management becomes a daily top management task and needs therefore to be integrated with the internal management processes (see figure 3).

Figure 3: The extended Corporate Reporting und Communications framework

Combination of old and new success factors

The recipe for present and future success at companies in all business sectors combines (short-term) profitability with the development of (longer-term) non-material potential in the form of intangible assets. Thus, enterprise management becomes a sort of balancing act: Companies must not only ensure short-term profit and cash flow to finance the future, but also ensure that the programs for developing potential in a fundamental sense are in place and on track.

To achieve this, management must have a broad and deep understanding of all essential value creation activities of the company. They must learn to apply systems thinking so that they can estimate the dynamic interactions in the system and their overall affect on long-term success of the company.

Bad management decisions that result from an inability to recognize and properly manage intangible assets will, at a minimum, result in lost opportunities for growth. Ultimately, they may threaten a company’s existence. A management system that enables managers to systematically avoid making incorrect decisions can have a major effect on a company’s success and help achieve sustained profitability. Supporting management and information systems themselves then become an important production factor.

¹ Baruch Lev, Intangibles: Management, Measurement, and Reporting, Washington D.C. 2001, p. 122-127

² Juergen H. Daum, Intangible Assets and Value Creation, John Wiley & Sons Ltd, Chichester, 2002, p. 219-333

Book tip (for this article’s topic):

Intangible Assets and Value Creation

by Juergen H. Daum

John Wiley & Sons Ltd, Chichester, 2002
ISBN 0470845120
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Website about this arcticle’s topic:

Juergen Daum’s Website on Enterprise Management Best Practice

- The Competence Center for Enterprise Management, Leadership and Business Control

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