BRAINPOWER Intellectual capital is becoming corporate America's most valuable asset and can be its sharpest competitive weapon. The challenge is to find what you have -- and use it.
(FORTUNE Magazine) – BRAINPOWER has always been an essential asset. It is, after all, why Homo sapiens rules the roost. But it has never before been so important for business. Every company depends increasingly on knowledge -- patents, processes, management skills, technologies, information about customers and suppliers, and old-fashioned experience. Added together, this knowledge is intellectual capital. Pope John Paul II recognized it in his recent encyclical, writing of a new, important form of ownership: ''the possession of know-how, technology, and skill.'' Hugh Macdonald, house futurologist for ICL, the big British computer maker, calls it ''knowledge that exists in an organization that can be used to create differential advantage.'' In other words, it's the sum of everything everybody in your company knows that gives you a competitive edge in the marketplace. Such collective knowledge is hard to identify and harder still to deploy effectively. But once you find it and exploit it, you win. Says Dr. P. Roy Vagelos, CEO of Merck & Co.: ''A low-value product can be made by anyone anywhere. When you have knowledge no one else has access to -- that's dynamite.'' Dynamite, indeed. Merck, voted five years in a row America's most admired company in FORTUNE's annual survey, has invented more new medicines than any other U.S. pharmaceutical company. Intellectual capital has always been most visible and most valued on the leading edge of science, whether in smelting bronze 5,500 years ago or in writing software today. ''We guard our research even more carefully than our financial assets,'' says Vagelos. You can also see it clearly in professional services. Your lawyer doesn't charge $375 an hour because his physical assets -- his desk, his bust of Oliver Wendell Holmes -- are so costly. Many corporations sell little else but knowledge: Think of database publishers, software houses, syndicators and program packagers, consultants, advertising agencies. Today the intellectual content of even mundane human activities is multiplying, as the charts on these pages show. A mere piece of information -- John Doe's address, say -- isn't an asset, any more than one brick in a factory wall is. You can, however, make an asset out of your list of a thousand households to which you delivered pizza with anchovies last year. To picture intellectual capital at work, consider these three examples: -- Helios, a new medical imaging system from Polaroid Corp., will reach the market this year, after just three years in development. That's twice as fast as wild-eyed optimists in the company had predicted. The reason: interdisciplinary teamwork in the labs. ''Our researchers are not any smarter,'' says CEO I. MacAllister Booth, ''but by working together they get the value of each other's intelligence almost instantaneously.'' -- At Pioneer Hi-Bred International, scientists breed special strains of corn for disease resistance, high yield, or specific attributes like oil content. A decade ago such work ate up hundreds of acres of farmland and consumed untold numbers of man-hours. These days they can do it by manipulating the plant's DNA directly, using a petri dish. Apart from the cost savings, the company expects to knock two years off the seven- to ten-year time it takes to develop a new hybrid. Moreover, Pioneer now can focus on individual customers -- breeding strains rich in cornstarch for industrial users or in specific oils for food processors. The upshot, says research vice president Rick McConnell: ''Corn is no longer a commodity.'' -- IDS Financial Services, the financial planning subsidiary of American Express Co., codified the expertise of its best account managers in a software program called Insight. ''Now even the worst of our 6,500 planners is better than our average planner used to be, '' says Chairman Harvey Golub. One result: In four years the percentage of clients who leave has dropped by more than half. These companies have learned to exploit their intellectual capital. In Pioneer Hi-Bred's case, brainpower is replacing land -- the elemental form of wealth. IDS has turned the talent of a few employees into an asset available to all its planners. Polaroid is managing its knowledge to dramatically shorten development time. In most companies the management of intellectual capital is still uncharted territory, and few executives understand how to navigate it. They may know about the assets that take tangible form, like patents and copyrights. They may have an inkling of the value of others, such as the computer software that runs their information systems. They may even intuit that training and the experience gained on the learning curve belong somehow in their asset base. But talent is intellectual capital too. The value of a lab, for instance, includes its scientists' ability to make new discoveries in the future. How do you put a pricetag on that? Or on intangibles like design, service, and customizing, which distinguish winners from losers? Even cost competition increasingly turns less on how many machines you own than on how well you use them. These intellectual assets sometimes behave in ways that defy ordinary rules. Managing know-how is not like managing cash or buildings, yet intellectual investments need to be treated every bit as painstakingly. Besides, as Ted Smith, director of knowledge-based systems at Baby Bell US West, says, ''Managing knowledge as an asset spawns whole new disciplines.'' It alters how executives think about economics, technology, human resources, and planning. The first step in getting more from your intellectual assets is to find them. Ask your CFO how much cash you have in the bank or the value of your land and buildings, and she won't even have to put you on hold to get the answer. Ask what you should spend to replace the old lathes in the Provo plant, and you'll have the number by noon. Lots of luck, though, if you inquire about your intellectual capital. How much could you get if you sold the R&D that doesn't bear fruit? You know what your payroll is, but what's the true replacement cost of your people -- the value of the skills you'd have to replenish if they left tomorrow? Odds are, no one even knows what those skills are, says Jeffrey Staley, vice president of Scientific Generics, a management consulting firm. Staley, an alumnus of Arthur D. Little and Digital Equipment Corp., helps companies map their technology assets -- that is, locate them, define them, and lay out routes for getting them to other parts of the company. Often his clients are startled to learn how much intellectual capital they have. One division of AMP, for example, knows how to drill minuscule holes in ultra-thin plastic and metal rings to make connectors for fiber-optic cables. Its drillers are the best in the world, and the precision of their work allows AMP to make some connectors for half its competitors' cost. Yet it wasn't until the company, working with Staley, mapped its technology assets that AMP learned how to transfer the skill to making connectors for copper wiring systems. Surprises like that are typical of intellectual assets. Explains Virgil Barry, a consultant at the A.T. Kearney firm: ''When you buy a machine, you know exactly how much value it adds. When you hire a researcher or develop a new process, you don't know where it will lead.'' Step two is matching the company's intellectual needs with its strategic plan. Polaroid is chockablock with scientists who know all there is to know about the chemistry of film. But the age of digital photography is dawning, and Polaroid needs electronics experts. To get them, the company revamped its human resources management. First, it made a sophisticated model of its hiring requirements; the forecast combines historical employee-turnover trends with data about the current work force, such as probable retirement dates, to estimate how many people with what skills will leave in the next decade. (Even with low turnover, new hires will number in the thousands.) That information is then meshed with the company's long-range plan to show whether departing workers should be replaced by newcomers with similar or different training -- a chemist by a chemist, or by a software engineer. That's not all. Polaroid wants the present work force to equip itself for those jobs. Lots of companies reimburse employees who take job-related courses. Polaroid has them piped into its offices from nearby Harvard, MIT, and Northeastern, and has hooked up a satellite relay from the National Technological University -- a consortium of 39 institutions -- to offer advanced degrees in disciplines like materials science. As an added incentive, Polaroid pegs raises and promotions to acquiring new skills. A worker who masters a skill that his department needs gets a raise, whether or not a promotion comes with it. Says Sam Yanes, director of corporate communications: ''The old system had no way of compensating employees who invest intellectually in the future of the company. Now we've connected human- resource planning to business planning.'' Polaroid is far ahead of the pack. In most places, intellectual capital enters the strategic planning process -- if at all -- sometime after the decision about who gets the fourth corner office. Even if scientists and engineers come to strategy meetings, says Staley, ''they sit in the back of the room. If the boss asks, 'What do you think about this idea?' they say, 'Yeah, I guess we can do that.' '' Rarely is there a systematic attempt to find out what technologies the company will need to carry out the plan, or to analyze the strategic implications of technology gaps, such as whether to make or buy a critical component.
ONCE you've got a handle on your intellectual assets, how do you package them? Most companies are filled with intelligence, but too much of it resides in the computer whiz who speaks a mile a minute in no known language, in the brash account manager who racks up great numbers but has alienated everyone, or in files moved to the basement. Or it's retired and gone fishing. The challenge is to capture, capitalize, and leverage this free-floating brainpower. One way is to automate it. Till now, says Dennis Yablonsky, CEO of Carnegie Group, a software design company in Pittsburgh, ''the time and energy invested in computers has gone into automating systems that relate to tangible assets -- like payroll and inventory -- not knowledge assets. Knowledge has been too hard to get to: It's in people's heads, it's unstructured.'' As technology gets more powerful, that is changing. At Xerox, when a repairman finds a part that failed, he logs the fact into an information base that will guide engineers to problem areas when they design a new copier. Carnegie Group has formed a joint venture with US West, Digital Equipment, Ford Motor, and Texas Instruments called the Initiative for Managing Knowledge Assets (IMKA). IMKA's aim is to make intellectual assets available through software that links databases, artificial intelligence, and plain old rules of thumb. IMKA software just installed at Ford keeps track of the equipment and processes used to make electronic components at every manufacturing plant around the globe -- down to such details as how solder flows across a circuitboard. Why would that matter? When employees in a plant in Brazil tried to speed up production by rotating the boards made there 90 degrees, the failure rate jumped. Flowing at a new angle, the solder shorted out the circuits. IMKA software could have told them that would happen before they wasted time and money trying.
AUTOMATION, HOWEVER, isn't the only way to capture intellectual capital -- and often isn't even the best. Sometimes ordinary storytelling works better, says management consultant David Nadler, president of Delta Consulting Group. Take Xerox again: A study by the company's Palo Alto Research Center revealed that repairmen learn most about fixing copiers not from company manuals but from hanging around swapping stories. ''Most managers would say those guys are wasting time,'' says Nadler. Instead of busting up the gang by the water cooler, companies should make opportunities for storytelling at informal get- togethers and loosely organized off-site meetings, and through videotapes and bragging sessions. Make no mistake: Harnessing your intellectual capital is not easy. It will force you to think hard about what kind of outfit you run, and maybe even change it significantly. ''You can't just take a stodgy organization, hire smart guys, and expect good things to happen,'' says Julio Rotemberg, an MIT economist who is studying how management style affects innovation. Getting results from investing in knowledge, Rotemberg's studies show, requires a corporate culture that allows it to flow freely, which means breaking down hierarchies and scrapping rules that stifle new ideas. His colleague Roger Samuel, program director of a five-year MIT study of information technology management, cites a company in which two accounting groups bought the same computers and software. One group's boss told its people exactly how to use the new equipment; the other, while providing guidelines, encouraged them to fiddle around. Asks Samuel, ''Guess which one had the successful experience?'' Measuring such successes presents a whole new set of problems. Managers and accountants carefully calculate physical inputs like ore and labor; economists monitor money flows. ''When I was a kid in the bank, the most important economic indicator we looked at was freight car loadings,'' says retired Citicorp chairman Walter Wriston. ''Who the hell cares about them now? What we ought to have is something that measures the knowledge people bring to what they do.'' But we don't. Intellectual assets appear on no balance sheet, flash on no Quotron. One reason people give intellectual capital short shrift is that they can't see the brain gain -- the returns on their investment. The problem with trying to measure intellectual capital directly, says Robert S. Kaplan, a professor of accounting at the Harvard business school, is that it mostly consists of ''self-created assets.'' Standard accounting practices don't capture them; indeed, most disappear into the welter of the expense budget. ''We don't have even a nonfinancial number to measure enhanced ability that would work for a broad spectrum of companies,'' Kaplan says. Seldom does a market ascribe value to intellectual assets. Book publishers are one exception, because they capitalize the advances they pay writers. These rarely correspond to the authors' eventual earnings -- in 1989 the publishing division of Paramount wrote off $20 million in unearned advances. But at least the payments result from a market transaction that ascribes a value to the author's talent. By contrast, Dun & Bradstreet's databases, worth billions, appear on no balance sheet. At American Airlines, jetliners show up as assets. However, the information system that runs Sabre -- the reservation service that analysts figure makes more money than the planes do -- is almost entirely an intangible asset, and that is nowhere to be seen on the balance sheet. That's fine for the SEC, which holds that the fewer intangibles on the balance sheet, the better. (Some intellectual capital does show up after an acquisition, as part of goodwill.) But what about enlightened managers who want to evaluate the return on their intellectual capital and know whether it is growing? There is help. Since these invisible assets cast long shadows, the best technique for tracking them may be to measure the shadows themselves. One surrogate measure, says David Teece, an economist at Berkeley, is Tobin's q. That's the ratio between a company's market value (stock price times shares outstanding) and the replacement value of its physical assets. The ratio was invented by James Tobin, a Nobel Prize-winning economist at Yale, who used it to analyze why companies make capital investments. But, says Teece, it also ''reflects something the market values that's not on the balance sheet, part of which is intellectual capital.'' As you'd expect, high-tech companies have a higher q than basic industries. In 1990, Carnegie Group compared market value with book value (a number like , replacement value, but more forgiving because it depreciates physical assets) for 100 companies. Says Dennis Yablonsky: ''Generally the more high tech, the higher the ratio of market to book value.'' For software leader Microsoft it was nearly 8 to 1; for Emerson Electric, the ratio was 2 to 1. Tobin's q can give only a relative measure of brainpower, because it shows much else: takeover talk, a company's market clout, general bullishness. (The q can be less than 1 in bear markets, which doesn't mean a company is moronic.) But taken with enough salt, Tobin agrees, his ratio reflects knowledge assets. For example, you can gauge whether you are closing or widening the gap with a competitor by comparing q's. In companies that depend heavily on R&D, the value of intellectual assets can be approximated by measuring the results of research. Take Merck. The company generated a 1990 return on assets, as usually measured, of 22.2%. (The median for the FORTUNE 500 industrial companies: 4.8%.) Says senior vice president Frank Spiegel: ''On a financial accounting model, it looks as if we have excess profits.'' But as Merck and other drug companies would like critics of their ''greed'' in Congress to understand, that model ignores the cost of the knowledge that produces those expensive drugs. Last year Merck sank $854 million into R&D -- almost half what it spent on materials and manufacturing. This year it will invest $1 billion. Internally, Merck counts R&D as capital spending. Most other companies treat it as an expense. To track R&D, Merck calculates the net present value of its patents, using discounted cash flows tied to the cost of capital. The company also factors in product life cycles, which are getting shorter as competition intensifies. Viewed this way, says Spiegel, ''we look pretty normal'' in terms of ROA. More important, the model lets Merck make sure it is investing enough in R&D to replenish its intellectual capital. Why not just tote up the raw cost of R&D? Not good enough, says Kaplan: ''The value of these investments only loosely correlates with what you spend. A company might put $100 million into R&D and get nothing -- or get a billion a year for ten years. It's like drilling for oil.'' Also, research depreciates. At Westinghouse, says R&D chief Isaac Barpal, the average technology becomes obsolete in five to seven years -- at the company's electronic systems group, in just two or three years. Other knowledge assets can be defined and treated the same way as R&D. | Motorola calculates returns on its employee training costs; the company says some programs yield $33 in cash flow for every dollar spent. US West breaks its technology investments into two classes: those that create knowledge assets (such as expert systems that embody problem-solving techniques) and those that simply automate support functions like payroll. The payoff on the former is about twice the payoff on the latter. Once you understand the value of knowledge assets, you can start using them in earnest to increase returns on physical assets -- earning more bucks from the bricks. Failure to manage know-how is one reason capital-intensive industries show low returns on assets, says Alcoa's president, C. Fred Fetterolf. ''Our engineers have really been capital managers,'' he notes, spending pots of money on machinery and not enough brainpower on improving processes. To change that, companies need to track organizational learning. Whether charting learning curves, defect rates, or some other intellectual standard, the key is to measure not only how much improvement but how long it takes to achieve it. Argues Ray Stata, chairman of Analog Devices, an electronic components maker: ''The rate at which individuals and organizations learn may become the only sustainable competitive advantage.'' Take on-time delivery -- an important way brainpower can increase profits. Analog Devices logged the monthly percentage of late shipments for each of its seven divisions for a year. One division cut the number in half every four months. Others were barely improving; that is, they weren't learning. By tying bonus plans to these results, the company rewarded winners and motivated laggards.
EVERY COMPANY needs its own way to measure intellectual capital and the returns on it. The expertise that matters to a supermarket chain might be irrelevant to a stockbroker or a carmaker. Says ICL's Hugh Macdonald: ''It almost doesn't matter what the bloody metrics are, so long as you can know that this thing, whatever it is, is getting better or worse. If you don't keep your intellectual capital refreshed, it will erode.'' The economic landscape of knowledge-intensive business can differ markedly from the familiar neoclassical world. ''Buy land,'' Will Rogers advised; ''they ain't makin' any more of it.'' But we make more knowledge every day. Considered as capital, knowledge has other peculiarities. For instance, you can sell it to someone and still keep it yourself. It is also more flexible than physical capital. Says MIT's Roger Samuel: ''You can turn a farmer into an investment banker more easily than you can turn an auto assembly plant into an electronics factory.'' Where knowledge is the main ingredient in a product or service, up-front costs tend to be enormous, marginal costs relatively low. The average R&D outlay for a new drug approved in the 1980s was $231 million; seven out of ten drugs that made it to market never recovered their research cost. The marginal manufacturing cost for a typical prescription, however, is just a few dollars. ''Home runs matter a lot,'' says Spiegel. Merck CFO Judy Lewent invented a videogame, based on high tech's high-risk economics, in which players place their bets on a set of chancy high-return investments, then try to survive as the results come in. The player who stints on investment doesn't last long. Often high-tech competition is vicious, with no purse money for place and show. The U.S.-led victory over Iraq -- the most lopsided war between big armies on record -- was a direct result of the intellectual supremacy of allied arms and doctrine, not superior numbers of troops or tons of TNT. Its winner-take-all outcome has parallels in less lethal struggles. The VHS videocassette player virtually wiped out the Betamax format, because JVC quickly shared its VHS technology with others and that format became the one in which most prerecorded videocassettes were made. To avoid a fate like that of Betamax, Citibank tied into the Cirrus automatic teller network in New York, after years of a go-it-alone strategy. DEC joined the Open Software Foundation, having concluded that its proprietary VAX operating system would be worth more if it was compatible with the other systems too. In all these cases, the companies grabbed for what are called network externalities, meaning that a network's value grows faster than the number of participants in it. Take a non-network business: Imagine two candy bar makers each with 50 customers, who all buy one candy bar for $1 apiece. If one adds five customers, his revenue is 10% greater than his rival's. Now consider two discrete phone systems, each with 50 customers who call all the others at a buck a pop. Because each phone connects to 49 others, each network generates $2,450 for its owner. But if one signs up 10% more customers, they can call 55 times 54 people, or 2,970. That's 21% more potential revenue for the successful company. In networks, you can violate the law of diminishing ) returns for years without getting caught.
WHEN A NETWORK gets big enough, its value can become so overwhelming that its competitors must join or die. Says Anthony Oettinger, head of Harvard's Program on Information Resources Policy: ''The map of the United States is littered with old river towns, canal towns, and railroad towns that died because of new networks like interstates and airline hubs.'' Network power can even lock in inefficiencies: Soda cans, for example, could be made more cheaply if they were squat or tall and skinny -- but they wouldn't work with the network of vending machines. Fine, you say, but I'm in the candy bar business; what's in it for me? Simply this: Network economics is available to anyone who wants to get the greatest returns out of his intellectual capital. Point-of-sale information sent through an electronic network can tell you instantly which candies are moving at which stores, helping you sharpen inventory management and marketing. Knowledge can be organized into the ultimate network: expensive to create, cheap and fast to use, accessible from any point at any time, valuable in geometric relation to the number of its parts. Says MIT's Roger Samuel: ''In theory, everybody in an organization could add value to everybody everywhere -- and the organization could get the exponential returns of a network.'' The greatest challenge for the manager of intellectual capital is to create an organization that can share the knowledge. Like money in a mattress, says Hugh Macdonald, ''intellectual capital is useless unless it moves. It's no good having some guy who is very wise and sits alone in a room.'' By finding ways to make knowledge move, an organization can create a value network -- not just a value chain. It can link customers and suppliers to wipe out inventory, or put designers and production engineers at the same table (real or electronic) so that they can design products that are easy to build. Costs can be stripped out or value added to the total system, not just one part. ''Polaroid grew functionally,'' says CEO Mac Booth. ''Now we're trying to create cross-disciplinary teams without diluting the functional excellence. Networking can do that in a hurry -- and how fast that system can build value!'' Merck recognizes the importance of diffusing knowledge through the company. Research, development, and marketing all share the same mission. Says Vagelos: ''The marketing and production people are brought into the planning for a new drug so early you can hardly see a ripple. Scientists know that they haven't succeeded till their discovery is on the market.'' Merck makes that clear in its reward system. It grants stock options to scientists who invent potential new drugs. Unlike regular stock options that vest on predetermined dates, these cannot be exercised until the compound passes various hurdles on its way to government approval. When research doesn't result in a marketable product, Merck will find other ways to reward the scientist if the information is published and adds to the general store of knowledge. When a company turns expertise into capital, it creates something enduring. Take IDS. Says CEO Harvey Golub: ''Few of our portfolio managers are stars, but our mutual funds are often top ranked. And it's not because of patents or unique products. There's a value that's not just financial.'' What is it? Intellectual capital can be as ephemeral as the Holy Grail. In Arthurian legend, when Sir Galahad was allowed to gaze directly into the Grail's divine mysteries, he renounced the material world and was borne aloft on angels' wings. That won't do for a business executive, who needs to make intellectual mysteries serve material purposes. Golub gropes to describe them. ''There's something about the culture -- not just the knowledge but the way it gets applied -- that gives the organization skills beyond the talent of the people.'' When skills belong to the company as a whole, they create competitive advantages that others can't match. The organization becomes more than the sum of its parts.
CHART: NOT AVAILABLE CREDIT: SOURCE: ALUMINUM ASSOCIATION CAPTION: I THINK, THEREFORE I CAN The beer has a head, but the can has brains. Technology lets manufacturers make more containers from the same amount of metal.
CHART: NOT AVAILABLE CREDIT: FORTUNE CHART CAPTION: CORNY BUT WISE Intelligent plant breeding produces corn hybrids whose yields per acre are still growing.
CHART: NOT AVAILABLE CREDIT: FORTUNE CHART/SOURCE: DEPARTMENT OF DEFENSE CAPTION: MILITARY INTELLIGENCE Smart bombs hit faraway targets with pinpoint accuracy. Result: fewer bombs needed, fewer pilots -- and civilians -- killed.
CHART: NOT AVAILABLE CREDIT: FORTUNE CHART/SOURCE: MIT SLOAN SCHOOL OF MANAGEMENT CAPTION: SENDING DATA SMARTER A page of text zips from New York to Chicago faster and cheaper than ever. The message may be no more intelligent, but the means of transmission are.
CHART: NOT AVAILABLE CREDIT: FORTUNE CHART/SOURCE: BUREAU OF LABOR STATISTICS CAPTION: THE AUTOMOTIVE IQ The cumulative value of quality improvements in new cars partly reflects intellectual investments in safety, fuel economy, emissions controls, and other features.