YOUR COMPANY'S MOST VALUABLE ASSET: INTELLECTUAL CAPITAL Business pioneers are finding surprising ways to put real dollars on the bottom line as they discover how to measure and manage the ultimate intangible: knowledge.
By Thomas A. Stewart REPORTER ASSOCIATE Stephanie Losee

(FORTUNE Magazine) – IN 1494, a mathematically minded Venetian monk named Luca Pacioli published his Summa de arithmetica, geometrica, proportioni et proportionalita, the first accounting textbook. It is famous for showing how to use double-entry bookkeeping, which makes the modern corporation manageable, even possible. Without it, executives and investors -- people who allocate resources, evaluate risk, and measure returns -- would have no way to get a coherent view of the many streams of goods and money that flow through a business. Now, half a millennium later, comes a worldwide cry that Pacioli's scheme won't cut it anymore. In a knowledge-based company, says Judy Lewent, the highly regarded chief financial officer of Merck & Co., "the accounting system doesn't capture anything, really." In London the venerable Royal Society for the Encouragement of Arts, Manufactures & Commerce, which once counted Ben Franklin among its fellows, is halfway through a three-year study of the sources of sustainable business success in the new economy -- its premise, that the old dipsticks and gas gauges don't indicate enough. The pinchpenny Caledonians of the Institute of Chartered Accountants of Scotland are examining nonfinancial measures of corporate performance. In North America the Conference Board and the American Institute of Certified Public Accountants have similar projects, as does the Canadian Institute of Chartered Accountants. The reason, says Edmund Jenkins, an Arthur Andersen partner who chairs the AICPA task force: "The components of cost in a product today are $ largely R&D, intellectual assets, and services. The old accounting system, which tells us the cost of material and labor, isn't applicable." What has the accountants' mental knickers in a twist is the difficulty of measuring and managing the chief ingredient of the new economy: intellectual capital, the intangible assets of skill, knowledge, and information. As defined by Larry Prusak, a principal at Ernst & Young's Center for Business Innovation in Boston, intellectual capital is "intellectual material that has been formalized, captured, and leveraged to produce a higher-valued asset." Even in manufacturing, argues James Brian Quinn of the Tuck School of Business at Dartmouth, perhaps three-fourths of value-added derives from knowledge. More than ever, learning results in earning power. U.S. men with postgraduate educations have incomes 130% higher than those who never finished high school, a pay gap nearly double what it was in 1980. Hip companies call themselves "learning organizations," a vague vogue term for a culture that cherishes continuous improvement. Accounting for intellectual capital is more than an exercise for the cloistered or the fad-struck. What's at stake is nothing less than learning how to operate and evaluate a business when knowledge is its chief resource and result. Canadian Imperial Bank of Commerce, North America's seventh- biggest bank, with $107 billion in assets, began investigating the subject after the conjoined debacles of the savings-and-loan crisis and the collapse of real estate values in the late 1980s. Recounts senior vice president Rob Paterson: "We asked ourselves why banks had become such crummy lenders. No other business has done its primary job so badly. Are we stupid? No. But we don't understand what we're lending against anymore." In the emerging economy of knowledge, CIBC concluded, "soft" assets (like the programming know-how of a Microsoft) can be a better credit risk than "hard" assets (like the buildings of a Texas shopping mall). These days, Paterson says, "it's the value of tangible assets that can vanish overnight." But how to value the intangibles? Unwilling to wait for accountants and scholars, CIBC is striving to make managing intellectual capital a business reality -- an effort that has already changed the bank's human resources strategy and is beginning to reshape operations. A major division of Skandia Group, the biggest financial services company in Scandinavia, has begun releasing an annual report on its knowledge assets, prepared by Leif Edvinsson, whose title is director, intellectual capital. Says Edvinsson: "When we started three years ago, we were pioneers searching for some kind of proof we were on the right track. Today it's a movement." Albeit a young movement, bringing together a sometimes ill-assorted group of accountants, consultants, engineers, human resources managers, and mathematicians. Several major companies have undertaken significant efforts to manage their corporate brainpower. Though the subject is elusive -- by definition, intangibles are hard to grasp -- the experience of CIBC, Skandia, Dow Chemical, Hughes Aircraft, and others makes clear that the knowledge assets of a company can be identified, that management processes can enhance them, that it is possible to describe and measure how knowledge adds value, and that managing intellectual capital improves financial performance. What seemed just a few years ago like a Grail quest -- an adventure worth pursuing, despite its doubtful prospects of success -- appears now to be yielding useful, robust tools for managing and evaluating companies. Needed tools. Managers and investors woefully neglect intellectual inputs and outputs, though these far outweigh the assets that appear on balance sheets. Charles Handy, a fellow at the London Business School and foresighted author of The Age of Unreason, estimates that the intellectual assets of a corporation are usually worth three or four times tangible book value. No executive would leave his cash or factory space idle, yet if CEOs are asked how much of the knowledge in their companies is used, they typically say, "About 20%." That comports with the observations of Betty Zucker, who studies knowledge management at the Gottlieb Duttweiler Foundation, a Swiss think tank. Says Zucker: "Imagine the implications for a company if it could get that number up just to 30%." Dow Chemical had something like that in mind in 1993 when the company created a new job, director of intellectual asset management. The idea was to turn a passive function -- central record keeping for Dow's 29,000 in-force patents -- into active management of the opportunities patents represent. Says Gordon Petrash, who holds the job: "Patents aren't the only intellectual assets -- there's art and know-how -- but they're the easiest place to start." Easiest doesn't mean easy. Petrash found that Dow exploited fewer than half its patents. Worse, most were orphans: No business unit was responsible for commercializing or licensing them. Surprised, Petrash checked with other companies and found that most have at least as high a percentage of unused, unattended patents -- some worth potential millions but all costing money. (Keeping an invention's patents in force over their lifetime costs some $250,000 in legal bills, filing fees, taxes, and so on.) Just from working with business units to create and weed patent portfolios, Petrash's group has saved more than $1 million in its first 18 months. Petrash's chief contribution, though, is a six-step process for managing intellectual assets. It begins with strategy: Define the role of knowledge in your business -- for instance, the importance of intellectual investments to develop new products, vs. brick-and-mortar spending to achieve economies of scale. Next, assess competitors' strategies and knowledge assets. Third, classify your portfolio: What do you have, what do you use, where does it belong? Fourth, evaluate: What are your assets worth; what do they cost; what will it take to maximize their value; should you keep them, sell them, or abandon them? Fifth, invest: Based on what you learned about your knowledge assets, identify gaps you must fill to exploit knowledge or holes you should plug to fend off rivals, and either direct R&D there or look for technology to license. Sixth, assemble your new knowledge portfolio and repeat the process ad infinitum. The method is straightforward, says Petrash, "but we don't find anybody else doing the whole package." Just making intellectual asset management an explicit task pays benefits. When Dow discovered a new way to make polyolefin plastics (one use: coating wire and cable), the six-step process -- especially analyzing competition and technology gaps -- led the company to plan its research and write its patent in ways that make it tough for rivals to work around Dow.

PETRASH AND Patrick Sullivan, a Berkeley intellectual property expert, are training Dow managers to master the process by sharing tips and best practices. Petrash says: "The business guys understand how to do this with their hard assets. We help them do the same with intellectual assets." The long-range goal is to make managing patents as routine as managing any other asset -- and to extend the work into less defined areas of intellectual capital, such as trade secrets and technical expertise. One organization trying to capture and leverage this softer, often tacit knowledge is Hughes Space & Communications, a division of Hughes Aircraft that has $1.2 billion in annual sales and is the world's leading maker of commercial communications satellites. Customization characterizes knowledge work -- whether it's tax auditing, writing scripts for situation comedy, or designing satellites -- and satellites are not only made to order but are also enormously complex, expensive, and unforgiving. Business is tough too, with fewer military contracts and more competitors. Consequently, says Arian Ward, leader of business engineering, "it's very, very important to leverage what we learn so we can do the job better and faster next time." The problem -- indeed, the habit -- is what Ward calls "losing the recipe." Knowledge hard won by engineers who designed a satellite two years ago might be unknown to a team attacking similar problems today; or the new group, knowing the solution but not the research that led to it, might not see its applicability or trust the work. The result: "islands of knowledge," similar to the "islands of automation" familiar to reengineering experts who labor to link incompatible computer systems. A big step in bridging the islands, in Ward's view, is to realize that knowledge takes at least two forms. The first is rules based, where following procedures yields the one correct answer to a specific problem. Rules can often be automated, whether by a simple spell-checker or by a fancy expert- system software that produces, say, the best circuitry design for a signal processor. (This automation can be more expensive than it is valuable. But how can you put a value on a subprocess when there is no market to set a price for it? See box, "How to Measure the Back Office.") Most knowledge is less structured: The answer varies with the context; it takes the form of wisdom, experience, and stories, not rules. To capitalize this knowledge -- that is, turn it into usable tools -- Hughes Space & Communications hopes to build its own "knowledge highway." This summer Ward began a pilot project that will connect existing "lessons learned" databases, using groupware such as Lotus Notes; it will, for example, give designers of new satellites better access to reports of defects found in previous ones or alert them to regulatory issues earlier than now. If, as Ward expects, the demonstration shows that there is much to gain from creating the highway, he will get to work widening the road. To him, intellectual capital consists of "intellectual material and relationships" -- so exploiting it means dealing with both content and culture. In addition to expanding lessons-learned databases and investing in special software to make them easier to search, Ward envisions company-wide knowledge maps, some computerized, some not. "Not giant indexes," he emphasizes, "but maps that show where the knowledge of the enterprise is located -- in whose heads, for example." The goal is not to create an encyclopedia of everything everyone at Hughes knows -- that was fine for the philosophes of 18th-century France but would be impossible today, when scientific knowledge grows so fast. Instead, the purpose is to keep track of the folks who remember the recipe, and nurture the technology and the culture that will get them talking: "People think in terms of stories, not facts," says Ward.

THE PERSON who has done the most to uncover the hidden values of intellectual capital is Skandia's Leif Edvinsson. In the fall of 1991, Edvinsson, 48, who has an MBA from the University of California at Berkeley and a banking background, was hired by Jan R. Carendi, head of Skandia Assurance & Financial Services (AFS), to become the corporate world's first director of intellectual capital. AFS sells annuities, variable life insurance policies, and other savings and insurance instruments from offices in ten countries, including the U.S. It is Skandia's biggest and fastest-growing division, whose 1993 gross premium income ($2.2 billion) was 39% of Skandia's total. One of AFS's highest-ranked executives, Edvinsson is responsible for measuring the assets that do not appear on the balance sheet. Carendi explains: "Our financial assets remain here at 5 o'clock, but much of our intellectual capital goes home. Leif's job is to capture that asset." Edvinsson is an unabashed experimenter, constantly seeking ways to "tangibilize hidden values" and new images by which to describe them. In a brief conversation, he might compare them to the roots of a tree, the walls of a house, or a body's nervous system. Whatever the metaphor, three principles undergird Edvinsson's thinking: First, the value of intellectual assets exceeds by many times the value of assets that appear on the balance sheet; second, intellectual capital is the raw material from which financial results are made; third, managers must distinguish between two kinds of intellectual capital, which he calls human and structural. The distinction is crucial. Human capital matters because it is the source of innovation and renewal, whether from brainstorms in a lab or new leads in a sales rep's little black book. But growth in human capital -- through hiring, training, and education -- is bootless if it cannot be exploited. That requires structural intellectual assets, such as information systems, knowledge of market channels and customer relationships, and management focus, which turn individual know-how into the property of a group. IBM, after all, was much richer in human capital when it had 406,000 employees than it is today, with 235,000. If physical exams followed generally accepted accounting principles, fat would be counted among a body's assets. For managers and shareholders, Edvinsson argues, structural capital counts most: It doesn't go home at night or quit and hire on with a rival; it puts new ideas to work; and it can be used again and again to create value, just as a die can stamp out part after part. It can amplify the value of human capital, marshaling the resources of the corporation -- customer lists, talent from other departments -- to support a new idea. Or it can subtract from human capital, as anyone knows who has watched the whole kludgy apparatus of his company -- a rigid budget process, a snail's-paced MIS department, a turf- conscious manager -- grind genius into gruel. Dave Ulrich, a University of Michigan business professor who works with AT&T, GE, Sears, and others to manage knowledge better, expresses the interplay of human and structural capital in a simple formula: "Learning capability is g times g" -- a business's ability to generate new ideas multiplied by its adeptness at generalizing them throughout the company. Compiling knowledge into structural intellectual capital helped Skandia AFS move quickly to take advantage of the worldwide trend toward deregulation of insurance and other financial services. In one project, Edvinsson worked alongside technologists and actuaries to cut about half the time and money involved in opening an office in a new country. They did it by identifying techniques and technology that could be transplanted anywhere. While AFS's product line differs from place to place, the process of recording payments need not, for example. Says Lars Lekander, a former senior vice president: "The financial event is the same from Bogot to Uppsala."GC and CR: I hope we needn't destroy the rhythm of that quote by adding Colombia" and Sweden" From this work AFS created what it calls a "prototype concept" -- a collection of software applications, manuals, and other structured know-how that can easily be customized to take account of local laws or support any line of financial products. The company has used similar knowledge-transfer strategies to encourage cross-border sales, offering products developed in one country to customers in another. Those sales now account for about 15% of Skandia AFS's premium income. Skandia AFS recently released a "Balanced Annual Report on Intellectual Capital 1993" (see box, "One Company's IQ Accounting"). The nine-page document -- written by Edvinsson and Elisabet Mikklesen, his intellectual-capit al comptroller -- warns readers that it is not part of Skandia Group's annual report, that its figures are unaudited, and that it is just "a project in progress." Indeed, one reason for issuing it was to collect criticism, particularly from the investment community. Because it is the first such report, it is short on historical data; nor are there time-tested correlations between intellectual capital indicators and financial performance. Those will come, Edvinsson says, along with new indicators.

CREDIT Sweden's long winters: Edvinsson regularly travels from the company's offices in Stockholm to proselytize on behalf of the young movement he has helped to create. One of those journeys brought him together with Hubert Saint-Onge, whose business card opaquely proclaims him "Vice President, Learning Organization and Leadership Development, Canadian Imperial Bank of Commerce." Saint-Onge, who hangs his hat in human resources, is responsible for translating the rhetoric of a learning organization into a business reality bankers can believe in -- a mandate that brought him into the group of people trying to describe and measure intellectual capital. "Leif gave us the idea of structural capital," Saint-Onge says. "We gave him customer capital." In CIBC's elegant taxonomy, intellectual capital is created from the interplay of three elements: individual skills needed to meet customers' needs (human capital), organizational capabilities demanded by the market (structural capital), and the strength of its franchise (customer capital). If CIBC were taken over, these assets, especially its base of six million customers, would be worth something over and above the financial assets the bank controls, and appear in the purchase price as goodwill. Says Saint-Onge: "We want to be able to measure, manage, and grow them in running the company, not selling it."

IN CIBC'S MODEL of intellectual capital formation, each of the three elements can be measured and targeted for investment. Take human capital. By defining it in terms of what people must know to serve customers, CIBC has devised a brand-new approach to employee education. Working from CIBC's new Leadership Centre, a 125-room residential campus an hour north of downtown Toronto, Saint-Onge and his colleagues developed what they call competency models. These describe the various talents employees should have: a knowledge of accounting, selling skills, expertise in credit analysis -- about four dozen in all. Obviously, the range and depth of learning expected of a customer service representative differ from what a branch manager or loan officer should know. To begin helping employees learn, CIBC took a surprising step: It abolished training. If that sounds bass-ackwards, consider: Most training programs are pitched too high or too low, are delivered in classrooms to an audience that can't put it to use now if ever, and cost the earth. Says Saint-Onge: "Most companies can't tell you how much they spend on training. It took us six months to decipher -- $30 million a year! And one penny out of a hundred hits the mark." Now the bank puts the monkey on employees' backs: Armed with their lists of competencies, employees are responsible for learning what they don't yet know or enhancing what they do -- to perform their current jobs, not to prep for the job on the ladder's next rung. They can use books and software at their branch Learning Room; managers are instructed to let them shadow colleagues to learn from them; if necessary, they can take courses. Department heads track, for example, how fast their crew is learning, or whether it is weak in any particular area -- data that provide a far better picture of human capital development than the amount of time or money spent in training. To measure the growth of intellectual capital, CIBC is considering a jambalaya of indexes, figuring that, just as no one number reveals a company's financial health, so intellectual capital should be charted along many lines. Some measure the flow of knowledge from people (new ideas generated and implemented) to structures (new products introduced) to customers (percentage of income from new revenue streams). For example, to gauge whether the structural capital is a support or an impediment, the bank can measure costs per transaction, improved cycle time, and costs of key processes, among others. Growth in customer capital ought to show up in rising customer satisfaction scores, faster complaint resolution, lowered price sensitivity among customers, and longer-lived, deeper customer relationships. For CIBC the final product ought to be better management of all the bank's resources. Says Paterson: "Most companies don't really allocate capital. They just budget expenditures. But -- grossly simplified -- what if I put you in charge of a division, said, 'Here's X billion in capital, here's the return we want, a few rules -- on your bike, Stewart, off you go.' You could invest that capital in acquiring people, training people, disposing of people, in technology, in brick and mortar. What's the right mix? Can you make apples-to- apples comparisons? That's the goal." Shy of that, the stock market, in theory at least, should run its own calculation of a company's intangibles and reward investors as appropriate. Indeed, unless managing intangible assets leads to tangible results, the quest to understand intellectual capital will falter.

WILL IT, or will it grow? A 1994 survey by Robert Eccles and Sarah Mavrinac sponsored by the Harvard business school and Ernst & Young's Center for Business Innovation found a chicken-and-egg situation. Managers said they use and treasure information about customer satisfaction, R&D productivity, and product and process quality, but they don't much want to disclose it to parade their intellectual capital, as on a balance sheet, fearing they would give away competitive secrets or attract litigation from disgruntled investors. Financial analysts and investors reported that they want the dope too, but fear being duped: In the absence of reporting standards, they worry that it might be subjective or that data compiled by GM would not be comparable with figures from Ford. And no one in business wants regulations that would set standards and mandate disclosure. Says Paul McLoughlin, a vice president at Salomon Brothers who with skeptical enthusiasm has followed the development of ideas about measuring intellectual capital: "This has to be a business issue. It can't be fuzzy and it has to make a difference. Until there is a defined market for a measure of intellectual capital, it's just an interesting question, like 'Is God dead?'" The pioneers in mapping and measuring knowledge assets believe the possibility very much alive, thank you, and getting livelier all the time. Their work is important precisely because it has just begun and because they are testing it against the dollars-and-cents realities of corporate performance. Says Ernst & Young's Larry Prusak: "I'd rather see what companies are doing than hear grand theories. Brains are what business runs on. We need more people out there showing how to use them better."