Baruch Lev is a long time leader in research on intangible assets. Although he is better known in accounting and finance circles, HR practitioners really need to understand his work. The debate in accounting is how to account for intangibles, while HR has to create them. His work is also of importance to anyone interested in balanced scorecards. David Creelman spoke to Dr. Lev.
DC: Let´s begin by discussing what kinds of intangible assets exist in organizations and why they are important.
BL: There are many convoluted definitions of intangibles. I usually don´t get excited about definitions and I don´t think we need a very complicated definition. Intangible assets are similar to physical assets. An asset is something which generates benefits such as cash flow or cost savings in the future. Intangibles are assets without physical embodiment. So you cannot touch them, you cannot kick them. A patent, or a process like Wal-Mart´s inventory system, that I will describe in a moment, are extremely valuable assets because they create very large benefits.
A fairly parsimonious classification of intangible assets, is to consider three types, those generated by discovery, by organization processes, and by human resources. First, let´s consider intangibles related to discovery. These intangibles are very important in pharmaceuticals, biotech and software development where R & D-using that term in a very broad sense-results in patents and trademarks which are then transformed into products and services. Unlike most intangible assets, many of these "discovery" intangibles are protected legally by a patent or a trademark and are recognized as intellectual property.
The second group of intangibles is less understood but no less important. I call it structural capital: types of organizational processes which create sustainable value. For example, Wal-Mart has a system where information from retail purchases goes directly from the store to Wal-Mart´s suppliers. This allows the suppliers to manage Wal-Mart´s inventory. It´s an incredible achievement because Wal-Mart, which carries hundreds of thousands, if not millions, of types of merchandise has basically pushed most of the costly inventory management to the suppliers.
Another well-known example of structural capital is Dell´s build-to-order process. This process is a huge advantage, many competitors have tried to imitate it but Dell still has a very significant lead. A way of doing business is normally not patented but can, at least for a time, create a competitive advantage and generate above normal returns. The third large group of intangibles is human resource intangibles.
These are well known but the question whether these are really assets is much less understood. Human resource intangibles derive from practices like training, hiring processes or using incentive-based compensation. If these practices create a sustainable advantage, they are human resource assets. The issue an economist has with calling these "assets" is that in many cases the research shows the benefits from human resource processes almost totally go to the employees. It doesn´t mean these processes are unimportant but we need to make a distinction between the somewhat narrow concept of an asset, which is something that creates measurable benefits, and other things.
DC: To what extent do intangibles contribute to the total value of a company?
BL: There is a beautiful study by Leonard Nakamura who is a senior economist at the Federal Reserve Bank of Philadelphia. He used three methods to estimate the value of intangible investments in the United States and he gets the value for the year 2000 of about $1 trillion. That´s a big number even for the United States. The entire investment of corporations in property, plants and equipment was $1.1 trillion in the year 2000, so the level of intangible investment is very close to the level of the entire investment of tangible assets. Given that the growth rate of intangible assets is much faster than tangibles, my guess is that now, or in the very near future, the level of intangibles will surpass the level of tangible investments.
DC: Senior managers are aware of intangibles but it is worth emphasizing that, given these magnitudes, if they are not devoting half their time to intangibles then they are misdirecting their efforts.
BL: I would say they should be spending even more than half their time on intangibles because it´s more difficult to determine the return on intangibles.
There are basically two reasons for this. Intangibles are usually more risky than tangible assets, in many cases when investing in intangibles you may loose the entire investment. I have never checked this but people say one in ten drugs makes it to the market, which means that investment in nine of ten came to naught.
The second thing that makes dealing with intangibles difficult is that most intangibles don´t have markets. A tangible asset like real estate is relatively manageable because you have a pretty good idea of the value and you can determine what you should do with a property. With most intangibles there are no markets, so the value is very difficult to estimate. I get corporations asking me very difficult questions such as, "Should we invest in R&D, or trading, or rent?"
DC: How do you answer those questions?
BL: First, let me make one distinction. Recently I´ve seen several studies of co-relations between human resource practices and the capital market. These are typically large sample studies where researchers looked at several hundred companies and co-related investment in training with the profits or with the return on the stocks in these companies. This type of research is very valuable. They suggest to management that, on average, a specific type of investment increases productivity-but you are not the average. You are one specific company. So it´s very important to move to a specific evaluation of your human resource practices.
DC: I think that´s a very critical distinction: what one is able to demonstrate in large samples and what one is able to demonstrate when your sample size is one.
BL: Exactly. I often sense some confusion about this. For example, I did a very large study on the rate of return on R&D in the chemical industry. I got high numbers and people got extremely excited. I was besieged by companies saying, "Come and compute the rate of return on our R&D in the chemical industry.
Of course this cannot be done with the same methodology. For my study I had 83 companies and 25 years of data so I could use the best statistical methods. However, in an individual company they rarely have ten years of clean data and you cannot use the same statistical methods.
For work in individual companies I look at three things: input, intermediate output and final output. So in the case of sale representatives at a chemical company the inputs include compensation, training, and the information technology that supports them. As a first step, I quantify these inputs, which is not always easy, you would be surprised that many corporations, even large ones, don´t have good data.
DC: I´ve worked with a lot of large companies, I´m not surprised!
BL: I´m happy you have seen this because some people say, "How can it be that we don´t have these numbers? We have an extensive accounting system." And the answer is that, yes the accounting system deals with the information in some way, but it is very noisy. For example, divisions are restructured or are merged with other divisions so it´s very hard to get usable historical data.
To do this work properly, you have to be very careful to get data which is consistent. Once I have the input quantified I move to the intermediate output. These are usually non-financial measures but they are an important part of the story. In the case of sales representatives the intermediate outputs are metrics like the number of contacts with clients per month, customer churn, number of new customers, and so on.
The third part of this kind of value chain scoreboard is the final output, and these are usually financial measures. In the case of sales representatives the final output could include metrics such as change in sales, revenue from new customers, or gross margins on sales. Once you construct such a scoreboard, over time it becomes an incredibly valuable way of assessing the effectiveness of your sales force. If I see inputs increasing, for example higher compensation, more training, more information technology, and if intermediate outputs or final outputs are going down, we know we have a very serious problem. You can read more about the scoreboard in my book, Intangibles: Management, Measurement, and Reporting
DC: Just to put this in perspective, many people are advocating that HR calculate ROIs by measuring costs and guessing at financial benefits. Your value-chain approach is far more sophisticated.
BL: ROI is a very deceiving idea. It is very difficult to apply the right way. You can always put numbers on paper that show how profit results from a change in training. However, in computing ROIs from training, your are using a very long convoluted chain with lots of intermediate steps in it.
For example, I was working with a pharmaceutical company when it embarked on a huge training program for all managers with very good universities, which costs a fortune. They knew exactly the investment in this case, how much it cost in time lost, in payment to these universities, in travel and in everything. However, the benefit from this training was very difficult to assess. Even if there was an increase in the profitability of the company, how much came from the training and how much came from a great invention in the R& D lab; how much came from the brand and how much came from other things? So in the area of human resources the simple approach to the internal rate of return is really very difficult to apply.
DC: I would go a little bit further saying that a training ROI is not worth attempting in the vast majority of cases because you end up making up numbers.
BL: I would agree with you and there is the potential for embarrassment when you present your work to the CFO or financial analysts and they start asking difficult questions. That´s why I take an approach where you can really relate the outputs directly to the inputs.
DC: This technique of looking at the intermediate variables and causal chains sounds very much like Robert Kaplan´s strategy map, which is what underlies a balanced scorecard.
BL: I am sure there are similarities in our work. Let me give you another example of something that I´m currently working on. I´m looking at R&D in a very large pharmaceutical company. Again I take the approach of input, intermediate output and final output. The inputs include compensation and extensive training including people going off for sabbaticals at universities. They also have very extensive investment in information technology. They have systems that link thousands of R&D people all over the world, so they can talk to each other and share findings. So the inputs are very extensive.
Then we go to the intermediate output, which in this case includes things like new patents and the number of valuable patents-which you determine by looking at the number of patent citations. We can also look at the whole product pipeline, which in the case of pharmaceuticals involves stages one through three of clinical research, then FDA approval, marketing of new products, and so on. We can look at these intermediate outputs every quarter and if we are investing in training, compensation or other inputs, then we should be seeing a richer product pipeline.
The final output in the case of R&D includes things like the percent of revenue which comes from new products, cost savings resulting from R&D on production processes, and licensing revenue-IBM gets more than $1.7 billion just from licensing revenues. So here again you have the kind of a system which starts with input, then immediate output, then the final output, and gives you a way to assess the whole process.
DC: So you are focusing on tracking outputs rather than trying to put a dollar value on some intangible asset like training.
BL: That´s right. I wouldn´t assign a dollar value. The key is the linkages.
DC: It strikes me that your approach embodies a way of thinking quite different from traditional HR. Were one of your students to take on an HR role they´d be thinking, my job is to manage these incredibly important intangible assets, and I need to be a master of this methodology that links inputs to intermediate outputs to final outputs. How do people react to your ideas?
BL: People get excited because this is new and you can defend it. You can come up with all kinds of very nice measures, but if they will be torn apart by the CFO then they´re not useful. The approach I´ve described is, I think, practicable and will help you manage investments in HR so that you improve your outcomes.
DC: Before I let you go, can you tell me about your background?
BL: My education and training is in economics and finance-and finance and accounting are very closely linked. For years I was at the University of Chicago, then Tel Aviv, then twelve years at the University of California, Berkley. The last four or five years I´ve been at NYU.
I've also done lots of work in the real world. I was an investment banker for a couple of years and I was an economic consultant for ten years. I mention this because it was this work that brought me to intangibles. In the early ´90s I did work for the telephone companies, cellular phone companies and for cable companies. I saw the accounting systems did not function well for these types of high growth, intangible-intensive companies. It was in this practical work where I really saw a need. So I´m somewhat an authority here; I´ve studied this for six or seven years and I find it extremely exciting.
DC: I know I´m overstating the case when I say that accounting and HR are merging but there is no doubt they are converging-something I think is very neat. HR needs to manage intangibles, accountants need to measure intangibles-a marriage made in heaven (if one believes that heaven has a certain sense of humor.)
BL: Yes, and to go the last mile, the issue keeps arising of putting a value of human resources on the balance sheet. This has a lot in common with putting an ROI on training that we discussed earlier. I don´t think you get anything from trying to put a dollar value on HR. Even if you do put a number on it, you just generate a huge amount of animosity.
What I´m talking about is a measurement system-which is accounting. You account for input, you account for output. It´s much better than traditional accounting because traditionally accounting doesn´t link directly input and output, all you have is the income statement that shows revenues and costs but you cannot assign specific types of revenues to specific costs.
I can´t determine, for example, how much of the revenues come from this year R&D, last year´s R&D, R&D fifteen years ago, training, human resource practices and so on. This is one of the major weaknesses of accounting. What I´m talking about is a much more advanced type of accounting which links inputs and outputs and provides you with the necessary managerial tools.
DC: Thanks for taking the time to speak to us. I´m looking forward to reading your book.
Baruch Lev´s book "Intangibles: Management, Measurement and Reporting" is available from Amazon.com
