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The effects of knowledge capital on profitability aren’t as simple as they may seem.

An article in Fortune this spring (“We’re Worth Our Weight in Pentium Chips,” March 20, 2000) used the measure of cost per pound as a way to show that “manufactured goods increasingly are congealed brainpower” – in effect, it tried to explain the worth of knowledge capital embodied in various products. Such approximations may be useful in explaining the value of so-called “intangible” goods. They also may begin to demonstrate that the value of knowledge can reveal itself only in the form of the price someone is willing to pay for it. Of course, we should use caution in extending cost-per-pound metrics too far, as in estimating the knowledge held by a person (such as one who weighs 350 pounds) or the knowledge contents of a pound of gem-quality diamonds (1,866 carats) costing $7.2 million.

Nevertheless, I found the cost-per-pound metrics a helpful means to illuminate the connection between prices, the financial structures of corporations and knowledge capital. A few examples from the Fortune article are shown in the table below. I then set out to discover how to rationalize the enormous disparities in these prices.

My first approach was to examine differences in labor costs. USX-Steel has a high ratio of labor to revenues, but General Motors does not and Intel’s is even less. The General Motors case is particularly telling. By far the largest cost for GM is component purchases (54 percent of revenues); the cost of labor for assembly is small in relation to the price of a car. Because operating costs do not explain the differences, I decided to look at the capital accounts. The structure of capital assets clearly differentiates USX-Steel from GM and Intel.

The amounts of financial capital employed by these firms vary dramatically. Intel requires $23.4 billion of financial capital to deliver its semiconductors. General Motors needs $15.7 billion of financial capital to deliver millions of cars. Yet USX-Steel needs only $2.3 billion of financial capital to produce tons of materials that weigh more than all of the machinery employed by both Intel and General Motors.

Ultimately, what explains the large differences in prices per pound is not financial capital but knowledge capital. (Knowledge capital is computed by dividing economic value added by the interest rate paid for acquiring the knowledge capital.) Intel’s $107.1 billion in KC exceeds its financial capital and accounts for 76 percent of the total knowledge capital for all three firms. GM’s KC, $33.4 billion, accounts for 23 percent. USX-Steel possesses only $2.1 billion of KC, which is less than its financial capital.

These comparisons in capital shed light not only on prices of information-age products but also on new issues of the information economy. For instance, a key question concerns the ease of entry and competitive viability of firms that, in order to compete, depend on a high ratio of knowledge to financial capital. Is it more desirable to be a General Motors (with 1998 revenues of $161 billion) or an Intel (with 1998 revenues of $23.3 billion)?

One way of answering this question is from the shareholder’s standpoint. GM’s return on shareholder equity (ROE) has consistently declined, from 82 percent in 1994 to 17 percent in 1998. In contrast, Intel’s ROE has climbed steadily, from 30 percent in 1994 to 41 percent in 1997.

GM’s falling profitability explains why, in keeping with the trend to associate the prospect of huge gains with things e-related, it is diversifying into information services. It has issued press statements announcing that “the world’s largest automaker is turning itself into the world’s largest e-commerce company… moving into online mortgages, communications services and information delivery.”

Such pronouncements may be good for public relations, but they have questionable value in cases, such as GM’s own, in which enormous financial assets dwarf the existing worth of knowledge capital.

For the time being, a dominant firm (such as Intel) that controls a large amount of knowledge capital is likely to be more profitable than a dominant firm (such as USX-Steel or GM) that depends primarily on financial capital. But such a simplistic view about the “new economy” could mislead companies into making foolish investments. Sustaining competitive advantage through ownership of knowledge capital is a precarious proposition, much more vulnerable than the ownership of financial assets. I will discuss this issue next month.

Paul A. Strassmann originated the trademarked concepts “information productivity”, “return-on-management” and “knowledge capital.”