Leading Lights: Knowledge Strategist Paul Strassmann


Knowledge Executive Report

October, 1996

Having surveyed the corporate landscape, Paul Strassmann does not like what he sees. He is convinced that more companies are destroying knowledge assets than actively generating them. He believes our hidebound dependence on traditional accounting principles, which fail to account for knowledge in any meaningful way, is the key reason for the corporate world's continuing troubles. His may be a voice in the wilderness now, but it probably will not be for long.

The companies that grasp the vital importance of valuing and managing knowledge can be expected to take their industries by storm in the coming years and such thinking will become commonplace. Of course, some knowledge-intensive firms, who are consciously turning their intellectual assets into a competitive advantage, are already demonstrating their might. Strassmann points to high flyers like Microsoft, Coca Cola and Abbott Laboratories as supreme creators of Knowledge Capitaltm a term he recently trademarked. Meanwhile, Strassmann claims IBM and General Motors have been in the last decade among the chief destroyers of Knowledge Capital.

He has developed most of his insights over 30 years as a top-level information executive in government and business and another decade as an independent consultant.

It is important to understand the challenge he raises to top executives, managers and the traditional accounting profession. In order to achieve true, demonstrable productivity gains, he contends, companies must more effectively measure and leverage their information or knowledge assets. Much has been wasted on knowledge capital destroying reengineering programs and massive IT investments tied to traditional financial indicators, as he sees it.

He thinks companies should instead focus on information management, which includes the coordination of suppliers, employees and customers in tasks through managing, training, counseling, recording and reporting (activities traditionally considered "overhead"). Information Productivitytm which he considers a key index of a company's strength or weakness, measures the value added by information.

Strassmann contends that Information Productivity levels are actually negative in a great many U.S. and international firms he has measured, suggesting that managers are being paid bonuses based on the reported net accounting profit despite their failure to successfully manage and exploit information. "Information is treated as an instantly perishable commodity," he points out. The deck is clearly stacked against those who would manage knowledge.

"Insofar as the contributions of people, information and knowledge are concerned, the financial statistics remain silent because none of these contributions to creating greater economic value are recognized in generally accepted accounting principles," he adds. The fact is that the annual costs of information have long ago surpassed the costs of equity capital... Except for some firms, such as in steel, mining, transportation and real estate, the scarce commodity is information. It is through effective information management practices that the users of information... create all business value.

Knowledge Inc. Editor Britton Manasco spoke with Strassmann recently about the need to effectively measure knowledge and productivity as well as the darkening skies ahead for companies that fail to embrace this challenge.

KI: Are there other people engaged in similar efforts in terms of measuring and valuing knowledge assets that you admire and find as good debate partners?

STRASSMANN: This is a topic that has been around for a long time. I have certainly debated this issue with my friends at Ernst & Young. This issue is about twenty years old. Numerous attempts have been made, some books published. Unfortunately, it never went anywhere because nobody could nail anything down in dollar terms. Even the people from Skandia AFS have fallen short. You cannot take those numbers and do anything with them that would be acceptable as a valuation of assets on the stock market.

KI: How is your work different from the efforts of others in this respect?

STRASSMANN: What everybody is trying to do is work the problem of knowledge asset valuation from the bottom up. They point to software and patents and trained people. They try and estimate the valuation of that and add it up to come up with total Knowledge Capital.

Well, that is not the way it works. That is not what value is all about. Value is what the customers' demand as values and are willing to pay for it. It is a top-down issue. Once you have completed the top-down validation, which demonstrates that the market recognizes the value, then you are entitled to look at the details. So, the difference is, fundamentally, between the top-down versus bottom-up approach.

I do valuation of outputs before looking at the valuation of inputs. I first examine the capacity of a firm to receive revenue from customers who are willing to pay a premium price because they recognize that, in addition to the capital goods and manufacturing capabilities that you offer knowledge. Until the customer recognizes that fact, a firm's Knowledge Capital is not worth anything. My approach is top-down first. Then I do a bottom-up analysis in a context.

KI: How far do you think we've come in the 20 years that valuing knowledge assets has been discussed and debated?

STRASSMANN: Unfortunately, we have not come very far. There is no company -- with some minor exceptions -- that is willing to put on its annual report a verifiable number that is recognized as Knowledge Capital. People continue to focus on the conventional, deadly stuff: the old, industrial age accounting. When they are enlightened, then they add all kinds of fancy prose either in the letter to the shareholders from the president or as an appendix or in speeches. They say, "People are our most valuable assets." The fact is that when they report their statistics, they are still reporting Return-on-Equity, Return-on-Investment or Return-on-Assets. What they say and what they do does not hang together.

KI: Do you find any allies in the accounting profession, or are they mortal enemies?

STRASSMANN: The accounting profession is very well set in its ways. They have trouble even doing the traditional auditing of financial assets. They say that they cannot even validate petty cash or account for all of the equipment. They are not interested in accounting for knowledge assets. "We have enough trouble," they say. "We don't need more."

They have not paid attention to Knowledge Capital and that is a problem. If you overpay for an acquisition, the accountants would say, "Let us write it up as goodwill." That is as far as they have been willing to go. Well, writing up value in excess of equity is not goodwill. It is what they have paid for Knowledge Capital. The phrase "goodwill' does not mean much.

KI: Are any of your large clients actively adopting the approach to valuing Knowledge Capital you champion?

STRASSMANN: I do not know for sure. If you ask a missionary, "Will the tribal chief adopt Christianity?" The answer is, "Who knows for sure?"

Top management, however, are very much interested in ideas about the valuation of Knowledge Capital. They are looking at stock prices. The stock market clearly recognizes Knowledge Capital. Stock market valuations of equity in the United States are over six times financial book assets. How can you possibly explain paying more than six times book value for something? Of course, the CEO will tell you about all the talented people in the organization.

The truth is that there is a premium on Knowledge Capital that should be added to the financial equity value. It turns out that if you take Knowledge Capital Valuation according to Strassmann and then add it to shareholder book equity, you find that it tracks the stock market. It is quite obvious that the stock market is willing to recognize Knowledge Capital and pay for it. Why else would you pay 3,000 times earnings for a Netscape? Sure, that has come down a bit, but it is still an extraordinary valuation. There is no way to rationalize it unless you recognize that people are paying for Knowledge Capital.

KI: "The existing methods and concepts of accounting, budgeting, planning are biased against anything that is not a tangible asset," you write. What are some of the implications of such myopic accounting and planning processes?

STRASSMANN: The consequences, which I have written about for the last fifteen years, are that the tangible things get disproportionate attention and the intangible things sort of get sloughed away.

Let me give you an example. For years and years, the big debate about computers -- whether it be mainframes or PCs -- was about hardware costs. Everybody has been neglecting the fact that, meanwhile, we have accumulated huge knowledge assets both in training and software. When you suddenly decide to change equipment because you can find a cheaper computer, you may reduce your hardware costs, but that is less and less significant. Meanwhile, you throw out a couple of billion dollars worth of Knowledge Capital.

At the Department of Defense, where I started working on these issues, we realized that the value of a heavy armed division is not the tanks but the people who ride them. The cost of an armored division is largely the training the soldiers have received -- the Knowledge Capital they have accumulated.

The consequences are that if you disregard Knowledge Capital because it does not show up in the budget you are likely to make very poor and costly decisions. I have shown in many of my articles that capital is now a small fraction of total inputs to a firm's output and that information is now the dominant input in the economy by far. The question is, how much of that information is expensed and how much is converted into capital? That is the most significant issue.

This really gets down to some fundamental economics. Capital is accumulated labor. That is how you justify the price for capital. Well, Knowledge Capital is also accumulated labor. The question then is, is the labor accumulated or is it wasted? If you make a sales call, how much of that sales call is Knowledge Capital and how much is just a sales expense? So, this theoretical issue of valuation has far reaching implications for lots of things we do.

KI: Could you give a definition of Knowledge Capital?

STRASSMANN: Knowledge Capital is the value that a customer assigns on top of the cost of sales and cost of capital. It is the surplus value on top of the traditional value. The people who possess the accumulated knowledge about a company are the carriers of Knowledge Capital. They are the people who leave the workplace every night and may never return. They possess something for which they have spent untold hours listening and talking while delivering nothing of tangible value to paying customers. Their brains have become the repositories of an accumulation of insights about how "things work here"-- something that is often labeled with the vague expression "company culture." Their heads carry a share of the company's Knowledge Capital, which makes them a shareholder of the most important asset a firm owns -- even though it never shows up on any financial reports. Every such shareholder of knowledge assets in fact becomes a manager, because information acquisition and utilization are the essence of all managerial activities.

KI: You have also coined the related terms Management Value-Added and Return-on-Management.

STRASSMANN: Management Value-Added is the engine of all corporate success.

It is Management Value-Added that creates all Knowledge Capital. You can have somebody sitting in the office reading manuals and acquiring knowledge. However, that is not worth anything until management can put it to use so that customers are willing to pay for it. Knowledge Capital is a computable, verifiable ratio. And until you have something repeatable and verifiable you cannot prove much. That is why all the efforts to value knowledge, until now, have been loose. No one could prove numerically the assertions that executives make frequently about their knowledgeable employees.

Management Value-Added is what is left over after absolutely all costs are fully accounted for. This calls for subtracting from the profits after tax an allowance for the costs of shareholder equity as well as other adjustments to correct for accounting peculiarities largely influenced by the tax code.

Return-on-Managementtm, a supplementary metric to the conventional Return-on-Investment measure, is a ratio that accounts for both Management Value-Added and the real costs of management. Knowledge Capital is an extension of Return-on-Management.

KI: You have pointed out that management often tends to disregard key issues associated with Knowledge Capital when it seeks efficiency. It is vital to focus on efficiency, but also to develop an asset management perspective, as you put it.

STRASSMANN: You need both. You have to be efficient. That is necessary, but not sufficient. In addition to that, you must be accumulating Knowledge Capital. Anybody can cut costs by consuming capital. I can start selling off parts of my house in what is called a reverse mortgage and thereby show income, but I will be consuming capital. Similarly, anyone can cut payroll to show improved profits in the next few quarters. The question is "What are you left with after you have got rid of the brains?"

KI: You think companies typically fail to preserve Knowledge Capital amidst turbulent change.

STRASSMANN: A lot of companies downsize and outsource in order to increase efficiency. That is okay, but before they do that they must also consider what impact such moves will have on Knowledge Capital. Of course, when they downsize they do not calculate what it will do to their Knowledge Capital. What they do, invariably, is slim down, reduce costs and destroy assets in the process. Five years later they wonder why the company is in worse shape than it was before.

KI: What will drive the effort to account for Knowledge Capital?

STRASSMANN: What is going to happen is the people who understand knowledge assets are going to be the winners. People who manage knowledge assets as part of their strategy are going to win.

And people who speak to the old paradigm of cost reduction and return on financial capital are just going to lose. They will be using a yardstick instead of an altimeter when attempting to fly. If you mix up the those two methods of measurement you are going to crash the airplane.

KI: You argue that companies can generate and grow Knowledge Capital by treating all overhead expenses -- such as training, meetings, software -- as potential investments in assets with residual value. You measure this by talking about what you call Overhead-to-Asset Conversion Efficiency. Are there some companies that you would point to as being especially progressive in this sense?

They say, "People are our most valuable assets."... What they say and what they do does not hang together.

STRASSMANN: Microsoft is the supreme artist in converting overhead expenses to knowledge assets. They have generated more Knowledge Capital than anybody else I have seen recently. They do it by not only appropriating capital from their own employees, but they also use the Knowledge Capital of their customers.

In 1995,they gained $8.3 billion in Knowledge Capital while expending only $3 billion for Sales, General & Administrative (SG&A). To explain Microsoft's extraordinary Overhead-to-Asset Conversion Efficiency of 277% one has to understand that Knowledge Capital does not need to reside exclusively in the heads of employees. It also occupies the mind-share of customers who have expended their own time and money to employ Microsoft products. The company, for instance, has been able to pass on the costs of testing new software to its customers and learn from them. Customers pay Microsoft for assistance in overcoming deficiencies in Microsoft products. It appears that Mr. Gates understands the concept of Knowledge Capital very well.

KI: Where else -- apart from Microsoft -- have you seen impressive efforts to generate and manage Knowledge Capital?

STRASSMANN: The pharmaceutical companies understand how to generate Knowledge Capital. For instance, Abbott Laboratories has generated Knowledge Capital faster than its SG&A. It is a highly profitable firm due to the fact that its Knowledge Capital can be reapplied without further expense. They do not have to pay for all of their current SG&A in every fiscal year. They recycle SG&A at a very low cost, which saves on expenses and increases the value of each employee.

But there are other companies that are effectively generating Knowledge Capital. Parts of General Electric are fantastic generators of Knowledge Capital. Advertising firms understand these concepts. The company that has created more Knowledge Capital than anyone else in the US in the last decade, in terms of absolute amounts, is Coca Cola. It is a knowledge company. All they sell is water with a little sugar and bubbles. It is their intimate knowledge of the marketplace, their brand name advertising and relationships with their distribution outlets that create their superior valuation.

KI: How will the economy have changed ten years from now as a result of the growing relevance of generating and managing what you call Knowledge Capital?

Mr. Gates understands the concept of Knowledge Capital very well.

STRASSMANN: It is hard to tell.The reason is that the US economy does not look good in aggregate. The number of firms that destroy Knowledge Capital is greater than the number of firms that create Knowledge Capital. General Motors and IBM have been the largest destroyers of Knowledge Capital in the US. They annihilated about $200 billion worth of Knowledge Capital. The decline of both GM and IBM in the mid-1980's is directly traceable to the central controls instituted by their finance bureaucracies over the management of useful information. It led to the disabling of the capacity of the working operators to use their capacity to apply their knowledge to improving what they were doing. If the emphasis of a firm is on improving the efficiency of financial capital, it will necessarily lead to the gradual downgrading of the roles of the operating people.

KI: How do you expect companies to act differently in a knowledge economy?

STRASSMANN: In a knowledge-based firm, there would be a major overhaul of the present financial planning and budgeting methods to explictly account for the custody, stewardship and growth of Knowledge Capital. In the absence of such a change in performance planning and measurement, firms will continue favoring the less productive uses of financial capital. Indeed, they will fail to capitalize on their knowledge assets.

General Motors and IBM have been the largest destroyers of Knowledge Capital in the US. They annihilated about $200 billion worth of Knowledge Capital.

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