The rise of knowledge capital

In Renaissance Europe the economic system was mercantile. City-states and nations controlled monetary wealth by centralising...

In Renaissance Europe the economic system was mercantile. City-states and nations controlled monetary wealth by centralising power. In 19th century Europe, after Adam Smith, governments relinquished their command to the "invisible hand" that distributed wealth to the masses. Now, at the start of the 21st century, there are indications that the economy is changing again.

At the start of the 21st century it seems that the age-old concept of business is changing again. Mark Vernon explains how the new economy works

On one hand, seemingly age-old business functions in finance, from accounting to asset management, are changing fast. And on the other, tax regimes and the rules of commercial engagement are evolving too, leaving governments struggling to keep up. So how much has commerce changed and what are the implications for companies trying to compete amid the uncertainty?

The legislative framework provides a good place to start, since governments take the lead in setting the economic environment. Speaking in Oxford at the end of last year e-commerce minister Patricia Hewitt said the Government would "construct a market framework for economic success" and "help make sense of the economic and social transformations taking place".

But in Hewitt's time the Government has introduced IR35, the tax rule burden for IT contractors, and the Regulation of Investigatory Powers Act, which could expose companies' private communications to public scrutiny.

"I have been lobbied on reforms to capital gains tax, to ensure they do not overburden start-ups with tax liabilities, and on the payment of National Insurance in relation to share options, again an issue that can stymie an entrepreneurial culture," says Anne Campbell, MP for an area of Cambridge that includes the UK's Silicon Fen and Hewitt's parliamentary private secretary. But in spite of these red tape details, Campbell advocates the less is more position on e-business regulation.

IT consultancy Gartner takes a more reformist line. The group believes that Internet-related taxation is under-regulated with considerable differences in tax schemes opening up between Europe and the US. This will be a major source of friction in international trade by 2003.

"There is a mismatch between what governments are doing and what is necessary to create a favourable context for e-business to thrive," says Andrea Di Maio, senior analyst. "We see governments throwing money at the micro-climate such as rushing to create online portals and interactive-based services. This is something that could be better serviced by the private sector."

Governments need to focus on the bigger picture. The overall sense is that national governments are finding it hard to work to the rhythms of a global economy.

"From the legal perspective, there are simply no such things as global laws," says Maitland Kalton, director of Kaltons, the specialist e-commerce law firm.

He believes that groups such as the World Intellectual Property Organisation are taking the correct steps in a global direction, but even they have yet to find ways to surmount the fundamental issue that regulations are by nature national, which brings them into conflict with the Internet, which is international.

Another significant feature of the changing economy is the substitution of intangible for tangible assets as a company's most prized possessions. "When the new economy sent share prices soaring, people started raising questions about how we value stocks," says James Schiro, chief executive officer of PriceWaterhouseCoopers (PWC).

"The market may be in the midst of a correction but we still must address traditional market valuation criteria, which are overwhelmingly focused on earnings. Other historical data do not effectively measure a company's worth alone in today's knowledge-driven economy", Schiro adds.

PWC recently completed an annual worldwide survey of chief executive officers and concluded that corporate reporting must be brought into the 21st century. "We cannot just focus on backward-looking financial measures but must look at value drivers like intellectual capital, brand equity, R&D, customer loyalty and other indicators of performance and potential," Schiro continues.

As Jacques Hal‚, director of methods research at Butler Group, says, "Information management has overtaken capital both in importance and in magnitude."

Hal‚ points out that the cost of capital ownership exceeds information in only 8% of corporations, or alternatively the cost of information management exceeds goods in 36% of companies.

"Information, not capital, makes the decisive difference in a firm's economic performance," he says. The challenge is to improve the productivity of this information, and e-commerce is the means to do it since it cuts costs from the value chain.

Of course, many IT solutions claim to do precisely this. One of the more interesting means of leveraging information stems from the enterprise resource planning (ERP) fold. PeopleSoft has coined the phrase enterprise performance management (EPM) to suggest a move beyond traditional ERP that deals with the business of assessing the value and utility of intangible assets.

Non-transactional, intangible data must be included in the management information system to accurately reflect the range of variables that contribute to new economy corporate success. "Basic decision support tools in the 1980s evolved into the balanced scorecard of the 1990s that yielded a more subtle representation of the organisation, notably by weighing non-financial data against transactional data," says Robin Cooper, a founding father of activity-based management principles. "Much can be achieved by setting financial results in an appropriate context for analysts, such as [looking at] competitors' performance, customer satisfaction or the knowledge capital that the organisations holds," he says.

Hal‚ is quite specific about the significance of information assets and says there is no mystery about how they should be accounted. Quantifying knowledge capital is a better measurement of the source of economical profit than financial capital, he says, and economical profit has itself emerged as a better measurement of wealth creation than simple accounting profits.

"This relationship makes it possible to prepare a revised balance sheet for any firm by adding a line item knowledge capital on the asset side of the ledger, and by increasing (or decreasing) the reported valuation of shareholder equity by the identical amount," Hal‚ says.

The point is that, like money, the effect and value of knowledge capital can now be measured. Value beyond financial assets is not a new idea: it used to be called goodwill. But if its incorporation into companies' financial reports is advocated by no less than PWC, its direct addition to the bottom line is more controversial.

Over-reliance on intangibles played a significant part in the collapse of the dotcoms whose value and ability to borrow ended up leaving them overexposed.

And this ambiguity sums up the question of value in the emerging economy. What is an asset and how to account for it are questions that businesses will be trying to answer for some time.

Virtual remedy for taxation ills

Charlie Cook is a skilled IT contractor who is conscious of economic changes associated with the new economy. Some are good - like flexible working. Some are not - like IR35. But deciding to be proactive in an evolving situation, Cook joined an organisation called the eVirtualCompany, which tries to solve the microeconomic problems that face contractors today.

In essence, eVirtualCompany offers contractors the benefits of full-time employment with the flexibility and freedom of freelancing. After registering online, completing a profile and signing a contract, eVirtualCompany makes contractors compliant with IR35, maximises contracting rates and delivers benefits such as medical and life insurance. Cook also had no further need to maintain a limited company. Work followed. For example, while searching the eVirtualCompany project database, he found a project with Exodus.

He then uses eVirtualCompany's Web-based software to manage his time, expenses and career profile. Cook is paid on the 20th of every month.

Valuing intangible assets

What does improving the productivity of information assets mean in the new economy? An answer is provided by the Dutch bank BACOB/Artesia's implementation of activity-based management, using PeopleSoft's EPM product.The point is that to survive as a profitable finance group the bank needs to be a low-cost provider.

"Low-cost providers are those companies that succeed in making the most effective and the most efficient use of goods and services in their organisations," says Jos Miseur, financial controller. "The key question is are we doing the right things? Are our activities effective? Are we doing the correct things right? Are we executing them efficiently?"

The ABM approach provides answers to questions. For example, which activities are the real cost drivers? Are overhead costs really necessary? Can we replace non-value-added activities by activities that do add value for customers? "ABM gives us the potential for a systematic profitability analysis based on causal relations between the resources and the ultimate cost objects," says Miseur.

That should translate into competitive success.

This was last published in March 2001

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