The Value of Knowledge Capital
by Paul A. Strassmann
American Programmer, March 1998
This article also available in Adobe Acrobat (PDF) format (152 Kb).

This article is an excerpt from the author's
forthcoming book, Knowledge Capital
(New Canaan, CT: The Information Economics
Press, forthcoming 1999).

Indiscriminate discarding of knowledge as an enterprise
asset, whether in the form of accumulated employee
training or junking of legacy software, has its origins
in ideas proposed over a century ago about the value of
capital and labor. These theories claim that only
capital assets increase the productivity of labor.

Consequently, the productivity of an enterprise is
measured only in terms of the productivity of its
capital, such as return-on-assets or
return-on-investment. The providers of capital are then
entitled to the surplus, called profit or rent.

If knowledge happens to be necessary for labor to make
better uses of capital, that becomes the justification
for a higher wage rate for labor. By this reasoning,
those performing the actual labor are not entitled to
collect rent from the knowledge they have accumulated.
Labor can receive only fair compensation for the time
worked. The most they are allowed to claim is to be
awarded premium wages and a bonus here or there.

The above reasoning is not only misleading, but also
results in judging the value of employees on the basis
of their wages, rather than how fast they accumulate
useful knowledge. The productivity of labor is not only
a matter of wages. Productivity comes from knowledge
capital aggregated in the employee's head in the form
of useful training and company-relevant experience.

The individual's point of view

Let me illustrate this by an example. You hire an
untrained person who meets entry-level requirements,
such as literacy, a work ethic, and socially acceptable
behavior traits. His or her wage will be based on
prevailing wage rates for entry-level skills.

Ten years later, that person becomes a manager or
expert, earning three times the entry-level wages. How
does a firm justify spending three times more on the
identical person?

The accumulation of company-specific knowledge explains
the difference. During those 10 years, the organization
invested anywhere from a year's to several years' worth
of salary in helping the employee to function more
effectively. Hardly any of that expense shows up as a
direct cost.

Most of it is in the form of attending meetings, having
phone conversations, keeping up with company gossip,
and making errors that, if corrected, can be charged to
learning. None of that contributes to anything the
customer is willing to pay for. Industrial engineers
call such expense ``overhead.'' I call it money spent
on an accumulation of company-specific knowledge
capital. If organizations spend their money well,
employees with 10 years of accumulated knowledge will
be worth more than what the company pays them. In that
way, the company will be recovering the investment on
its knowledge capital as incremental profits.

Let us look at the same situation from the standpoint
of the employee. To increase their earning capacity,
employees count on the company to invest in developing
their skills beyond whatever investments they make on
their own, such as reading books, attending courses,
and getting involved in professional activities.
However, working for the company consumes most of the
time available to do this.

Therefore, the best hope for raising one's earning
potential is what shows up on the r*sum* as experience
that is not company-specific. All employees hope to
acquire marketable knowledge that has a greater value
than their compensation. If that happens, the employees
will be able to recover their investments in knowledge
by getting promoted to higher-paying positions. If that
does not happen, they can hope to find better-paying
employment elsewhere. They can then collect incremental
profits on their knowledge assets in the form of the
difference in the wage rate they could not get from
their current employer.

If you replace the word ``software'' wherever the word
``knowledge'' was used above, you will find the
statements to hold true, except that open systems
software will increase the capacity for knowledge
accumulation at a faster rate, whether seen from the
standpoint of the firm or the employee. If a
corporation's investment in people increases the value
of people faster than their salaries, everybody gains.
The corporation creates employee value-added. The
employee acquires knowledge capital on which he or she
can collect added income.

Tragedy occurs when none of the above works out. This
is the case when the corporation practices and teaches
obsolete skills. Then the employee is not marketable,
except at depressed wages. The recent waves of layoffs
from ``reengineering'' have not increased unemployment
among information workers.

They find other jobs, but with lower compensation. An
aerospace engineer could end up as a manager of a copy
shop, working 30 percent more hours for 40 percent less
pay. It is possible to calculate the ``fair'' price for
the new compensation by writing off the engineer's
accumulated knowledge capital in aerodynamics and
structural design to zero.

The cost to develop information workers, which I define
as an overhead expense for acquiring company-specific
knowledge, is very often much greater than the
depreciation of the fixed assets and greater than
profits for most corporations. The time has come for
enterprises to manage knowledge capital as perhaps
their most significant asset.

The marketable knowledge information workers acquire
during their lifetime is the only means to increase
their earnings. The potential lifetime earning capacity
of a recently graduated engineer, with a starting
salary of $40,000 and real income growing at 4 percent
per annum, is $6 million. Without the added value from
continually acquired knowledge, the lifetime earnings
would be 67 percent less. This explains why it is
necessary for individual information workers to start
managing their own knowledge capital for maximum
returns to themselves as well as to their employers.

The corporate point of view

The calculation of the management value-added makes it
possible to count the worth of the people who possess
the accumulated knowledge about acompany. These are the
carriers of Knowledge Capital®.[1] They are the people
who leave the workplace every night (and may never
return), while storing in their heads knowledge
acquired while receiving full pay. 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 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 shareholders 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
information utilization are the essence of all
managerial acts.

The term ``management'' is used here as applicable to
every information activity that is not directly engaged
in the generation of revenues. I define customers as
the people from whom you collect cash. When some
corporate staff unit declares that it caters to other
staffers as ``customers,'' that is just a misnomer.
They are overhead and therefore remain a part of
``management'' regardless of their claims.

If a new-hired factory worker spends half a day in
general orientation and indoctrination meetings, he
partakes in a managerial activity. The work of an
executive secretary can be also seen as managerial,
since this job involves information gathering, storage,
and dissemination tasks. Meetings, training,
consultations, giving advice, accounting,
administration, interviewing, or correcting quality
defects are by this definition all managerial
functions, because if they were fully accounted for,
they would be charged to ``overhead'' and not to direct
costs of sales.

In a typical company, an average employee spends at
least one-third of his or her time acquiring
intra-company information that is unrelated to the
delivery of goods or services. Employees in managerial
and staff positions expend all of their time on tasks
not directly related to the delivery of goods or
services. More than 25 percent of payroll dollars in an
information-intensive enterprise, and well over 50
percent of the payroll dollars in most government
agencies, are expended on information activities that
should be recorded as managerial overhead.

This learning and talking and listening is expensive
and reduces corporate profits. If that accumulation is
ultimately convertible in greater productivity for the
enterprise, then the expense was worth it by earning a
return on the Knowledge Capital investment.

Consider the costs of managerial knowledge accumulated
by an employee over a 10-year period. With full costs
of employment at about $60,000 per annum, the
decade-long exposure to managerial information would
result in knowledge inputs costing about $150,000. What
would be then the measurable outputs from all of that
accumulated knowledge?

Calculating Knowledge Capital®

The management value-added has been previously shown as
the net result of all managerial activities. Management
value-added is the net surplus economic value created
by the firm, since the suppliers, the tax authorities,
all labor, and all shareholder expenses are already
fully accounted for.

The creation of management value-added is something
that defies the laws of conservation of energy. These
laws state that the output of any system in the
universe can never be greater than its input.
Delivering a positive management value-added must be
therefore an act of creativity that springs forth from
something that is intangible, as if it were an artistic
conception. The source of this creative energy is
Knowledge Capital. This ephemeral element can be
quantified only indirectly by observing how much
management value-added it yields.

Another way of looking at the same phenomenon is to
infer the value of Knowledge Capital from its periodic
yield. If management value-added is the interest earned
from an accumulation of knowledge residing with the
firm, then the value of this principal can be
calculated by dividing the management value-added by
the price one pays for such capital.

Mergers and acquisitions of companies have made the
pricing of all capital explicit.[2] The Standard &
Poor's 500 companies, which account for approximately
70 percent of the value of all public traded U.S.
companies, had fixed assets worth an estimated $1.2
trillion at year-end 1995, while showing a market value
of $4.6 trillion.

This suggests that there are intangible assets,
generally acknowledged to be the knowledge assets of a
firm, approaching $3.4 trillion. These assets require a
better understanding.

Valuation Attempts

Over the last two decades, numerous attempts have been
made to find ways of reflecting these intangible
knowledge assets on financial reports. Perhaps the
best-known firm that publishes supplemental financial
reports on its intangible assets is Sweden's Skandia
Insurance Company. It accounts for its intellectual
capital by documenting assets not recognized by
generally accepted accounting practices. This is
accomplished by issuing a supplementary report
unconnected with the official financial statement. [3]

The supplement includes a valuation of Skandia's
computer systems, experience with work processes,
trademarks, customer lists, and an assessment of
employee competence.

Unfortunately, the attempts to assign a valuation to
software assets, trademarks, experience, and employee
know-how have thus far run into the difficult problem
of pricing such assets. It is now widely understood
that the costs of acquiring knowledge and the
profit-generation potentials of such knowledge are
unrelated.

The value of intellectual property is in its use, not
in its costs. This means that it is only worth what a
customer is willing to pay for it. Two movies made with
the identical actors, for the same $50 million budget,
will have totally different valuations if audiences
like one but not the other. The same applies to
software, new ventures, inventions, and employee
training. This is why the numerous attempts that have
been made to report the intellectual property of a firm
on its balance sheet have faltered.

Knowledge assets become reflected in the financial
accounts only after there is a merger or acquisition at
substantial premiums over book value. When that
happens, such assets become identified by the
nondescriptive phrase allowance for good will.
Thereupon they become subject to depreciation
accounting exactly as if they were tangible equipment.

It seems to me that if companies were allowed to record
their Knowledge Capital in the valuation of their
shareholder equity as a matter of accounting routine,
many of the inconsistencies that currently show up in
accounting and tax treatment of company valuation would
vanish.

Market pricing of Knowledge Capital

It is the risk-adjusted interest in future earnings, in
excess of the cost of capital, that an investor is
willing to pay for as the value of any intangible
assets. Since investors cannot differentiate between
the price of capital for financial or knowledge
investments because they are intermingled, I use the
same price for all capital as a first approximation.
This yields a simple equation:

Knowledge Capital = management value-added / price of
capital

This relation 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.

An Example of Knowledge Capital Valuation: Abbott
Laboratories

Abbott Laboratories is an example of a company that has
successfully kept accumulating Knowledge Capital faster
than equity capital. It has a stock market valuation
that is a large multiple of its financial assets. The
earning capacity of Abbott Laboratories and its
productivity are gaining not because the company is
hoarding financial assets, but because it is using the
capabilities of employees more effectively.

A great deal of investment analysis is concerned with
indicators such as the market-to-book ratios, where the
term ``book value'' refers to the shareholder equity.
Stocks are overvalued if the market value of shares
rises materially above a trend line for the book
values. However, if one adds the valuation of Knowledge
Capital to the valuation of equity capital, the market
valuation of a firm such as Abbott Laboratories will
turn out to be not only consistent over an extended
time period, but also rationally explainable.

I have analyzed a number of corporations using this
method and found that adding Knowledge Capital to book
value equity capital shows a good correlation with the
prices investors are willing to pay for shares of
information-intensive enterprises.

How to grow Knowledge Capital

One can view Knowledge Capital as the result of a
stream of expenses that have helped an organization to
become more effective over a period of many years.
Meetings are not necessarily wasted, because they may
contribute to greater employee awareness. Training is
useful if it is put to good use by making it possible
to reach higher levels of quality and productivity.
Software can become immortal if it is not discarded but
instead reused over and over again.

Almost everything that counts as an accumulation of
knowledge is usually paid for and written off as an
overhead expense and charged against current profits.
This decreases profits, increases expenses, and
diminishes Return-on-Management® [4] unless management
sets out deliberately to treat all overhead expense as
a potential investment in Knowledge Capital.

Managers should therefore monitor what portion of their
sales, general, and administrative (SG&A) expenses,
plus research and development (R&D) costs, is frittered
away as a one-time happening and how much of it can be
seen as an asset with a residual value.

In the case of Abbott Laboratories, that is an
important question, since more than a half of its stock
value is derived from its gains in Knowledge Capital.
The answer can be found in computing the firm's
overhead-to-asset conversion efficiency.

The 10-year sum of all SG&A expenses for Abbott
Laboratories is $18.9 billion. During that period,
Knowledge Capital has grown by $8.6 billion. This
defines the overhead-to-asset conversion efficiency as
44.3 percent. It means that slightly less than a half
of overhead expenses has been well expended for the
benefit of long-term utility. A way of displaying this
steady trend is shown in Figure 1.

Abbott Laboratories has succeeded in generating
Knowledge Capital faster than its SG&A plus R&D
expenses. This firm is highly profitable because its
accumulated knowledge can be reapplied without further
expense. Its current SG&A plus R&D is indeed lower than
most of its competitors', because the company does not
have to pay for all of it in every fiscal year. It
recycles SG&A plus R&D at a very low cost, which saves
on expenses and increases the value of each employee.
This is why ``knowledge recycling'' may become the next
management buzzword.

I have analyzed the overhead-to-asset conversion
efficiency of hundreds of companies and found that a
surprising number of companies suffer from negative
conversion efficiency. As they cut SG&A and R&D during
reengineering, their long-term Return-on-Management
declines because their attrition of Knowledge Capital
proceeds at a faster rate than the savings generated
from wholesale dismissals of people. There seems to be
a trade-off between indiscriminate cost-cutting and the
demoralization of valuable employees that leads to a
suicidal death spiral.

One of the most efficient instances of
overhead-to-asset conversion efficiency is Microsoft.
In the period from 1986 through 1995, the company
gained $8.3 billion in Knowledge Capital while
expending only $10.5 billion for SG&A plus R&D.

To explain Microsoft's extraordinary overhead-to-asset
conversion efficiency of 79 percent, one has to
understand that Knowledge Capital does not need to
reside exclusively in the heads of employees. It also
occupies the mindshare of customers who have expended
their own time and money to became habituated to
Microsoft products.

Software as Knowledge Capital

Over 40 percent of all computer budgets is expended on
software ``maintenance.'' This involves continuous
refurbishing of old programs. It consumes large amounts
of money to repair poorly designed and badly organized
translations of business processes into software code.

An additional 10 percent of all computer budgets is
expended on new projects. A close examination of
proposals will show that much of the financial
justification for starting anew is to reduce
expenditures for maintenance.

If someone would try to sell a house that requires an
annual upkeep equal to a half of the purchase price,
nobody would buy it. A rapidly deteriorating capital
asset is not worth much. Yet the very high ratio of
life-cycle maintenance costs to the original
acquisition cost demonstrates that today's application
software is one of the flimsiest artifacts that
management will ever buy.

The idea of constructing software to qualify as a
high-residual value, low-maintenance capital asset has
never been accepted. As Howard Rubin has put it, ``If
CIOs were judged the way CFOs are, they would be in big
trouble because they do not know what are their
assets.''

In a survey of 2,000 firms, not more than 80 percent
had any idea of the size and quality of their software
portfolio. This means that a big part of the millions
of lines of code they own is poorly utilized.[5] It is
clear that software managers do not have the incentives
to invest in an architecture that is survivable in the
long run. The computer people, the vendors, and the
consultants also prefer whatever is new, fashionable,
and quick.

The reason for the flimsiness of application software
can be found in the lack of understanding by most
executives that software has become an increasingly
significant store of a corporation's Knowledge Capital.

While a comptroller may question the reasons for
getting rid of old forklift trucks, software will be
written off without any examination as to its reuse.
Software expenses are now wasted because management
uncritically accepts the view that software is largely
unrecoverable every time technology, the organization,
or business practices experience major changes.

The existing methods of accounting do not recognize
that, for most corporations, the accumulation of
expenditures for software over a 10-year period will
exceed the value of shareholder equity in about 30
percent of cases. As long as software is treated as an
expense that must realize short-term returns,
corporations will be paying many times over for
software that performs similar business functions
without the benefit of any reuse.

Software asset management is perhaps one of the most
exciting new opportunities for accelerating the
accumulation of Knowledge Capital, because it
represents an encapsulation of accumulated expert
knowledge that can be purchased in the open market at a
fraction of its original cost. Software should be seen
as one of the best means for accumulating and
preserving an enormous amount of information about the
ways a corporation functions.

It should be recognized as a knowledge asset so that it
can be managed as something that keeps growing in value
steadily, reliably, and safely. It must be designed for
evolutionary growth instead of keeping it alive by
patching it up until such time as a sudden convulsion
makes it necessary to replace it without much delay.

Management must insist that applications software be
preserved by means of technical designs that
accommodate rapid changes in computer technologies.
Management should demand delivery of software
applications that take advantage of innovations in
operating systems, adapt to revisions in organization
structure, and take advantage of any streamlining of
business practices. Much of the attraction of the
recently introduced Java language may have its origins
in the general perception that elements of all computer
applications should be reusable by making them capable
of running on any computer, on any operating system, in
any network environment.

Insights

If a company scraps 100 forklift trucks before they are
depreciated, that will be recorded as a loss. If 1,000
employees with career-life learning costs of at least
$150 million leave a corporation, none of the financial
reports will reflect that. When knowledgeable employees
leave, they are written off as having no value, even
though during their years of employment the corporation
paid for all of the knowledge they acquired on the job.

The existing methods and concepts of accounting,
budgeting, and planning are biased against anything
that is not a tangible asset. No wonder that many prior
attempts to calculate the productivity of
``information'' have foundered on the reluctance of the
current stakeholders to be subjected to the sort of
measurements that were previously reserved only for the
laboring classes.

Why industrial-era accounting methods have been
maintained in the present information age is for
students of corporate power politics to debate.[6] It
should suffice to remind us that when industrialization
induced a shift from the extraction of funds from
feudal land possessions to earning profits on invested
capital, most of the assumptions about how to measure
performance had to change. When the expenses for
acquiring information capabilities cease to be an
arbitrary budget allocation and become the means for
gaining Knowledge Capital, much of what is presently
accepted as management of information will have to
shift from a largely technological view of efficiency
to an asset management perspective.

Analysis of corporate financial statements now shows
conclusively that effective information management
could have a greater impact on overall corporate
performance than efficient financial management. The
shift of resources from financial to information-based
assets has been noticed. ``Knowledge'' courses and
conferences are the rage. Even prestige firms such as
McKinsey & Company now feature a ``director of
knowledge management'' and a ``director of knowledge
development.''

The two-hundred-year dominance of financial capital in
establishing the market value of corporations is now
history. The era of the overwhelming importance of
information management has arrived. The information age
is now a reality, because information management can
now be planned, budgeted, and controlled as a corporate
input and not merely as a technology investment.

Information-based strategies cannot be developed unless
they are linked to measures of performance, yet
traditional financial indicators offer little help in
this regard. The dependence on traditional capital
efficiency-based measures of performance is why
information finds practically no place among the
typical performance metrics examined by corporate
executives, auditors, and investors. Yet accumulations
of information and knowledge are implicitly recognized
every day when companies are bought at a large multiple
of their financial valuation. What's missing is a way
of making information and knowledge an explicit measure
of performance.

The time has come for those responsible for
``information management'' to rise to the challenge of
placing the management of Knowledge Capital high on the
agenda of every organization.

-------------------------------------------------------
Paul A. Strassmann is chairman and CEO of the Software
Testing Assurance Corporation. His career also includes
service as chief information systems executive for
General Foods, Kraft, and Xerox (1956-1978), and the
U.S. Department of Defense (1990-1993); as vice
president of strategic planning for office automation
businesses for Xerox (1979-1985); and as professor,
consultant, and author (1985-1990). His last position
was Director of Defense Information and Principal
Deputy, Assistant Secretary of Defense (Command,
Control, Communications, and Intelligence). Mr.
Strassmann was responsible for organizing and managing
the corporate information management program across the
Department of Defense. He had direct policy,
information security, and budgetary oversight for all
defense information technology expenditures. Mr.
Strassmann is now visiting professor of information
management at the U.S. Military Academy at West Point.

Mr. Strassmann can be reached at
55 Talmadge Hill Road, New Canaan, CT 06840
fax +1 203 966 5506
e-mail: CEO@STACorp.com
Web: www.STACorp.com