Performance Measurement from the Intellectual Capital Perspective - A theoretical approach to support a corporate performance measurement system through a groupware-based intranet application

  Performance Measurement from the Intellectual Capital Perspective - Content  

  Figures  III

Tables  IV  IV

  Abbreviations  V

1  Introduction  1

2  Strategic Management in the Information Age  4

2.1.1  The Industry-Based View of the Firm  5

2.1.2  The Resource-Based View of the Firm  7

2.2  A New Type of Organization  8

2.2.1  Characteristics of the New Organization  8

2.2.2  New Organizational Forms  9

2.2.3  New Strategies  10

2.3  Value Creation in the Information Age  12

3  Intellectual Capital  16

3.1  Shortcomings of Traditional Accounting Methods  16

3.2  Economics of Knowledge-Based Resources  18

3.3  The Concept of Intellectual Capital  20

3.3.1  Human Capital  22

3.3.2  Structural Capital  25

3.3.3  Customer Capital  27

4  Performance Measurement with the Balanced Scorecard  32

4.1  Financial Perspective  34

4.2  Customer Perspective  36

4.3  Internal Business Process Perspective  37

4.4  Learning and Growth Perspective  39

4.5  The BSC as a Strategic Management System  40

4.5.1  Cause-and Effect Relationships  41

4.5.2  Implementing a Balanced Scorecard  42

4.5.2.1  Clarifying and Translating Vision and Strategy  44

4.5.2.2  Communicating and Linking  44

4.5.2.3  Planning and Target Setting  45

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  Performance Measurement from the Intellectual Capital Perspective - Content  

4.5.2.4  Strategic Feedback and Learning  46

4.6  A Critical Look at the Balanced Scorecard  47

5  Enabling the Balanced Scorecard  50

5.1  Requirements for an Automated Balanced Scorecard  52

5.1.1  Strategic Requirements  53

5.1.2  Technical Requirements  54

5.1.3  A Critical Look at Automated Balanced Scorecard Solutions  59

5.2  NetFicient  61

5.2.1  NetFicient Add-Ons  64

5.2.2  NetFicient Knowledge  65

5.2.3  eSurvey and NetFicient Project  66

5.2.4  A Critical Look at NetFicient to Support a Balanced Scorecard  67

5.3  Conclusion  69

6  Outlook  71

  Appendix  73

  A 1 The Structural Analysis of Industries - Porter’s Five Forces  73

  A 1 1 Threat of Entry:  73

  A 1 2 Intensity of rivalry among existing competitors  74

  A 1 3 Pressure from substitute products  75

  A 1 4 Bargaining power of buyers  75

  A 1 5 Bargaining power of suppliers  75

  A 2 Sveiby’s Balance Sheet of Intangible Assets  76

  A 3 Intellectual Capital Measures  78

  A 3 1 Financial Perspective  78

  A 3 2 Customer Perspective  79

  A 3 3 Internal Business Process Perspective  81

  A 3 4 Learning and Growth Perspective  82

  Bibliography  83

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  Performance Measurement from the Intellectual Capital Perspective - Content  

  Figures  

  Figure 1 I - Outline  

  Figure 2 I - Porter’s Three Generic Strategies  

  Figure 2 II - Strategic Changes in the Business Environment  

  Figure 2 III - Shifting Strategy Focus  

  Figure 3 I - Conceptual Roots of Intellectual Capital  

  Figure 3 II - Stewart’s Three Columns of Intellectual Capital  

  Figure 3 III - Structural Capital  

  Figure 3 IV - Buyer-Seller Intimacy as a Reason for IC Growth  

  Figure 3 V - Skandia’s Navigator  

  Figure 4 I - The Balanced Scorecard  

  Figure 4 II - Core Measures of the Customer Perspective  

  Figure 4 III - The Internal Business Process Perspective’s Generic Value Chain  

  Figure 4 IV - The Learning and Growth Perspective  

  Figure 4 V - Cause-and Effect-Relationships  

  Figure 4 VI - The BSC as a Strategic Framework for Action  

  Figure 5 I - Systems and IT Development Focus of the BSC  

  Figure 5 II - Enabling the BSC  

  Figure 5 III - Requirements for an Automated BSC  

  Figure 5 IV - Strategic Requirements  

  Figure 5 V - Connecting the BSC to Existing Back-End Systems  

  Figure 5 VI - Gentia’s Automated BSC Solution  

  Figure 5 VII - Gentia’s Supplementary CRM Application  

  Figure 5 VIII - Three Phases of the BSC Process  

  Figure 5 IX - Net Ficient Add-Ons  

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  Performance Measurement from the Intellectual Capital Perspective - Content  

  Tables  

Table 2 IAAAAAAA  Deutsche Bank’s Internet Strategy  10

Table 3 IAAAAAAA  Book-to Market Ratios in Million US  17

Table 3 IIAAAAAAA  Four Modes of Knowledge Conversion  24

Table 5 IAAAAAAA  Pros and Cons of Automated BSCs  61

Table 5 IIAAAAAAA  Pros and Cons of using NetFicient in a BSC Process  68

Table 5 IIIAAAAAAA  Summary of how to Exploit the Solutions Mentioned in a BSC  

  Process  70

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Performance Measurement from the Intellectual Capital Perspective - Content

Abbreviations

AB Aktiebolaget (equivalent to Plc. in Sweden) AG Aktiengesellschaft (equivalent to Plc. in Germany) a.m. above mentioned BET Break Even Time BSC Balanced Scorecard CRM Customer Relationship Management CVP Customer Value Proposition DCF Discounted Cash Flow DIN Deutsche Industrienorm e.g. exempli gratia (for example) ERP Enterprise Resource Planning EVA Economic Value Added FAQ Frequently Asked Question GmbH Gesellschaft mit beschränkter Haftung (equivalent to Ltd.) HTML Hypertext Markup Language IC Intellectual Capital i.e. id est (that is) Inc. Incorporated ISO International Standardization Organization IT Information Technology KM Knowledge Management M&A Mergers & Acquisitions MS Microsoft NOPAT Net Operating Profit After Taxes OLAP On-Line Analytical Processing OTD On-Time Delivery Plc. Public Limited Company p. Page pp. Pages R&D Research and Development ROCE Return on Capital Employed ROE Return on Equity

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Performance Measurement from the Intellectual Capital Perspective - Content

ROI Return on Investment ROIC Return on Invested Capital SBU Strategic Business Unit SEC Security Exchange Commission SEK Swedish Crowns SFC Skandia Future Center TQM Total Quality Management WACC Weighted Average Cost of Capital WWW World Wide Web

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Performance Measurement from the Intellectual Capital Perspective - Introduction

1 Introduction

The transformation from the industrial age to the information age ¹ or knowledge society ² represents a time of great change for business organizations as well as for individuals. Service industries replace manufacturing industries and the traditional factors of production: land, labor, and capital are replaced by intellectual assets as the scarce resources. “If there is one distinguishing feature of the new economy that has developed as a result of powerful forces such as global competition, it is the ascendancy of intellectual capital.” ³ Intellectual capital (IC) and its measurement is the main topic of this research project. The declining importance of physical assets as well as the quest for shareholder value creation have made the performance evaluation of companies that used to be solely based on financial figures inadequate. For information age companies it is essential to value performance beyond quantitative measures. ⁴ Practitioners like Security Exchange Commissioner (SEC) Steven Wallmann as well as academics like New York University’s Stern School of Business accounting professor Baruch Lev stress the current accounting model’s bias towards physical assets and emphasize the necessity of incorporating non-financial measures to evaluate organizational performance. ⁵ The Balanced Scorecard (BSC) is a performance management and measurement system that fulfills this criterion. In addition to the traditional Financial Perspective, the BSC measures performance from the Customer Perspective, the Internal Business Process Perspective, and the Learning and Growth Perspective, thereby functioning as a tool to navigate businesses in a competitive environment that is growing more and more complex. The aim of the thesis is to illustrate how the BSC can be used as a strategic management system that places a strong focus on IC and its measurement. Furthermore, it will be analyzed how information technology (IT) can be used to facilitate a BSC and its implementation.

The research project is based on a cooperation between Deutsche Bank AG and the Groupware Competence Center of the University of Paderborn. Along with Lotus Development GmbH, the two cooperation partners developed the product NetFicient, a groupware-based intranet application. NetFicient is marketed by the Deutsche Bank

¹ Stewart (1997): p. 3

² Drucker (1996): p. 67

³ Bontis (1998): p. 64

⁴ Eccles (1991): p. 131

⁵ Lev (1997): p. 1; Wallman (1997): p. 104

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Performance Measurement from the Intellectual Capital Perspective - Introduction

department GTS/Commercial Banking Applications/eCommerce/eCommunities internally as well as externally. The increasing utilization of BSCs was the reason to examine how potential NetFicient customers could benefit from the various NetFicient functions when introducing a BSC.

The paper begins with an introduction to Strategic Management in Chapter 2. It is intended to provide a brief overview of the historical evolution of strategy in management literature. The most important frameworks are going to be mentioned, however, the center of attention are the changes in the competitive environment that organizations have to cope with nowadays. Therefore, an emphasis is placed on the strategic prerequisites companies have to accomplish in order to successfully compete in the ‘new economy’. Besides, the shifting perception about value creation will be briefly illustrated. Chapter 3 will deal with IC. The above mentioned shortcomings of traditional accounting will be explained with a focal point on economics of knowledge-based resources. Furthermore, the IC concept will be illustrated and explained. A case study about Skandia, a Swedish financial services and insurance company will be leading on to the BSC concept, presented in Chapter

4. The potential of the BSC to function as a strategic management system - focusing on performance measurement from the IC perspective by adding non-financial measures to the traditional financial ones - will be examined. In Chapter 5 enabling systems for BSCs will be discussed. On the one hand, automated BSC solutions are going to come under scrutiny and on the other hand it will be assessed how NetFicient can contribute to a BSC process.

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Performance Measurement from the Intellectual Capital Perspective - Introduction

Performance Measurement from the Intellectual Capital Perspective - Strategic Management

2 Strategic Management in the Information Age

The word strategy has its roots in the Greek language where strategia means generalship (formed from stratos - the army). It is not a coincidence that concepts and theories of corporate strategy or business strategy go back to a military background. Strategic management professors Henry Mintzberg and Brian Quinn even start their book on ‘The Strategy Process’ with a lengthy description of the battle of Chaeronea where Alexander the Great from Macedonia defeated the Athenian and Theban troops in 338 BC by carefully analyzing the strengths and weaknesses of his own troops as well as looking at the troops of his opponents. ⁶ Robert M. Grant, another leading researcher on strategic management outlines two similarities between military and business strategy: the distinction between strategy (“the science or art of planning and directing large-scale military movements and operations” ⁷ ) and tactic (“a plan, procedure, or expedient for promoting a desired end” ⁸ ). According to Grant tactic is the scheme to win a specific battle while a strategy is the means to win the whole war. ⁹ He emphasizes three common characteristics of strategic decisions military as well as business-related: ¹⁰ 1. They are important. 2. They involve a significant commitment of resources.

3. They are not easily reversible.

Hence, the translation of these rather martial words into the peaceful world of business means that strategy is the ‘battle’ of a company to create a competitive edge in the market. Therefore, companies formulate visions (defined as “view of a realistic, credible, attractive future for the organization, a condition that is better in some important ways than what now exists” ¹¹ ) and mission statements (“a firm’s mission provides a framework for organizing and communicating its basic identity and intentions” ¹² ) as a center for their strategy. The underlying goal of any business strategy must be the creation of value (value creation will be treated later on in this chapter) by performing activities different from the competition and therefore

⁶ Mintzberg/Quinn (1991): p. 6

⁷ N.n. (1997): p. 778 (Webster’s Universal College Dictionary)

⁸ N.n. (1997): p. 802 (Webster’s Universal College Dictionary)

⁹ Grant (1998): p. 15

¹⁰ Grant (1998): p. 15

¹¹ Fry/Killing (1995): p. 17 (A vision answers the question: “What do we want our business to look like in five years from now?” Fry/Killing (1995): p. 14)

¹² Fry/Killing (1995): p. 17 (A mission gives the answer to: “Why are we in business?” Fry/Killing (1995): p. 14)

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Performance Measurement from the Intellectual Capital Perspective - Strategic Management

delivering a higher value to the customer. Without activities “a strategy is nothing more than a marketing slogan that will not withstand competition” ¹³ Mintzberg/Lampel have identified ten different schools of business strategy formation since 1960 that have been treated in management literature. These schools are reinforcing each other and researchers do not hesitate to stress that strategic management is an evolutionary process. Therefore, it is not possible to address a certain school to a specific event or time. ¹⁴ Nevertheless, it is possible to make a distinction between two perspectives in strategic management that are gaining relevance with the rapid changes currently occurring within the business environment.

Management literature has treated strategic management from two perspectives: The industry-based view. The resource-based view.

As the aspect of strategy will be relevant for chapter four both views will be briefly discussed.

2.1.1 The Industry-Based View of the Firm

In 1980 Michael Porter’s book “Competitive Strategy”, a groundbreaking work on strategic management appeared. According to Porter the strategic focus of a company had to be on the external environment, i.e. the industry a firm was competing in. The essence of his book was the idea that industry competition was driven by five forces (see Appendix 1) and that a company had the possibility to create a competitive advantage in its industry by choosing one of three generic strategies:

¹³ Porter (1996): p. 64

¹⁴ Mintzberg/Lampel (1999): pp. 21

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Performance Measurement from the Intellectual Capital Perspective - Strategic Management

Choosing overall cost leadership as a strategy a company has to defend its low-cost position by achieving significant economies of scale and the maintaining of a relatively high market share.

The choice to compete on differentiation usually yields above-average returns by establishing, for example, a high brand loyalty and a resulting lower sensitivity to prices.

The focus on a specific market segment or product line creates a defendable market position by serving a narrow target group superior to other competitors. For the information age company this differentiation does not represent an adequate approach anymore as Porter denies that, under normal circumstances, a company can choose more than one of the three generic strategies. ¹⁶ Nowadays, the business environment has significantly changed. Through the World Wide Web (WWW), mobile communications and other technological breakthroughs companies are able to choose more than one of the generic strategies. Computer producer Dell’s built-on-demand strategy ¹⁷ is a good example of a company being able to capitalize on the advantages of mass customization achieving significant economies of scale. In other words Dell can pursue the strategies cost leadership and differentiation simultaneously while still serving the mass market. ¹⁸ Hence, it is not sufficient anymore to solely focus on the external environment of a company as there is an urge to take internal factors into consideration that were neglected before.

¹⁵ Porter (1980): p. 35

¹⁶ Porter (1980): pp. 35 and 41

¹⁷ Schinzer (1998): p. 6

¹⁸ Kim/Mauborgne (1999): p. 45

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Performance Measurement from the Intellectual Capital Perspective - Strategic Management

2.1.2 The Resource-Based View of the Firm

The information age company needs to shift its focus of strategic management from the external industry analysis to a combination of external analysis and a focus on the internal environment of a company. Locating an attractive industry and trying to make money by choosing to compete on one of the generic strategies is not enough anymore. The resource-based view of the firm emphasizes the uniqueness of each organization. ¹⁹ It regards each organization as a combination of physical and intangible assets that interact with each other in order to create a competitive edge in the market. ²⁰ But the competition on resources is nothing particularly new. It is, moreover, the resources that have changed over the last years. Not too long ago the most crucial resources were factors like capital (now more or less abundantly available to everybody with an internet-related business idea through venture capitalists or business angels, and increasingly backed by a large number of private investors on equity markets), brand loyalty (currently most traditional consumer goods companies have significant problems with the valuation of their shares on the stock markets ²¹ because customers tend to switch brands more easily and increase their purchases of private labels), or technological leadership (a technology can usually be copied without bigger problems nowadays). ²² Today the resource-based approach “sees competencies, capabilities, skills, or strategic assets as the source of sustainable competitive advantage for the firm”. ²³ IC becomes the most valuable resource for any organization. Especially in this rapidly changing business environment the management of resources must be paid careful attention to. Investment in resources (such as training or research and development (R&D)), upgrading resources (“moving beyond what a company’s already good at” ²⁴ ), and last but not least leveraging existing resources into new markets foster the need to reassess the traditional structure of organizations. ²⁵ In order to achieve these objectives a new type of organization is needed.

¹⁹ Grant (1998): p. 112

²⁰ Collis/Montgomery (1995): p. 118

²¹ Baumann/Gorgs/Salz/Zöttl (2000): pp. 86

²² Wernerfelt (1984): p. 174

²³ Nonaka/Takeuchi (1995): p. 46

²⁴ Collis/Montgomery (1995): p. 126

²⁵ Collis/Montgomery (1995): p. 127

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Performance Measurement from the Intellectual Capital Perspective - Strategic Management

2.2 A New Type of Organization

Currently organizations experience a business environment that is characterized by the rapid diffusion of what not long ago were considered sustainable competitive advantages such as new technologies, management techniques, or superior customer service. ²⁶ It is the challenge of the information age company to find new sources of competitive advantage. But traditionally organized companies do not allow for the flexibility needed to compete in this environment. Moreover a new perception about business is needed. Companies need to consider new organizational forms and new values among their employees in order to guarantee for the evolution of new strategies.

2.2.1 Characteristics of the New Organization

It is obvious that economies, especially Germany where the old ‘Deutschland AG’ ²⁷ is still omnipresent, need to rethink their attitudes towards business culture. Lengthy decision processes through hierarchies and complicated ownership structures often restrain companies from reacting quickly to changes in the competitive environment. Kjell Nordström and Jonas Ridderståle, two professors from the Stockholm School of Economics as well as internet entrepreneurs (Spray Ventures, Razorfish) in their rather unconventional book ‘Funky Business’ have identified four characteristics that a company needs to posses to be successful on the market as well as internally in retaining key people and key competencies in the company. An organization needs to be: 28

1. Focused: Market transparencies lead to demanding stakeholders. Nothing but superior value creation will be accepted. “So, funky organizations do not aspire to be the very thing for everyone. Instead, they are trying to become something for someone.” 29

²⁶ Porter (1996): p. 63

²⁷ The term refers to the linkages between the big industrial conglomerates, banks and politics caused by cross-ownership of stocks and supervisory board mandates.

²⁸ Nordström/Ridderståle (1999): pp. 128

²⁹ Nordström/Ridderståle (1999): p. 132

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Performance Measurement from the Intellectual Capital Perspective - Strategic Management

2. Leveraged: Organizations have to recognize their core competencies, core business and core customers in order to leverage their main resources. In the information age this leverage can be used to compete in several industries without producing the actual good or service.

3. Innovative: Innovation goes beyond actual product development and can mean human resource innovations, financial innovations, or service innovations. It is a mindset that “turns the company into an idea and dream factory”. 30

4. Heterarchical: Organizations need structures that foster experimentation. Failures must be accepted (“In Silicon Valley, failure is not a black dot - it is a badge of achievement.” ³¹ ) and employees must feel that they were on playgrounds rather than in pyramids where strong hierarchies restrain innovation and creativity. 32

Particularly, the plea for more freedom to experiment and the ability to accept failures as a part of the development process of IC is something that is lacking in the German business environment. The a.m. characteristics are the basis for the creation of new strategies.

2.2.2 New Organizational Forms

Industrial age companies are usually organized hierarchically and often vertical integration was the means to control the whole value chain from production process to after sales service. But this type of organization does not fulfill the conditions needed to compete in the future. Sophisticated employees desire more responsibility and require a share of the company’s profits and for the development of resources partnerships and alliances are going to be formed with other companies that were formerly regarded as competitors. New organizational forms evolve through: 33

1. Internal disaggregation: Decentralization and empowerment create an environment that shifts decision-making responsibility to the manager of the strategic business unit (SBU) while ownership of assets stays with the corporation.

³⁰ Nordström/Ridderståle (1999): p. 152

³¹ Nordström/Ridderståle (1999): p. 193

³² Nordström/Ridderståle (1999): p. 168

³³ Day/Wendler (1998): pp. 9

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Performance Measurement from the Intellectual Capital Perspective - Strategic Management

2. External disaggregation: “Corporations spin off parts of their business to the financial markets, thus reducing or surrendering their ownership interest.” ³⁴ This means is becoming more and more common as it makes performance visible and creates the incentive for employees to act as entrepreneurs (practical examples are AT&T’s spin-off of Lucent Technologies and Siemens’ spin-off of Infineon).

3. Relational forms: Alliances, joint-ventures, licensing agreements and especially joint-partnerships become more and more important for the information age company. A good example is Deutsche Bank’s internet strategy: 35

For organizations that are dependent on IC like Deutsche Bank these new organizational forms create the environment needed to develop the characteristics that allow for the flexibility to compete in the information age.

2.2.3 New Strategies

Studying modern management literature, one realizes a shift in the fundamentals of strategy. While strategies of industrial age companies placed a predominant emphasis on the analysis of competition, the information age company shifts its focus to the buyer. The strategy to successfully compete in the future is what Kim/Mauborgne from INSEAD in Fontainbleau call value innovation. They describe shifts in the three basic building blocks of strategy: competition, customers, and corporate

³⁴ Day/Wendler (1998): p. 10

³⁵ N.n. (2000): p. 89 (Der Spiegel)

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Performance Measurement from the Intellectual Capital Perspective - Strategic Management

capabilities. ³⁶ Competitive strategy is not about outperforming the competition by building layers of competitive advantage but “makes competition irrelevant by offering fundamentally new and superior buyer value in existing markets and by enabling a quantum leap in buyer value to create new markets”. ³⁷ Reinventing existing industries is the reason for the success of many young and innovative companies like online investment bank Charles Schwab, airline Virgin Atlantic, German online broker ConSors or internet auctioneer Ebay just to name a few. Customer strategy shifts from the delivery of superior service for a specific customer segment to targeting the mass market and accepting to eliminate unprofitable customers. 38

The third building block of strategy - corporate capabilities - shifts due to the recognition that companies cannot develop all of the relevant capabilities on their own. Moreover, companies need to consider new organizational forms in order to combine capabilities with other companies (a good example for this is General Motor’s virtual logistic platform TradeXchange that rival car producers DaimlerChrysler and Ford decided to join in order to make procurement more efficient ³⁹ ). Furthermore, a shortage of qualified personnel, especially in the information technology sector makes building up of non-core capabilities expensive. The shift of strategy focus is illustrated below:

³⁶ Kim/Mauborgne (1999): pp. 49

³⁷ Kim/Mauborgne (1999): p. 43

³⁸ Kaplan/Norton (1996): p. 73

³⁹ N.n. (2000): presentation Andersen Consulting

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Performance Measurement from the Intellectual Capital Perspective - Strategic Management

A very important aspect in the development of new strategies is employee motivation. In the industrial age the prevalent strategy was the allocation of scarce resources in order to achieve a goal. Nowadays, companies use stretch goals i.e. the motivation of employees by setting goals that are not feasible at first sight. Stretch goals are achieved by leveraging resources ⁴¹ and they are supposed to transform the company in case they are reached. 42

2.3 Value Creation in the Information Age

The ultimate goal of every business all over the world is the creation of value. ⁴³ Nevertheless, the term value is subject to different interpretations in different cultures. The underlying idea of value in this thesis is based on the shareholder value approach predominantly used in the Anglo-Saxon influenced business world. While the stakeholder approach, prevalently used in continental Europe, advocates that companies have a social responsibility and should pay respect to public interests along with shareholder interests ⁴⁴ shareholder value supporters argue that companies do neither have the political authority nor the competence to decide what is in social

⁴⁰ Kim/Mauborgne (1999): p. 50

⁴¹ Hamel/Prahalad (1994): pp. 129

⁴² Kaplan/Norton (1996): p. 226

⁴³ Grant (1998): p. 32

⁴⁴ Rappaport (1998): p. 5

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