I’ve been having a dialogue with a consultant for the last two years, and we recently had a very interesting discussion on intellectual capital (IC).
I thought you might find it of interest, since IC is what the professional knowledge firm is all about.
Our exchange focused on whether or not it is possible—or even desirable—to attempt to value IC, and perhaps placing that value on the financial statements, or a set of parallel statements.
Doug was not advocating this approach, just questioning the validity of doing it, and what the impact would be. I’ve had many other discussions with consultants and CPAs about, for instance, placing the value of a company’s brand on its balance sheet.
Should we account for IC, like GAAP accounts for transactions? Should IC be on the financial statements?
We both conclude no. Here’s why.
Hi Doug,
We do use IC as an integral part of a professional firm’s business model, which is why we refer to them as Professional Knowledge, not Service, Firms. PKFs sell IC, not time.
As for measuring IC, I find the work of others in that area interesting, and have met my share of firms that offer formulas and frameworks to value IC. All fascinating, but I’m still trying to answer, “What’s the point?”
Some insist they want IC to be put on the firm’s financial statements, which will and can never happen, since accounting is designed to capture value after a transaction, not value it before hand.
You certainly could devise parallel financials for IC, but again, what’s the point? The argument is to force managers to think about it, value it, etc.
But it seems to me that this is the “What you can measure you can manage mentality,” and with IC, effectiveness is always and everywhere more important than efficiency (the latter of which is always a measurement, where the former is always a judgment).
Since value is subjective, any formula or model for IC will be flawed from the get go. Not that it’s not a worthwhile exercise, such as how Interbrand values the world’s leading brands, but it’s the illusion of accuracy and precision. I’ve seen companies pay well over IC value calculations because value is subjective.
So, I come back to what’s the point of this? What’s the service being offering by valuing IC? What’s the value of doing so? I don’t think it’s as obvious as IC folks make it out to be. As you know, I wrote an entire book, Mind Over Matter, on this topic, but didn’t try to value IC—it can’t be done with any reliability.
Thanks Doug, look forward to your thoughts.
Ron
Thanks very much, Ron.
This is exactly the kind of response I was hoping for—informed and critical. I’m slowly committing Mind Over Matter to memory, so I have deep respect for your opinions.
I have a lot of skepticism myself. I take your point about accounting being the trail of the past. I have heard the argument that by putting NPVs on assets, is bringing the future into the present, and isn’t it true that IC is exactly about the future, and that is why [we need] a breakthrough in accounting? It is supported by IASB standards on intangible assets and impairment, which also track with FASB standards 38 & 38.
But the IC side intrigues me, because so many people believe there is such a need to recognize (and quantify and monetize) your subtitle (intellectual capital is the chief source of wealth). I think this belief is even more strongly held in the wake of the debacle over people pumping up risky underpinnings (lousy mortgages, among others) into highly leveraged clouds of crap. A wealth creation engine based on human knowledge, experience, relationships, performance, and results seems like a more positive economic foundation. But how to capture, how to harness?
Thanks again for your quick and thoughtful response. One of these days I’ll buy you a beer, or a glass of your favorite wine
Cheers, and great thanks,
Doug
Hi Doug,
I understand the argument, my problem is knowledge is also a social construct—it simply cannot be quantified, tracked, and put into a formula.
There is certainly value in valuing IC for a business sale, and indeed that is what happens. This is why accountants call the sales price over the book value “goodwill"—just a word that describes their ignorance, i.e., their inability to value an enterprise, only capture it after a transaction takes place.
But even formulas for IC won’t capture the subjective value of an enterprise. How many times have you seen a company pay way above a company’s value, as assessed and computed by business valuators? It happens a lot, and that’s because value is subjective.
And no, I do not think putting NPVs on assets is bringing the future into the present. Accounting can’t do that, and even if there existed formulas, they would be full of errors and inaccuracies.
Here’s another reason: knowledge is actually about the past, whereas entrepreneurism is about the future, and you can’t capture the Black Swans of entrepreneurialism by formulas. No amount of sophisticated IC formula could have predicted, captured, or harnessed eBay or Google. It takes the
risk-taking of entrepreneurs to create new wealth. Anything we can capture, measure and harness is almost by definition about the past that is already dying.
I’ve come to the conclusion that we’ll never be able to measure IC. So what?
We know it’s there—like dark matter in the universe—but there are too many variables. It’s spiritual, not material—meaning you can’t measure it.
To believe otherwise is the materialist fallacy—that everything needs to be measured to be understood. It doesn’t work—see the USSR, Cuba, North Korea and any other communist country.
This doesn’t mean we should ignore IC, only that trying to measure and value it is futile—like plunging a ruler into an oven to determine its temperature. It’s the wrong device.
There’s lots more to say on this topic, but it does make my brain hurt.
Ron
Doug made the final salient point about IC, what Joseph Schumpeter called the Creative Destruction of capitalism:
The key point is that the value does not arise from the accounting of it, however elaborate the accounting scheme might be, but rather in the context of a marketplace that is focused on performance and results, enhanced by a skunkworks generator, etc.
VeraSage prides itself on dissenting ideas, which is why we have a “Skeptic/Dissenter” category under membership.
Greg Kyte is the self-proclaimed “Champion of the Dissenters.”
I’m proud to post his first contribution and let our readers decide for themselves the merits of his arguments. I’m sure this won’t be the last we hear from Greg.
Enjoy!
Ron Baker is Wrong
Ron Baker and his stooges at VeraSage have long tried to discredit the well established modus operandi of professional firms: Time Accounting. To do so, they use the following simplistic equation:
Revenue = People Power x Efficiency x Hourly Rate
Unfortunately for the VeraSage minions, they have been attacking a straw man. The manifestation of the formula as conjured by Mr. Baker does not accurately represent the robust nature of the hourly billing convention. Professional firms naturally augment the formula with the processes by which they calculate Hourly Rates for their personnel. Best practices for calculating the Hourly Rate element include the use of the following formula:
Hourly Rate = RABR x Experience Factor x Stupidity Factor x Biorhythm Factor x Opportunity Cost Adjustment.
Allow me to enlighten the brainwashed value pricing hoard on the components of the augmented hourly rate element.
Reputation Adjusted Base Rate (RABR). Every firm has a reputation within the context of the business community that it serves, and this reputation determines the base rate to be used as the starting point for calculating billing rates for personnel within the firm. Also, it is universally accepted that the reputation of a firm equals the quality of its service. Arthur Anderson was unquestionably the most reputable accounting firm in the world in 2000, and to this day nobody questions the quality of their work.
Experience Factor. To begin to hone the firm-wide RABR to the individual practitioner’s hourly rate, it is obvious to everyone but Ron Baker and his goons that experience is the most important factor. Without a doubt, a college graduate with a piercing analytical mind and a penchant for big picture value creation cannot deliver the same quality of service that a middle-age alcoholic in the middle of a years-long divorce and a crippling debt burden with 20 years of experience can.
Stupidity Factor. Stupid individuals should have a lower billable rate than smart people. A Stupidity Factor of 1.00 means that the individual has committed the average number of errors during the prior period. A Stupidity factor above 1.00 indicates more errors, more stupidity, and a lower billing rate. No, no wait. A lower stupidity factor means lower intelligence and more errors. No, that doesn’t seem right. A higher stupidity factor means stupider people with higher rates. Yeah, there we go.
Biorhythm Factor. I am a morning person. I work best in the morning, and I am virtually useless in the mid-afternoon. Therefore, since my efficiency and the quality of my work are higher in the morning, I bill clients 15 percent higher before lunch. I also charge a fifteen percent premium for the 20 minutes right after drinking a Diet Coke. To be fair, I also give my clients a 15 percent discount for the 20 minutes immediately following calls from my ex-wife or for any time that I happen to be hung over. For price sensitive clients, we have a partner with clinical depression and irritable bowel syndrome.
Opportunity Cost Adjustment. One of Ron Baker’s harebrained arguments against time accounting is that it does not reflect the realities of economic laws. Is there a more irrefutable economic concept than opportunity cost? Opportunity cost comes into play constantly during busy season when personnel are working odd hours. I charge an opportunity cost premium on Tuesday and Wednesday evenings because I hate missing Idol, and I give a discount on Sunday mornings just so I can have a good excuse for skipping church.
So, sorry, Ron, your simplistic revenue formula has been turned on its head. It looks like I’ve single-handedly brought VeraSage to its knees, and I sincerely hope that you can get out of the lease on the office space for your (virtual) headquarters.
You know who you are. You LEAN, six sigma, black belt, ninja turtles.
Explain to me (and the world) how any of you and your methodologies would have come up with the idea of putting a piano in the atrium of the Mayo Clinic where this could happen?
The Legatum Institute was founded by Christopher Chandler, a New Zealand billionaire. In the institute’s view, man does not live on bread along, or merely political freedom and economic growth. Thus, there are two halves to prosperity, economic competitiveness and comparative liveability, which includes freedom of choice, ethical values, good health, equality of opportunity, civil liberties, spiritual faith, low unemployment, strong family life, and a temperate climate.
As its Web site reports:
The 2009 Legatum Prosperity Index is the world’s only global assessment of wealth and wellbeing. The Index finds that the most prosperous nations in the world are not necessarily those that have only a high GDP, but are those that also have happy, healthy, and free citizens. Now in its third year, the Index builds on the previous versions with expanded data and refined analysis and assesses 104 nations covering 90 percent of the world’s population.
The top 10 countries are:
Finland
Switzerland
Sweden
Denmark
Norway
Australia
Canada
Netherlands
United States
New Zealand
Sure, it’s a bit subjective, and is unsure about how to weigh religion in the Index, but it’s interesting and worth pondering.
It adds another dimension to assessing political and economic freedom without degenerating into meaningless platitudes that you find in some “happiness” and “environmental quality” indexes.
The Supreme Court of the United States has agreed to hear the case brought by the Competitive Enterprise Institute against the Public Company Accounting Oversight Board.
VeraSage is on record as begin against this horrible law which the American Enterprise Institute estimates has sucked a cool $1 trillion from the US economy. We, therefore applaud this decision and hope peek-a-boo and SOX are struck down.
What would you think of a company that had the following characteristics and beliefs?
No official structure, organization chart, no business plan, or company strategy; no mission statement, long-term budget, fixed CEO or human resources department (don’t need a mother and father of everyone in the company); no career plans, job descriptions; no one approves reports or expense accounts, and supervision or monitoring of workers is rare indeed.
Instead of dictating [our company’s] identity, [we] let our employees shape it with their individual efforts, interests, and initiatives.
On-the-job democracy isn’t just a lofty concept, but a better way to do things. ...People are considered adults in their private lives, at the bank, at their children’s schools, with family and among friends—so why are they suddenly treated like adolescents at work? Why can’t workers be involved in choosing their own leaders? Why shouldn’t they manage themselves? Why can’t they speak up—challenge, question, share information openly?
If we have a cardinal strategy that forms the bedrock for all these practices, it may be this: Ask why. Ask it all the time, and always ask it three times in a row.
We have been known to place ads reading: “We have no opening but apply anyway. Come and talk about what you might do for us, and how we might create a position for you.”
[The company’s] Lost In Space program, assumes young recruits don’t know what they want to do with their lives. So do what you want, move where you want, go where your interests take you. At the end of year, anyone you’ve worked for can offer you a job.
Telling people that the company trusts them and then auditing them makes it impossible for them to feel secure. ...We don’t require expense accounts because of what they say about character. We’ve learned that peer control is as effective as reporting and auditing. ...Even in cases of fraud, we shun audits or policing procedures because we feel that responsibility and peer interest are stronger than any internal controls (and that was before the collapse of Arthur Andersen, the king of audits and controls!).
Most people flourish under freedom, flexibility, and responsibility. Most who have left [the company] have been managers.
No management works quite like self-management. And working at [the company] means self-managing as much as possible. It isn’t nearly as frightening as it sounds. In the end, it’s self-interest at work. It requires conceding that managers don’t—and can’t—know the best way to do everything. People who are motivated by self-interest will find solutions that no once else can envision. They see the world in their own unique way—one that others often overlook.
The world desperately needs an “Age of Wisdom,” and workplaces would be an inspiring place to start. At [the company] we have little to teach and even less to “sell” in a packaged form. We’re just a living experiment in eliminating boredom, routine, and exasperating regulations—an exploration of motivation and passion to free workers from corporate oppression. Our goal is helping people tap their ‘reservoir of talent’ and find equilibrium among love, liberty and work. ...Once people learn to do that...I know we’ll be alright.
After a speech the owner of this company gave, he was asked, “...Can you please tell us what planet you’re from?”
These beliefs defiantly challenge the conventional wisdom of management practices. I’d love for the recent author of a letter to the editor of the Journal of Accountancy to read this. If he thinks timesheets are necessary for control, he’s deluding himself.
The above forces us to challenge nearly everything we think we know about how to properly run an organization. This 50-year old company, by the way, employs 3,000 people in three countries (some of them union members); engages in manufacturing, professional services, and high-tech software; and had revenues of $160 million in 2001—up from $35 million in 1994. If you had invested $100,000 in this company 20 years ago, it would now be worth almost $6 million.
When I discuss this company in presentations, I am met with a staring ovation of disbelief. This visionary leader knew what type of future he wanted for his company, and he was willing to pay the price to achieve it.
Is this the type of firm—and leadership—you would want one of your children to work for?
If you’d like to see Ricardo Semler for yourself, watch this presentation at MIT World (about 48 minutes).
Meet a real revolutionary who doesn’t just talk about the pace of change; he creates it everyday. There’s many lessons here for professional knowledge firms.
George Gilder responds to a question regarding the idea of banning profits and utters one of the most profound statements I have ever heard - “Profit is an index of altruism.”
Still, it’s worth reading, not only for the problems with hourly billing, but also why the partnership model needs to be revamped.
Our problem with the partnership model is it’s one based on broad-consensus, and as Margaret Thatcher was fond of pointing out, “Consensus is the absence of leadership.” Combined—hourly billing and partnerships—these two factors are responsible for the lack of innovation within legal firms.
To be innovative, one needs time to think, and in the billable hour model that’s “non-billable” time, an anathema. So all of the knowledge companies that provide anywhere from 15 to 20 percent free time to work on what you want, such as Google, Gortex, 3M, aren’t emulated by PKFs because of this mentality.
This article cites a survey by the Australian Corporate Lawyers Association that found only 1 percent of corporate counsel thought hourly billing was the best approach to pricing! Then is states this:
Major law firms say the are open to different models, but that no better alternative had been proposed.
Are they kidding? Look around the rest of the business world, and you’ll discover all sorts of pricing paradigms.
This is clearly letting the perfect be the enemy of the good. The logic seems to be, since we can’t find a perfect alternative to the hell of the billable hour—which most everyone despises—we’ll stay with what we know.
The article cites a partner from a major law firm saying there are no agreed common standards for value billing. Well, duh. That’s because value is subjective, and trying to standardize it is insane.
Are they waiting for a formula, like hourly billing?
A couple of alternative firms have started-up Down Under, Optim Legal and Advent Lawyers, that operate on a fixed-price model.
Yet the problem with these models is they’re all about “lower price,” not great value to the customer.
Don’t get me wrong, I’m not against a low-cost business model, and if that’s what you want to do strategically, go for it. But my guess is most readers of this site aren’t interested in competing on price but rather value.
As one General Counsel says:
The focus for us is not on costs for costs’ sake, but on value.
Unless you want to be Wal-Mart, firms should focus on maximizing customer profit.
Loosely defined, customer profit = Value - Price. Most people don’t think about customer’s making a profit, but they surely do from every transaction, otherwise it wouldn’t take place.
In-house counsel is screaming for value, not low price.
The smart law firms know this; the dumb ones price less than even hourly billing.
From the article, “… Sarbanes-Oxley is more harm than help. In a 2007 survey of professional fraud examiners, three-quarters said institutional fraud was more prevalent than before the law was passed.”
Nothing comes from nothing; nothing ever will. - Oscar Hammerstein
Boy, is that lyric ever wrong. (Bonus points, if you can name the song without Googling it.)
Recently, I read Charles Seife intriguingly titled book, Zero: The Biography of a Dangerous Idea and while I know it was recommended to me, I
cannot recall who provided me with the recommendation. I thought it was Ron Baker, but no, he has not read it. So, in a sense, even this review comes from nothing.
In this short, but fun read, Seife traces the history of the zero from its humble beginnings as an idea, through its use as a placeholder, to its current status as the only number capable of destroying everything (including temporarily disabling the USS Yorktown on the high seas. The humble zero shook the foundations of philosophy, caused arguments, even wars, and now is beginning to play its part in understanding the very origins and substance of the universe.
While I highly recommend reading the book, I did extract a few nuggets for reading here.
First, there are at least three ways that we can prove that something comes from nothing or to express it mathematically that 0 = 1.
Proof A:
Let a = 1 and b = 1; therefore b = a.
b2 = ab, Premise 1
a2 =a2, Premise 2
a2 - b2 =a2 - ab, subtract premise 1 from premise 2
(a + b) (a - b) =a(a - b), Factor
a + b = a, Divide both sides by (a - b)
b = 0 Subtract a from both sides
Since a = 1 and b = a, therefore 0 = 1.
Proof B:
Let a = (1 - 1) + (1 - 1) + (1 - 1)… = 0
Let b = 1 + (-1 + 1) + (-1 + 1) + (-1 + 1)… = 1
The ellipses in the previous two equations indicate the infinite repetition of the parenthetical express. Therefore the two are arithmetically the same, they are just grouped differently, therefore a = b, therefore 0 = 1.
Proof C: (hat tip to Joe Santoro)
00 = 1, therefore 0 = 1.
Why is this so important? Well, because if you can prove that 0 = 1, you can then prove that 0 = anything, certainly any number. For an example of this simply replace the 1 that leads the Proof B, let b example with any whole number, fraction, or decimal number. (By the way, there are an infinite number of decimal numbers between any two whole numbers.) In short, proving that 0 = 1 is the ultimate in understanding the idea of subjective value - value is what the customer says it is.
What is fascinating about the book was learning that some of the foundational mathematical concepts that we accept today are based on this idea that 0 = 1. Calculus is based on the idea than we can compute the area of an irregular object as long as we allow our estimations to set 0 = 1. Had this been explained in this manner to me back in high school or college perhaps I would not have dreaded the course so much. I equated calculating the area under a curve to torture. Theory is important.
One last idea I had while reading this book was to create a new formula (tongue in cheek of course) for computing value. Seife clearly points out that calculating speed in the old “A train leaves New York” type word problems is not always as simple as distance = rate times time. What train moves at an absolute constant speed? Any train would begin slowly, speed up, slow down around curves and crossings, etc. It does no good to calculate speed at a constant rate, i.e., 140 mph for 3.5 hours. What was required for mathematicians was a higher degree of understanding. They achieved this through Newton’s calculus. (Remember 0 = 1.)
An example would be calculating the velocity of a falling object, which falls at 32 feet per second per second. After one second, the object is falling at 32 feet per second after two seconds it is falling 96 feet per second and so on. This is expressed as v = gt2/2 where v is velocity, g the force of gravity and t is time. As Seife puts it, “Rate times time equals distance is not a universal law; it doesn’t apply under all conditions.”
Look at the last sentence again and replace the word distance with value. See where I am going. Imagine a formula for a professional firm using the “falling object” model (which, by the way, while still wrong, is less wrong than value = rate x hours). It would look something like this — value = rate x hours2/2. Picture explaining this to a customer, “Well we bill you $150 for the first hour, than $300 for the second, $675 for the third, etc., since we spent a total of ten hours on your matter, our bill comes to $7,500, any questions.”
Again, while still wrong, the above is less wrong. What is needed is for professionals to make the leap that 0 = 1 (that value is subjective). VeraSage has been sounding the alarm on this for years. Dare I say Ron Baker = Issac Newton.
We now have the math! Worshipers of the ABH give up! We have proven you wrong again, this time with your own beloved mathematical formulae.
Yesterday, the United States government agreed in principle to provide almost $8 trillion on behalf of American taxpayers. The complete story is available on Bloomberg and various other sources. The amount is more than one-half of the value of everything produced in United States last year alone.
The question of who is going to pay is settled. The citizens of the US are. This agreement is tantamount to repealing the Thirteenth Amendment to the United States Constitution which reads in part, “Neither slavery, nor involuntary servitude, except as a punishment for a crime...shall exist within the United States.”
If you think this is extreme consider this question, can I opt out of contributing without being put in prison? The answer of course is, no!
As a reminder the $8 trillion mentioned above does not include the unfunded liability for Medicare, Medicaid and Social Security. Our lives and our fortunes have been pledged to the government. We, in the United States, are all slaves.
For those of you, like me, out there with little financial understanding, I submit this quick video which helped me understand the concept of collateralized debt obligations or CDOs. It is my understanding that mortgage-backed securities (MBS) are at the heart of the trouble we are seeing.
If those of you with a better understanding of this topic have thoughts on this, I would love to hear about them.
RSS Feed
Comments | 0 Trackbacks | Permalink | Ask VeraSage? Economics Knowledge Workers On the Edge Debits Don't Equal Credits Choose an Industry: Accounting Advertising Consulting Law Other Technology