Theoretical Foundation Of Intellectual Capital

Published Date: 02 Nov 2017

Introduction

Lester Throw in his book "THE FUTURE OF CAPITALISM" mentioned that the era of brain power industries is causing a fundamental shake up in classical capitalism, because strategic assets are now the brains of employees."

With the competition getting even more serious management studies have evolved and proposed various theories and approaches to describe its multifaceted characteristics. One of this is the concept of intellectual capital (IC) which is a result of the fact anything that is measurable is achievable. Since the inception of economical studies capital, labour and land are considered to be the foundational assets of any economy. But due to globalization and enhancement of science, a new production system has evolved which is driven by knowledge, skills and technology. In this new economic system, intangibles have somehow gained ground as an eminent resource. Eventually gaining importance with researchers as well, this form of intangible capital has received a nomenclature called "Intellectual Capital". Ultimately ushers an area to research over its detailed relevance in implementation.

IC Perspectives by Researchers

The concept of Intellectual Capital first evolved in Japan when Hiroyuki Itarni studied the effect of invisible assets on the management of Japanese corporations. The concept then was eventually studied and taken forward by many researchers. Simchon (2005) defined IC as non- tangible or non-physical assets and resources of a firm, its practices, patents and the aggregate knowledge present with its members and their network of partners and contracts. In order to make conceptual separation and the concept more understandable, Dean and Krestschmer (2007) made evident as how each aspect related to IC distributes and accumulates information and knowledge differently through its various channels like organizational processes and structures, IT systems, individuals & networks and organizational technological knowledge. This particular view leads to explaining the concept through its credibility view or its usefulness of the same in an organization. Thomas Stewart, an ex editor of business magazine "Fortune" describes IC as "something that cannot be touched, although it slowly makes you rich". Then Jacob Ben- Stewart (1997) defines it as ‘packaged useful knowledge’ and Sullivan (2000) as ‘knowledge that can be converted into profit’. To add, Roos et al defined IC (1997) as the ‘sum of knowledge’ embedded in brands trademarks and processes.

Finally, comprehensive models of IC were proposed which suggested the IC components and its benefits to the organization. One of such was proposed by Saint- Onge, H. (1996) that divides the concept of intellectual capital into three facets: Human capital, Structural capital and Customer capital. A slight alternative of this model was developed by Dr. Nick Bontis who re-defines customer capital as relational capital that included knowledge entrenched in relationships with supplier base also. The elements of IC tried to lay platform which could add to the technique of measuring intellectual capital. Human capital is described as human resource inside the organization. It is recognized as competency, collective knowledge, skills, experience, talents, innovative ability & capacity, individual values & attitudes, aptitudes & know-how of the people within an organization (Subramaniam and Youndt, 2005). Structural capital is the scaffolding infrastructure for human capital, which remains with the organization when the employees leave at the end of the day. Unlike human capital, it is the property of a company and can be reproduced, traded and shared by and within, the organization. Relational capital is a company’s long term relationship with its customers and with its suppliers, strategic partners and shareholder networks and value of these assets is determined by the company’s reputation or image.

Another popular model for classifying intellectual capital(IC) was put forward by Malone and Edvinsson (1997) who defined IC as "possession of knowledge, applied experience, organizational technology, customer relations and professional skills that provide a company with a competitive edge in the market". According to this model, intellectual capital is constructed at two-levels: human capital and structural capital (refer to Appendix 2, figure 1). Further structural capital is divided into organizational capital and customer capital. So, from a sociological point of view, this customer capital encompasses all external relationships which can also be stated as "social capital" (Nahapiet and Ghoshal, 1998; Subramanian and Youndt, 2005). Human capital and structural capital is similar to that of Saint- Onge model i.e. the knowledge created by & stored in firm’s employees and the embodiment, empowerment & supportive infrastructure of human capital respectively. While organizational capital relates to new knowledge that is created by and stored in a firm’s information technology systems & processes, the customer capital is value of relationships between the firm and its customers.

According to Haanes and lowenghahl (1997) and Sveiby (1997) perspective of IC, resources of any company can be divided into tangible and intangible resources (Refer to Appendix 2; figure 2). In this model, intangible resources refer to intellectual capital of the company. These resources could be the competencies it has or the relations a business has with the outer world.(Sveiby 1997) Competence resources comprises of the ability to perform a given task. It is of individual and organizational or collective. Figure 3 (Appendix 2) highlights the various types of competency resources which contribute to intellectual capital. A relational resource includes the overall reputation of the company. Besides it focuses upon the relationship of the company with its clients, employees, potential employees, competitors and suppliers. For example, the relationship resource for an organization working on referrals like that of Amway shall be people dependent while in case of a marketing organization like that of ITC shall be organization dependent.

Another perspective is of Danish Confederation of Trade unit (1998) which speaks of three major components of measuring intellectual capital; People, System and the Market. (Refer Appendix 2; figure 4)

The People includes total ambience that employees face and various factors that affect them. These comprise of extent of motivation in terms of formal policies or informal practices, the culture, the education and training imparted to them and initiatives taken towards their holistic development.

The System: - it is the knowledge available in the company in various forms.

The Market: - It consists of relations between the companies with its outsiders.

Intellectual capital has thus portrayed in a huge way, the importance of considering human element and also respects the knowledge factor, which ultimately adds to the capital of any organization. Enterprises, that manage their intellectual capital better, can achieve stronger competitive advantage than the enterprises which do not (Borneman et. al.). Also it has been reported that companies which strengthen their intellectual capital through expert management aptitude as compared to the others, showed better performance. It proves that IC plays an important role in long term business performance of an enterprise (Brennan and Connell , 2000).

Measuring Intellectual Capital

The approaches for measuring intellectual capital are categorized into indirect methods, direct intellectual capital (DIC) methods, and scorecard (SC) methods (Luthy 1998 & Williams 2000). The indirect methods adopt the rate of return method and the market capitalization method. Indirect methods are financial measures of evaluating intellectual capital. Only disadvantage of measuring IC this way is that, by translating everything into money terms can seem superficial. However, these methods are extremely useful for investors to assess the value of the intellectual capital of the companies in which they are investing. On the other hand, direct intellectual capital methods are based on an estimation of the monetary value of intangible capital by identifying its various components. Identification of the various components is cumbersome and is purely an internal affair of the company. Scorecard methods are usually reported in scorecards or as graphs. They are very similar to the direct intellectual capital methods, except that they do not seek to measure and present monetary value of the intangible capital. Some of these methods are illustrated below:

M/B Ratio

The M/B ratio assumes that a company’s approximate worth i.e. tangible capital plus intangible capital is indicated by its market value. Therefore, the difference between the book value shown on the company’s balance sheet and the market value gives an approximate measure of the intellectual capital.

M/B Ratio = Market Value/Book Value

Intellectual Capital = Market Value – Book Value

Tobin’s Q Ratio

Tobin’s Q uses replacement cost of tangible capital, rather than book value of tangible capital, in the calculation. The theory is that if Q is greater than one and greater than competitors’ Q, then the company has the ability to produce higher profits than other similar companies. The company has something intangible—intellectual capital—that gives it an advantage. The difference between the market value and the replacement cost of tangible capital represents the value of intellectual capital.

Q Ratio = Market Value/Replacement Cost of Asset

Intellectual Capital = Market Value – Replacement Cost of Tangible Capital

Market Value Added

Market Value Added (MVA) illustrates the difference between market value of a company and the capital that investors have entrusted to it over the years, in the form of loans, retained earnings and paid-up capital. As such, MVA is a difference between "cash in’ i.e. contribution that investors have made and ‘cash out’ i.e. income generated by selling at current prices. If MVA is positive, it means that the company has increased the value of the capital entrusted to it and has thus, created shareholder wealth. If MVA is negative, the company has destroyed wealth. MVA is also used as a way of benchmarking market performance between companies.

MVA = Intellectual Capital = Market Value – Book Value

Economic Value Added

As defined by Stern Stewart, Economic Value Added (EVA) is the difference between a company’s Net Operating Profit after Taxes (NOPAT) and its Cost of Capital (C) of both equity and debt (Chen and Dodd, 2001). EVA is essentially the surplus left after making an appropriate change for the capital employed (IC) in the business. It may be calculated in any of the following ways:

EVA = NOPAT – (C * IC)

Since R = NOPAT/IC, EVA can also be expressed as:

EVA = (R – C) * IC

Where, R is the return on invested capital. In order to have positive EVA, an organization’s rate of return on capital must exceed its required rate of return.

VAIC

Value Added Intellectual Coefficient (VAIC) as proposed by Ante Pulic (1998) is an analytical tool designed to enable the management, shareholders and other stakeholders to examine and appraise the efficiency of value addition achieved in a firm by using the firm’s resources. The computation of VAIC can be explained as follows.

Important terms used in VAIC are:

Value Added (VA): The value added indicator is measured in monetary units. It is the difference between the output (OUT) and input (IN) and represents the value created by the organization during a year. Thus,

VA = OUT – IN, where

Output (OUT): Output has been defined as total income or total revenue generated by an organization during the year by selling goods or services

Input (IN): Input has been defined as the costs that are incurred by the organization towards purchase of inputs for business operations. All expenditure related to human resources – such as employees’ compensation and expenses on training and development etc - would be excluded from the ‘input’ for the simple reason that it would be treated as investment i.e. human capital and not a cost.

Value added can be calculated from the bank accounts also as follows:

VA = TOI - TOE + PE

Where:

VA = Total Operating Income (TOI) - Total Operating Expense (TOE) + Personnel Expenses (PE), where:

TOI = Interest Income - Interest Expense = Net Interest Revenue + Net Commission Revenue + Net Trading Revenue + Other Operating Income = TOI

TOE = Personnel Expenses + Other Administrative Expenses + Other Operating Expenses + Loan Loss Provisions = TOE

Human Capital (HC): Human capital is one of the most important components of intellectual capital. It covers all expenditure on employees’ compensation and development. The value-added approach regards employees as a key resource who invests their knowledge, skills and intellect in managing the organization and creating wealth; hence the expenditure on employees is considered as an investment or human capital.

Structural Capital (SC): In Pulic’s (1998) VAIC model, Structural Capital is obtained by deducting human capital from the value added.

Capital Employed (CE): It includes the net physical and material assets of the organization employed for attaining financial goals.

Three main ratios are required for calculation of VAIC:

Human Capital Efficiency (HCE): It is a ratio of VA to HC. This ratio gives the contribution made by every unit of money invested in HC to the VA in the organization. It is an indicator of value added efficiency of human capital. Hence,

HCE = VA/HC

Capital Employed Efficiency (CEE): It is a ratio of VA to CE; this ratio shows the contribution made by every unit of CE to the VA in the organization. It is an indicator of value added efficiency of capital employed. CE is equals to book value of the net assets for a company. Therefore,

CEE = VA/CE

Structural Capital Efficiency (SCE): It is the ratio of SC to VA. It is an indicator of value added efficiency of structural capital. Thus,

SCE = SC/ VA

Value Added Intellectual Coefficient (VAIC): VAIC is the sum total of the three ratios calculated above, i.e. the sum of the HCE, SCE and CEE, and indicates the intellectual capability of the organization. Accordingly,

VAIC = HCE + CEE+ SCE

Comparison of VAIC score of public and private sector bank in India

Banking sector is one of the most crucial sectors in any economy and its vitality enhances manifolds when developing economy is considered. Unlike the manufacturing sector where there are many indices of true business performance like plant, machinery etc, banking sector is completely dependent upon its intellectual capital and to be precise, it’s human and customer capital. Hence the survival of banking sector is totally dependent upon the efficient utilization of its intellectual capital. This research studies the intellectual capital evaluation for public and private sector banks, to identify the effectiveness of elements of intellectual capital and highlight the areas where banks need to improve.

Sample Banks under Study

A total of twenty banks - 10 top banks from PSU and 10 top banks from private sector - were selected on the basis of banks’ total assets as of March 2012. The period of the study is from 2008 to 2012.

Study is based upon the secondary data. The data has been acquired from the financial statements of the banks. Further the VIAC score and other ratios were calculated from the balance sheets and profit and loss accounts of the banks.

Private Sector Banks:

ICICI Bank, HDFC Bank, Axis Bank, Yes Bank, Federal Bank, Kotak Mahindra bank, J & K Bank, IndusInd Bank, ING Vysya Bank and South Indian Bank. (Refer Appendix 1; Table 1)

Public Sector Banks:

State Bank of India, Punjab National Bank, Bank of Baroda, Bank of India, Canara Bank, IDBI BANK Bank, Union Bank of India, Central Bank of India, Oriental Bank of Commerce, Allahabad Bank. (Refer Appendix 1; Table 2)

It has been rightly stated that human capital, intellectual material, knowledge and experience can be used effectively for creation of wealth or value for the achievement of organizational objectives. But can such intangibles work in isolation, without some contribution or support of tangible assets? In other words, taking the example of banks, human capital or executives of a bank cannot function efficiently without the branch infrastructure, new form of technology etc. Since value created by an organization would depend on the efficiency with which both intellectual and tangible resources have been used, the Value Added Intellectual Coefficient (VAIC) becomes a useful and potent tool to measure and evaluate the performance of business organizations, particularly service organizations like banks.

VAIC Analysis

VAIC score of the sample banks for the past five years was calculated and their grand average is further calculated to know their total intellectual capital efficiency at present. Also average HEC, SCE and CEE for chosen timeline was computed to identify the areas where these banks lack. Percentile and ranks for average HCE, SCE, CEE and VAIC has been calculated in order to identify the excelling dimensions of the sample banks.

Following are the resulting observations based on annual average VAIC scores (Refer Appendix 1; Table 3, 4, 5 & 6 :

It is evident from tables 3 and 4 that average VAIC score of five years is higher for private sector banks than that of Public sector banks. But in contrast the previous study in 2011, the rate of growth of efficiency score for public sector banks (12%) is higher than that of private sector banks (8.8%). This implies that public sector banks have improved upon the efficiency of their intellectual capital employed more than that of private sector banks.

Axis bank has consistently shown a commendable VAIC score since past five years. Though the trend has been fluctuating in its case, but a dip has been observed in its value since 2008 to 2012. This implies that the efficiency of intellectual capital of the bank was higher in past years but due to some reason it has dropped through the years. Similar is the case with ICICI bank.

Punjab national bank has the maximum VAIC score and is competitive to the top performers of public sector banks which denote better efficiency of the employed intellectual capital by the bank as compared to its competitors in same sector. Besides it has shown a relatively higher VAIC score as compared to its competitors since 2008.

Yes bank (30%) has shown the maximum growth of VAIC score since past 5 years amongst all the banks and is followed by Kotak Mahindra Bank (34.9%) and IndusInd Bank (32%). Amongst the public sector banks Bank of baroda (30%) has shown steeper growth as compared to other public sector banks.

On the other hand J&K bank (-12.5%) has shown the steepest dip in its VAIC score through the five years followed by Union Bank of India (11%) amongst the public sector banks.

It is evidently observed that percentage rise of average VAIC from 2008 to 2012 is much higher in case of private sector banks (8.82%) than in public sector banks (2.5%). This implies that the awareness and importance of optimum utilization of the various components of Intellectual capital is quite higher with private sector banks than in public sector banks.

Further from chart 1 and table 3 & 4, it is observed that 2008-10 witnessed the steep increase of VAIC score of both public and private sector banks. This was the recessionary time in the market and banks seem to have focussed on more of value addition in anything and everything employed in the business.

Further from table 5 and 6 it is evident that Axis bank leads the race of being most efficient with the employability of its intellectual capital. The trend is followed by Yes bank and ICICI bank at rank 2nd and 3rd. Punjab national bank is on the top rank w.r.t. its competitors in public sector banks while relatively it is on 4th rank.

Except for the rank 4, first 6 ranks are with private sector banks, thus reiterating the fact that value addition by the components of intellectual capital is much more in private sector banks than in public sector banks.

ING VYASA bank and Central Bank of India has poor performers amongst the group. Moreover Central Bank of India is showing greater dip in its VAIC score i.e. -2.03%, since past five years as compared to that of -0.3% of ING VYASA bank. Thus central bank of India needs to address this issue immediately in order to gain true value addition by its intellectual capital.

Following are the resulting observations based on annual average VAIC scores (Refer Appendix 1; Table 7& 8):

Banks are part of service industry where the primary resource remains the employee skills and their contribution is evident from its higher HCE score as compared to SCE and CEE score.

Axis bank expectedly shows the best value addition through its human capital from its highest HCE score and is followed by ICICI bank and YES bank with 2nd and 3rd rank respectively.

Correlation between HCE and VAIC is computed to be highly positive i.e. 0.94, which explains that for better overall value addition through the intellectual capital, emphasis over better value addition through human capital is necessary. It also explains the reason behind similar ranks of HCE and VAIC of top performers like Axis Bank, ICICI bank and Yes bank.

A poor show by SBI on the HCE and SCE scores only goes to highlight that even the oldest and largest banks could suffer in the long run if they don’t manage their human and intellectual capital efficiently

Central bank of India is equally poor in its HCE score but is most efficient in value addition through capital employed.

PNB with its high SCE and CEE score is average on HCE where it needs to improve.

While the overall top performers like Axis Bank and ICICI bank as per VAIC, seem to pay very less importance to CEE.

As far as SCE is concerned, private sector banks are performing better than public sector banks while public sector banks are ahead in CEE.

Yes Bank shows a consistently better performance, as compared to all in sample, in HCE, SCE and CEE, where it ranks 3rd in all the three efficiency measures.

Discussion & Conclusion

The results clearly shows that private sector banks realize, the performance of service industry like theirs depend upon its human capital while other capitals are necessary as supportive elements to enhance the efficiency of human capital. The competitive strategy outlined by Mr. Rana Kapoor, Co-founder and CEO of Yes Bank, not only highlights the paramount significance of the intellectual capital, particularly human and structural capital, but also sums up the mind of the private sector banks in India: "Our dream to be the best quality bank is an uncompromising objective. Quality is a sigma - summation of everything we do – the quality of management teams, human capital, systems, underlying processes and procedures and controls that go with that, six sigma processes, quality of our client base, our portfolio, efficiency of cost structures, service delivery which should be superior and consistent experience, the quality of our brand that should be a trust mark and speak for the quality itself." The bank is making heavy investments in human capital, which is evident from the fact that as many as 50% of its employees are MBAs or specialist postgraduates. It also has a younger ready-to fight workforce, with 83% of its employees being less than 30 years’ old (Business India, Feb 19, 2012). The words are well supported by the statistical data computed above.

Similar has been the story of PNB where KR Kamath, CMD PNB explicitly stated that bank’s focus is on building talent to optimize the use of new technology adopted. Therefore, achieving higher productivity by improving employee contribution and performance management; recruitment, talent retention in all cadres, succession planning; and providing adequate training to reduce skill gaps in view of large infusion of technology and large scale retirement of people are the major concern areas for the bank. The Team 2020 program is launched at identifying and grooming potential future leaders where they propose to utilize young officers in key positions in the areas of credit, risk management, treasury, international banking, HR, marketing and IT (People Matters, November 10,2012,Cover story)

While PSU banks have to make efforts to improve the efficiency of human and structural capital, private sector banks need to work at enhancing the efficiency of capital employed. A significant reason for the higher efficiency of capital employed in PSU banks might be the fact that most of them have been in existence for a long period and have depreciated much of their fixed assets. The private sector banks are relatively of recent origin and as their fixed assets get depreciated over time, the efficiency of capital employed might to some extent automatically improve.

Since banking is a service industry what matters is the performance w.r.t human capital and customer capital. Thus for all the banks to improve upon its service performance, it is essential that they could employ the investment made in human resource and customer base judiciously and hence value its intellectual capital.