Effects of Intangible Assets on Organizational Financial Performance: An Analytical Framework Chaichan Chareonsuk and Chuvej Chansa-ngavej * School of Management SIU International University 1010 Viphavadi-Rangsit Road Chatuchak Bangkok 10900, Thailand * Corresponding author s e-mail: chuvej@shinawatra.ac.th Abstract: This paper proposes a framework for the analysis of the cause-and-effect relationships between the financial performance of an organization and the intangible assets of the various functional departments in the organization. It is intriguing to note the similarity of this framework with the strategy map concept in the Balanced Scorecard approach. As is well-known, the Balanced Scorecard contains four basic elements: financial, customer value proposition, internal process, and organizational learning and growth. Each element is owned and performed by the different functional departments within the organization. Intangible assets are defined as non-financial assets without physical substance. Examples of these are customer loyalty, brand names, computer software, recipes, formulas, designs, patents, product developments, and corporate cultures. While conventional accounting treats tangible assets as assets, the investment in intangible assets is normally regarded as operating costs and expenses, rather than as long-term investment. For short-term strategies, profit and loss figures are normally used as the main financial performance indicators in the balance sheets and financial reports. On the other hand, there are currently no indicators to guide management in establishing long term strategies regarding intangible assets. Intangible assets may provide future benefits and competitive advantage for the organization when they are properly monitored and better-managed. An empirical approach based on structural equation modeling, also known as covariance structure analysis, to establish the cause-and-effect relationships in the proposed framework is also discussed. Keywords: Intangible assets, performance evaluation, Balanced Scorecard, Structural Equation Modeling 1. INTRODUCTION Traditionally, profit and loss figures are normally used as the main financial performance indicators in the balance sheets and financial reports for the short term strategies. The financial report is the outcome of actions previously taken. Profit (or loss) is derived from the financial difference between sales revenue and operation cost. The cost includes the expenses in brand building, customer database, training, product development, etc. These are treated in the operation cost and marketing expenses. However, the cause and effect relationships between marketing, production and human resource and financial performance have not so far been operationally examined and empirically quantified. Epstein and Mirza (2005) defined the intangible assets as non-financial assets without physical substance that are held for use in the production or supply of goods or services or for rental to others, or for administrative purposes, which are identifiable and are controlled by the enterprise as a result of past events, and from which future economic benefits are expected to flow. There are a whole range of possible classes of intangibles, such as brand names, mastheads and publishing titles, computer software, licenses and franchises, copyrights, patents and other industrial property rights, recipes, formulas, models, designs and prototypes, and intangible assets under development. Intangible assets are continuously growing in significance. In 1978, intangible assets were determined to constitute only 5% of all assets, while they become 78% of all assets today. Some public and private sector organizations do not attempt to incorporate the value of intangible assets. Chareonsuk and Chansa-ngavej (2006) studied the impact of intangible assets and business performance of the public-listed companies in Stock Exchange of Thailand (SET). From the study, there is a statistically significant relationship between intangible assets and business performance of the firms. It appears that management reporting and financial statements would tend to give an incomplete picture as a tool supporting meaningful decision making. Forward-thinking management has to ensure that intangible assets are measured, monitored, built, and leveraged. Financial profit alone could not guarantee the long term survival of companies. To be sustainable, companies need to depend also on other intangible factors, including organizational learning and growth, internal process efficiency and customer value proposition.
The Balanced Scorecard Strategy Map may be used to provide a framework to illustrate how strategy links intangible assets to value creating processes. The objectives in the four perspectives are linked together by cause and effect relationships. The company builds the core competence and training to support the internal process. The internal process creates and delivers the customer value proposition. When the customers are satisfied, the sales and profit are delivered in terms of financial performance. Modern management style has been changed in response to the global competition. The industrial age management has been replaced by the knowledge age leadership, with corresponding transformational effects on the economy and workplace (see Figure 1). The focusing on tangible assets in the industrial age has been changed to the monitoring of intangible assets in the knowledge age. As a consequence, issues concerning intangible assets are now more widely researched and practiced. Industrial Age Production Driven Functional Tangible Assets Top Down Management Knowledge Age Customer Driven Process (Integrated) Intangible Assets Bottom Up Leadership Figure 1 Development of management style Each company is composed of several functional departments. Each functional department has different tasks and is involved with different intangible assets. When the company can monitor and identify the relationships between intangible assets and the financial performance, the company can manage them and set both short term and long term strategies. This paper proposes a framework for an empirical analysis of the cause-and-effect relationships between the financial performance of an organization and the intangible assets of the various functional departments in the organization. Based on this framework, empirical results from survey questionnaires may be used as inputs to the Structural Equation Modeling (SEM) computer program to assess the reliability and validity of the relevant measurement scores and to test the cause-and-effect relationship hypothesis. As asserted by Byrne (1998), SEM is a statistical methodology that takes a confirmatory (i.e. hypothesis-testing) approach to the multivariate analysis of a structural theory bearing some phenomenon. SEM involves describing and testing causal relations among latent variables and can provide a comprehensive means for assessing and modifying theoretical models. Instead of testing the hypothesized relationships one by one, all the relationships among the model are tested simultaneously. 2. LITERATURE REVIEW There have been a large number of researches in intangible assets during the last decade (see Figure 2). Intangible assets are involved in the customers, external structure, human resources, and internal process. The intangible assets are defined as non-financial assets without physical substance that are held for use in the production or supply of goods or services or for rental to others, or for administrative purpose (Epstein and Mirza, 2005). Intangible assets are identifiable and controlled by the enterprise as a result of past events, and from which future economic benefits are expected to flow. Epstein & Mirza Non-financial assets without physical substance Kaplan & Norton Lev Intangible is the future benefits 1992 1990 Guilding & Pike Value Creator Marketing asset Value Manifestation Competitive Advantage Hunter et al. Human capital Intellectual capital Organization capital Customer capital 2001 2000 Bontis et al. Human capital effect to 1997 company performance Mortensen et al. Sveiby Innovation capital Structural capital Contract Market capital Goodwill 2005 2004 2006 Wingren Financial & expectation Customer Internal process Learning & Growth Internal structure External structure Competence structure Rajan Customer relationship Edvinsson & Malone Organization capital Customer capital Human capital Roos et al. Intellectual Capital BALANCED SCORECARD Figure 2 Development of researches on intangible assets
Several researchers have variously attempted to categorize intangible assets as summarized in Table 1. Table 1 Comparison of the intangible assets literature Kaplan & Norton (1992) Sveiby (1997) Edvinsson & Malone (1997) Roos et al. (1997) Wingren (2004) Balanced Scorecard Intangible Assets Monitor Skandia Value Scheme Intellectual Capital Balanced Scorecard with Intellectual Capital Financial Financial & expectation Customer External structure Customer capital Customer Structural capital Internal processes Internal structure Organizational capital Internal process Learning & growth Competence structure Human capital Human Capital Learning & growth When the intangible assets are addressed and defined, there are four approaches that could be used to measure the intangible assets (Luthy, 1998) 1. Direct Intellectual Capital method (DIC) Estimate the value of intangible assets by identifying its various components. Once these components are identified, they can be directly evaluated, either individually or as an aggregated coefficient. 2. Market Capitalization Method (MCM) Calculate the difference between a company s market capitalization and its stockholders equity as the value of the intellectual capital or intangible assets 3. Return on Asset method (ROA) Average pre-tax earnings of a company for a period of time are divided by the average tangible assets of the company. The result is a company ROA that is then compared with its industry average. The difference is multiplied by the company s average tangible assets to calculate an average annual earning from the intangible. Dividing the above average earnings by the company s average cost of capital or an interest rate once can derive an estimate of the value of its intangible assets or intellectual capital 4. Balanced Scorecard method (BSC) The various components of intangible assets or intellectual capitals are identified and indicated. Indices are generated and reported in scorecards or graphs. Wingren (2004) has chosen to use the BSC concept because BSC contains outcome measures and the performance driver of outcomes, linked together in cause and effect relationships. There are linkages and relationships between customer, internal process and learning/growth with financial performance. The financial performance is the outcome and visible to the observers. Among the above four approaches, the Balanced Scorecard introduced by Kaplan and Norton (1992) is the most well-known, although as discussed by Mouritsen et al. (2005) its original intent was not meant to be the measure for intangible assets. The Balanced Scorecard was intended as a tool to link financial performance with non-financial performance dimensions: learning and growth, internal process and customer perspectives. It acts as a measurement system, a strategic management system, and a communication tool. The concept of cause and effect separates the Balanced Scorecard from other performance management systems. The measures appearing on the Scorecard should be linked together in a series of cause and effect relationships to tell the organization s strategic story. For example, increasing promotional expenses will lead to the increase in brand value. Increased brand value will lead to higher sales revenue. Likewise, the investment of human capital will create the continuous learning and growth in the organization. When the employees have more experience and knowledge, they can create the internal process which serves and fulfills customer satisfaction. The profit and revenue are the final outcomes of this causal chain. The intangible assets are very much a part in the Balanced Scorecard. The intangible assets are linked mainly to the marketing and human resources. By using the Intangible Assets Monitor presented by Sveiby (1997). The intangible assets can be classified into three common types: 1. Employee Competence The employee competence is the capacity of employee to act in wide variety of situations. Employee is the most valuable asset of the company in the highly competitive market. It is the only one asset that creates uniqueness to the company and differentiates the company from the competitors. Sveiby (1997) emphasized employee capability as a key asset for organization growth. Employee satisfaction refers primarily to job and what they perceive it as offering. Employee satisfaction related positively to organizational commitment. Huselid (1999) and Hand (1998) have reported the existence of a positive and significant relationship between investments in human resources and the market value of companies. Bontis et al. (2000) found that human capital has positive effect to customer retention and loyalty regardless of industry type. Hitt et al. (2001) found that human capital has a positive effect on performance. Also, human capital is
shown to have moderate cause and effect relationship with strategy and firm performance. Moon and Kym (2006) confirmed that the human capital, structural capital and relational capital have direct impact on intellectual capital. 2. Internal Structure The internal structure includes patents, concepts, models, information technology systems, administrative systems and organization culture (Aaker, 1991). The leading companies; such as GE, Sony, IBM or Ford, are used to cover a wide variety of products, but could not sustain all product lines, thus changing to selective products, while improving the intangible factors, quality and innovation. Deng et al. (1999) suggested that patent attributes are statistically associated with stock return and market to book ratio. 3. External Structure The external structure includes relationship with customers and suppliers. The Balanced Scorecard is concerned only with customer value proposition. But, the external structure covers supplier. The external structure also encompasses brand-names, trademarks, customer satisfaction and the company s reputation or goodwill. Ittner and Larcker (2000) found a positive but non-linear relation between measures of customer satisfaction and financial performance. Moreover, customer satisfaction has significantly associated with positive stock return. Barth et al. (1998) and Seethamaju (2000) mentioned that brands have significant correlations with firm s market values. The customer is the key success in the business. Rajan (2006) reported that today intangibles, such as customer relationships, account for more than half of total assets of the firms in the United States. By using the categories developed by Sveiby (1997), Shaikh (2004) reviewed and classified the intangible assets in internal structure, external structure and employee competence as shown in Table 2. Internal structure External structure Employee competence Table 2 Framework of intellectual capital indicators Intellectual property Infrastructure assets Brands Customers/Customer loyalty Company name/distribution channel/business collaborations/market information used to capture and retain customers Customer satisfaction Know-how Education Work-related knowledge Work-related competencies Patents Copyrights Trademarks Management philosophy Corporate culture Management processes Information systems Networking systems Financial relations Whereas all organizations attempt to develop their people, technology, and culture, they do not always align these intangible assets with their strategies. The Balanced Scorecard strategy map enables executives to pinpoint the specific human, information, and organization capital required by the strategy. Draft (2001) reviewed three types of organization structure, namely functional, divisional, and matrix structure. In the functional structure, which is the most well-known, business activities are grouped together by common functions from the bottom to the top. The divisional structure is organized according to individual products or services. To be effective, the organizational design has to fit in with the policy deployment strategy. The following are three key components to be considered in the process of defining organization structure: 1) Organization structure designates formal reporting relationships, including the number of levels in the hierarchy and the span of control of managers and supervisors. 2) Organization structure identifies the grouping together of individuals into department and of departments into the total organization. 3) Organization structure includes the design of systems to ensure effective communication, coordination, and integration of effort across department. In the post-world War II period, all functions attempted to support the production in order to produce as much product quantity as possible with the lowest cost. Neither product development nor brand establishing was the main concern. During the last decade, however, the concept of organization has been transformed as shown in Table 3.
Table 3 Role profile in the past and present Functional Industrial focused Knowledge focused Director Managerial skill Leadership skill Purchasing Lowest cost Partnership, Vendor Managed Inventory R&D OEM(Original Equipment Manufacturer) Own design/technology Production Cost reduction Productivity Marketing Product Oriented Brand image, Customer relationship Warehouse Logistics Supply Chain Human Resource Pay roll, controller Employee asset When the organization is set, the performance evaluation and monitoring can then be addressed and implemented using appropriate performance indicators. The indicators ensure that the company has the right skill and know-how and align with organization goals. Effective employee competence measure helps company sustain growth and adapt to changes in the dynamic environment. In examining the cause-and-effect relationship by Structural Equation Modeling (SEM), it is noted that: 1. The causal processes under study are represented by a series of structural equations 2. The structural relations can be modeled pictorially to enable a clearer conceptualization of the theory under study. The hypothesized model can be statistically tested in a simultaneous analysis of the entire system of variables to determine the extent to which it is consistent with the data. If goodness-of-fit is adequate, the model argues for the plausibility of postulated relations among variables; otherwise, the tenability of such relations is rejected. Byrne (1998) discussed several aspects of SEM that set it apart from the older generation of multivariate procedures: 1. SEM lends itself well to the analysis of data for inferential purpose. 2. SEM provides explicit estimates of these parameters. 3. SEM procedures can incorporate both unobserved (i.e. latent) and observed variables. Kline (1998) observed that computer programs are important tools for the conduct of SEM. There are many programs available, such as LISREL, AMOS, CALIS, EQS, LISCOMP, RAMONA, and SEPATH. 3. DEVELOPMENT OF THE CAUSE-AND-EFFECT FRAMEWORK There are many intangible assets in the organization. To manage and prioritize intangible assets is significant for the company vision and mission. This research sets the guideline in establishing the cause and effect relationships of intangible assets in each function (see Figure 3). Step 1 : Review Vision and Mission of the company Step 2: Identify the role profile each function Step 3 : Identify the intangible assets in each function Step 4 : Establish cause-and-effect relationship framework Figure 3 Intangible assets identification process Step 1: Review the vision and mission of the company Vision and mission set the objective and direction of the company based on the SWOT (Strength, Weakness, Opportunity and Threat) analysis. Processes in the Balanced Scorecard have to be aligned with the vision and mission of company. All activities in the company have to serve the vision/mission in order to bring the company forward in the intended direction. Step 2: Identify the role profile each function Regarding the three types of organization that were reviewed by Draft (2001), most public companies in the Stock Exchange of Thailand (SET) are found to be organized using the functional structure, which is grouping the common business activities together, for example, purchasing, R&D, financial, production, and marketing (see Table 4).
Table 4 Organization structure of registered companies in Stock Exchange of Thailand (SET) Cluster Type of Agro & food Consumer Financial Industrial Property & Resources Service Technology Structure industry Product Construction Functional x x x x x x Structure Division Structure x x From our previous survey of public companies in SET (Chareonsuk and Chansa-ngavej, 2006), the functional structure commonly found in Thailand is shown in Figure 4. The exceptions are the Financial and Service clusters, which are organized using divisional structure because there are typically many different kinds of services, as shown in Figure 5. Managing Director Production Marketing Financial Administration/ General Affair Warehouse/ Logistics Research and Development Human Resources Purchasing Figure 4 An example of functional structure of a company in SET Managing Director Marketing and Communication Operation Group Human Resource Risk Management Group Business Center group Financial Management Group Corporate Banking group Asset Management Group Government & State Enterprise Relation Group Products and market management Group Credit risk transaction management Group Network Group Figure 5 An example of divisional structure of a company in SET
Chareonsuk and Chansa-ngavej (2006) further found that most departments have roles and responsibilities as shown in Table 5. Table 6 shows the differences in departmental structure for the various clusters of listed public companies in SET. Table 5 Roles and responsibilities in listed public companies in SET Department Responsibilities Management (CEO, Managing Control and direct the company. Director, General Manager, Director ) Build connection with external party including government. Purchasing/Procurement Negotiate and procure the material at the right time at competitive price with good quality. Develop and build network with supplier for cost reduction. Research and Development Process innovation: explore new products for customers by using existing production line. Product innovation: Create the new products by using the strength of company. Production/ Manufacturing Manufacture the products to serve customers requirement. Cooperate with suppliers in the product improvement. Marketing Serve all customers need Warehousing and logistics Delivery products right quantity on time and low cost Human Resources Develop and train employee to build their capacity serve the vision/mission. Financial/Accounting Manage and organize companies budget and capital To report the transparency account and comply with regulation. Table 6 The departments in each cluster of listed public companies in SET Cluster Department/Function Agro & food Consumer Financial Industrial Property & Resources Service Technology Business unit industry Product Construction Director x x x x x x x x Purchasing/Procurement x x x x x x x x Research & Development x x x x x x Production x x x x x Marketing x x x x x x x x Warehousing x x x x x Human Resources x x x x x x x x Financial/accounting x x x x x x x x Step 3: Identify the intangible assets in each function Each department can contribute and generate the intangible assets. Step 4: Establish cause-and-effect relationships The proposed framework of intangible assets and tangible assets (Figure 6) describes the cause and effect relationships of intangible assets in three categories: employee competence, internal structure and external structure and the financial performance. VISON/MISSION Tangible Value, Financial Performance Intangible assets External Structure Management External relation Shareholder advice Purchasing Supplier relation R&D Production Supplier relation Marketing Brand Customers loyalty, Customer Warehouse Business relation HR Internal Structure Management Process Philosophy Purchasing Networking Vendor list R&D Patents Copyright Production Work standard Productivity Marketing Customer list Warehouse Logistics system HR Performance Evaluation system Learning& Growth Work related knowledge/ Know how/it system Core competency/ Culture Intangible investment Training Expenses, marketing expenses, experimental expenses, IT expenses Figure 6 Framework of cause and effect relationships of intangible assets in organizations
A case example of a public company listed in SET is shown in Figure 7 to demonstrate the application of the framework of cause-and-effect relationships. The case example company is in the consumer product cluster and has the functional organization structure. LEADING IN SPECIALIZED PRODUCT LINE Tangible Value, Financial Performance Intangible Management Purchasing R&D Production Marketing Warehouse HR External Goodwill and Social respect of CEO Strong relationship with raw material manufacturi Supplier relationship Brand SUPERWARE Customer relation 66 countries Strong relationship with Government Management Purchasing R&D Production Marketing Warehouse HR Internal 40 years experience Vendor approve list ISO 14000 ISO 9000 Energy saving Customer database Training road map Learning & Growth Work related knowledge/ Technology Know how/sap system STREGTH STRETCH SYSTEM SPEED Intangible investment Training Expenses, marketing expenses, experimental expenses, IT expenses Figure 7 Cause and effect relationships of intangible assets for a case example company When the cause and effect relationships of intangible assets are thoroughly explored, intangible values that drive vision/mission would be considered in each budget and resource allocation. When the company is well managed, intangible assets would be efficiently and effectively converted into financial performance. The company will then have sustainable growth under dynamic environment. The questionnaire survey to be conducted to establish the cause-and-effect relationships will be focused in a particular function or department. For examples, the cause-and-effect relationships in the marketing function may be addressed as shown in Figure 8. Once the information of the relevant variables is collected, the SEM technique will calculate the correlations among the variables. External structure Brand Customer loyalty Customer satisfaction Internal structure Customer list Financial Performance Learning & Growth Figure 8 Framework of cause-and-effect relationships of the marketing function 4. CONCLUSION Since today s market is wide open and highly competitive, companies need to adapt their management style and strategic perspectives. Intangible assets are being more and more brought under control in efforts to improve company performance. The Balanced Scorecard is effective as a tool to measure the intangible assets (learning and growth, internal process and external structure). In particular, the Strategy Map is used in this paper to explain the cause-and-effect relationships among intangible assets and their relationships to financial performance. Once the strategy map of intangible assets in each department is established by linking them with the company vision and mission, the empirical questionnaire survey of cause-and-effect relationships will be undertaken in the next
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