If management requires measurement how may we cope with knowledge?

Abstract

Successful managers must be able to focus attention on factors that are critical in establishing and maintaining an organisation's competitive edge. This requires them to evaluate performance by using specific performance criteria, measuring actual results, and comparing the results to expectations. Since managing the knowledge and skills of employees is the current organisational challenge (Handy, 1996) it is time that serious consideration is given to the development of measures that meet this challenge. Where the knowledge and skills of employees are the principal asset of an organisation, most key performance indicators currently in use rarely provide appropriate or relevant information.

This paper proposes a measurement model to provide information that allows management to monitor its ability to nurture and to augment the talent and accumulated knowledge of an organisation's human resources. This model could be the vehicle that allows management accountancy to travel Puxty's (1993) long road in search of a planning, control and performance measurement system that accounts for the human element of an organisation's intellectual assets.

Introduction

Knowledge and information are among the most important sources of competitive advantage and success an organisation can have. Employee know-how, innovative capabilities and skills play a predominant role in defining the productive power of an organisation (Quinn, 1992) and account for an increasing proportion of an organisation's capital, even in traditional industries (Sveiby, 1997). As Coff (1997) observed, the knowledge and skills embodied in the employees of an organisation are often viewed as strategic assets.

It is the combined intelligence, skills and expertise of people that give an organisation its distinctive character. As such, it is the human elements of an organisation that are capable of learning, changing, innovating and providing the creative thrust which, if properly motivated, will ensure an organisation's sustainability. Knowledge and skills have advantageous attributes distinct from the attributes of other assets. Generally they grow with use. The learning and application of new knowledge leads to even greater knowledge, as well as to a motivation to acquire more (Becker and Gerhart, 1996). Knowledge may be shared without being depleted. In fact, sharing may be expected to result in increased feedback, acquisition of new knowledge, and modifications and adjustments to current knowledge. With knowledge being such an important factor in the success of organisations, it is critical that management devotes a reasonable amount of attention to it. Indeed, executives must be capable of answering the questi on, How will managing and using knowledge more effectively make us money?

To translate knowledge into value organisations need to focus. O'Dell (1998) suggests that there are three reasons why this is critical. First, focus ensures that valuable resources are applied to high payoff areas. There are only so many resources to spend on managing knowledge and, by better understanding what counts, organisations have a better chance of reaping valuable rewards. Second, focus helps ensure that the right knowledge is being acquired and transferred as well as allowing people to see a clear reason for this activity. Third, focus gets the attention of management and funding. What catches management's attention is success within their organisation or other organisations they respect, a compelling competitive need and demonstrated results. These demonstrated results are usually financial and so management must be able to explain what knowledge is valuable, show how they are effectively managing the acquisition and dissemination process and identify where their organisation may be missing the b oat.

The important thing about knowledge, once it has been acquired or created, is putting it to proper use. For this to happen organisations must have the capability to understand the nature of knowledge as a strategic asset (Teece, 1998). This exemplifies the need for knowledge management. Taking all this into consideration, Martin (2000) insists that the measurement of knowledge is important. He acknowledges that any attempt to do so is fraught with dangers, yet understands that there are risks in doing nothing. Decidedly then, the management of knowledge poses an interesting challenge. Accountants are the specialists responsible for providing information vital for operating and strategic decisions and for motivating and evaluating organisational performance and so it is they who ought to provide a relevant solution to this challenge.

The objective of this paper is to present a methodology that will provide an opportunity to supplant the empty rhetoric of Chief Executives who proclaim employees to be their organisation's most important asset. In so doing, it seeks to position accounting for the knowledge and skill base of employees as an important component in the performance reporting activities of an organisation. This aim is shared by the OECD (1996) which has recognised that improvement in the information and decision-making systems that shape human capital' acquisition and utilisation is a key factor in enhancing an organisation's competitiveness. Indeed, Roslender and Dyson (1992) argue that sustainable organisations will be those that are best able to marry the pursuit of commercial success with the fulfillment of employees. They believe the provision of accounting information on stock of employees' knowledge and skills will be critical to the effective management of human resources for "without such information effective human res ource decision-making is likely to be the exception and not the rule" (p.321). This accounting information, they say, will not be of the traditional kind but one that is congruous with a more strategic emphasis.

The implications are unequivocal. The construction of a germane model that develops relevant measures to establish a quantum and identify changes in the stock of employees' knowledge and skills should go some way towards meeting this objective. The model presented in this paper represents one information booth on Puxty's (1993) long road by suggesting a way in which this may be achieved.

Measuring Knowledge

Accounting information is one type of information that may be used to enhance organisational learning. It helps to evaluate how objectives might be achieved by quantifying the financial impact of each alternative available to the decision-maker. This ought to ensure "that if not the best, then at least better decisions about action can be made" (Chapman, 1997, p.202). The strength of accounting information is that, by using a single unit of measure, it allows an easy comparison and trade-off of the various relevant areas that are impacted by the decision at hand. Consequently, the science of accounting must identify ways to assist in directing and controlling the knowledge transformation process, and to evaluate and report regularly on the results of these processes.

The accounting for and reporting of employee knowledge and skills pose three principal challenges. First, there is a need for better tools to manage an organisation's investment in people skills. Second, there is a need for some form of indicator that is capable of differentiating between organisations in which the knowledge base is appreciating and those in which it is depreciating. Third, there is a need to measure, over the long-term, an organisation's return on its investment in people. To meet these challenges, accountants require an understanding of how the knowledge and skills embodied in human resources are linked to the overall strategic objectives of the organisation, how they contribute to the success of the organisation and how they compare to the knowledge and skill base of other organisations.

The third challenge, that of return on investment, requires the application of a financial value to the model. Unfortunately, the problems associated with formally valuing employee knowledge and skills are complex and often intractable. Despite these difficulties, there is clearly an obligation on accountants to apply their skills in the search for measurement methodologies, both financial and non-financial, that enhance and integrate knowledge within an organisation. While the model proposed in this paper does not address all of these issues, it nevertheless represents a development that looks to provide an important mechanism for tying measurement to management and, by linking measurements back to strategy, ensure that objectives are measurable.

The first step in establishing ways to measure the store of knowledge embodied in an organisation is to understand the composition of each individual's explicit, or domain, knowledge. Despite individuals being significant sources, conduits and generators of knowledge, the quantum of organisational knowledge is not just simply the aggregate of each individual employee's domain knowledge (Howells, 1996). Knowledge creation within an organisation centres on the crucial presumption that human knowledge is created and enlarged by means of social interaction. This interaction converts the domain knowledge of individuals into collective structural and procedural, or tacit, knowledge within the organisation (Nonaka and Takeuchi, 1995). From an organisational perspective, this form of knowledge has a more permanent dimension and the organisation may build on it a sustainable competitive advantage. The second step, then, is to assess the quantum of tacit knowledge for the organisation as a whole. Using both of these m easures it will be possible to understand how organisational knowledge is created, grown and even lost.

In the process of establishing quantum it is necessary to determine the most appropriate measurement base to be used. Essentially this will be a choice from two--a market based or a cost based measure. It is generally accepted that the price of anything that is established in an open market represents its true value at any given point in time. For those organisations whose shares are traded on any of the multitude of bourses around the world it is possible to establish the market value of the organisation as a whole. To disaggregate that value into its component parts, of which organisational knowledge is but one, is not a simple task. Furthermore, disaggregation of value is particularly fraught with danger. This is because the overall market value of an organisation will generally be greater than the sum of the value of its component parts due to various synergies. Even if a reliable method could be used to extract the value of organisational knowledge from the market value of the organisation as a whole, it s use would be limited to those publicly listed organisations. Alternative methods would still need to be developed that will allow the wide variety of other organisations to establish the value of their knowledge base.

The alternative is to use a cost based measurement system and this is preferred for two reasons. First, the value of something is normally at least equal to the amount one is prepared to pay for it (2). This amount will change from time to time and the basis of valuation should reflect these changes. Second, once the required cost information has been established, it may be applied in all organisations irrespective of their structure, size and nature of operations. It seems that this approach would provide the best outcome as it produces a more generic model to value organisational knowledge.

Furthermore, when developing a model, it is important to bear in mind that the more sophisticated the model the more expensive it will be to apply and attempting to achieve a greater degree of precision may not prove cost effective. The aim is, therefore, to provide a practical measure, for which the required inputs may be obtained at a reasonable cost, in order to ensure that the importance of knowledge will not be neglected in management's decision-making processes.

Domain Knowledge

Domain knowledge comprises three elements--formal education, post-secondary education and formal training. While it is acknowledged that it is not possible to have a post-secondary education without having first had a general education, each will be considered exclusive of the other. A similar situation generally prevails with each level of post-secondary education and a consistent approach will be taken there. This is not dissimilar to evaluating other assets that rely on the existence of something else but are acquired separately.

Since a cost based measurement system has been proposed as the basis of the valuation of organisational knowledge, Dobija (1998) provides a useful starting point for attempting to value each of these elements of domain knowledge. He proposes using the costs associated with attaining a particular level of education as the basis for establishing a pragmatic value of knowledge.

Such an approach appears to pose a problem in determining the value of organisational knowledge because most organisations have made little or no contribution to the cost of an employee acquiring a formal education. Does this mean that it is necessary to apportion the value of domain knowledge between the individual and the organisation? If the underlying reason for trying to attribute a value to the knowledge resident within an organisation was to create an asset in the financial statements then the answer is almost certainly yes. This is not the case. The purpose of this endeavour is to better understand how this vital resource is managed and therefore apportionment is not really an issue.

One of the difficulties associated with valuing education is that it may only be acquired over a period of years. As such, the annual costs will vary leading to potentially different valuations of the same element of domain knowledge. One way of overcoming these variations is to use a standard cost based on the most current information. Furthermore, estimating the value of each level of education must also take into account the opportunity cost of capital invested in that education over its duration. Accordingly, the capitalised value of costs is proposed as a surrogate measure for the value of the knowledge acquired from a particular level of education. This may be calculated using the formula:

K = c ([(1+r).sup.n] - 1/R)

c = the standard cost of acquiring knowledge in each time period

where: K = the value of knowledge

r = a long-run rate of return on investment

n = the number of years of education

The cost of acquiring knowledge (3) varies depending on whether formal education, post-secondary education or subsequent formal training is being considered. In each case it is appropriate to take into account both the visible costs, irrespective of who pays them, and the opportunity costs in determining a standard cost for each element of domain knowledge. For example, in many organisations a specialist provider conducts most additional formal training for employees outside the workplace. In addition to the payment of a fee to the course provider (4), the organisation will continue to pay the salary or wages of the employee during the period of training. Both of these elements should be taken into account in determining a daily standard cost for subsequent formal training.

A key to the development of a valuation model is a long-run rate of return on an investment over time. The question that arises is which of either a nominal rate of interest or a real rate of interest should be used in any calculation. The solution lies in the nature of the costs being used as the basis for determining the value of knowledge. If the valuation is based on historical costs, then it is appropriate to use the nominal rate of interest for it includes a premium to reflect the effects of inflation. However, if the valuation is based on current costs then a real rate of interest is more relevant. Since it is proposed to use standard costs based on current data in the model, a real long-run rate of return should be used in all calculations.

Using these parameters in the equation, the value, on completion of each level, attributable to formal education and post-secondary education may be calculated. For example, to determine the value of a formal education to a school leaver just prior to entering university, the following data (5) is entered in the equation: c = $9,230, r = 5.34% and n = 12. The result is a value attributable to this level of knowledge, that is K, of $149,840. Similar calculations may be conducted for each of the formal and post-secondary education elements, and indeed any of their sub-elements, of domain knowledge.

The value of domain knowledge acquired through subsequent formal training must be treated somewhat differently. The knowledge acquired from the attendance at a training program lasting one day may be put into use immediately upon returning to the workplace the following day. Moreover, training that has been provided over a period of years could, theoretically, be replaced in a few weeks as long as the volume of such training is normally in the region of a few days per annum. So, it would not be unreasonable to assume in this case that there is no accumulation of cost over time. Dobija's (1998) proposal, to use the value of education costs incurred over time as the basis for valuing the knowledge acquired, may therefore be deemed irrelevant in the case of formal training programs. What does remain relevant, however, is the notion that the value of something is at least equivalent to the amount one is prepared to pay. Accordingly, the knowledge value of each day of formal training, both to the recipient and th e organisation, is equivalent to its current cost.

Depletion of Domain Knowledge

Like most other assets, the benefit of domain knowledge diminishes over time though the nature and rate of depletion may be expected to vary for different types of knowledge (Becker, 1993). Since a formal education is intended to provide the recipient with lifetime skills, its benefits may reasonably be expected to remain with an individual forever. Yet, from an organisation's point of view, the benefit of knowledge acquired from that formal education, though not diminishing in what it provides year on year, is only available for the possible employment period of each individual employee.

In the case of a post-matriculation school leaver who joins an organisation immediately on leaving school, the organisation could look forward to the possibility of benefiting from the knowledge acquired from that education for a maximum period of 47 years (6). Since the domain knowledge attributable to a person of that standing is expected to be of equal benefit to the organisation in each of those 47 years, it may be considered equivalent to the organisation acquiring an annuity for each of those 47 years. The amount of the annuity should be calculated using the predetermined real long-run rate of return as the discount rate. After a year's employment, and ignoring, for the moment, the impact of inflation, the value of that employee's knowledge to the organisation would be the present value of that annuity for 46 years. That is, the depletion for the first year is the present value of the annuity receivable in 47 years time. Should the employee leave the organisation, without having received any additional training, after two years then the value of knowledge lost to the organisation is the present value of the annuity for 45 years (Baxter, 1971, pp.8 1-87).

This is different from the more professionally oriented post-secondary education and training received before or after joining an organisation. For this form of knowledge there is, in addition to the above, an element of obsolescence. Instead of simply depleting the value of knowledge acquired by the organisation over the potential period of employment, it ought to be depleted over the length of time it is expected to provide a benefit to the organisation. This will vary depending on the nature of the education and training received. Some forms of knowledge may indeed provide a benefit over the potential period of employment. Others may only provide a benefit during the time a person occupies a certain position in the organisation while the benefit period of specific training programmes may be a function of the expected state of technology. Clearly, because of the diversity of knowledge gained in this way, the most appropriate number of years over which to write off these types of knowledge might differ not only for different types of programmes but also for different organisations and different jobs within organisations.

What is required is a model, as simple as is reasonably consistent with reality, which takes into account the shorter period that an organisation will benefit from this form of knowledge and the value of money over time. In a study conducted by Flamholtz (1985, pp.285-288), a useful life of approximately fourteen years was established for a group of employees within a single organisation. This supports a contention that some part of any knowledge that is acquired by an individual is retained by them and is of use to them and their organisation over many years. It does not seem inappropriate then, from an organisation's perspective, to deplete the value of employee domain knowledge acquired from professionally oriented education over a fifteen-year period. Training programs are somewhat different in that they are generally tailored to specific issues that are likely to become obsolete much sooner. For that reason, a shorter period of five years has been chosen as the period of depletion. This may be done in a similar manner to that proposed earlier for depletion of an employee's domain knowledge attributable to a formal education.

Tacit knowledge

Tacit knowledge and domain knowledge complement each other. Earlier, it was stated that tacit knowledge is created and enlarged by converting the domain knowledge of individuals by means of social interaction within the organisation. This was identified as a crucial process in the quest to achieve a sustainable competitive advantage. As such, it is important that some form of measurement is developed to facilitate an assessment of an organisation's performance in expanding its tacit knowledge. This form of synergy is difficult to measure.

Previously it was decided that cost based measures should be used as the basis for establishing a pragmatic value of knowledge. Since organisational tacit knowledge is acquired through social interaction, or the sharing of employee experience, the only cost relevant to the organisation is the cost of labour for the time spent by its employees on this activity.

To set about determining the value of an organisation's tacit knowledge, it is necessary to first consider how much time is spent during the working day in sharing knowledge within the organisation. It is unlikely that any records will exist to provide concrete evidence of the time spent by employees on this activity. This being the case, securing an answer requires a rational assessment that will centre on the question of what may be considered reasonable-10, 15, 20 per cent? Undoubtedly it will vary from one organisation to another but, more importantly, it will almost certainly differ for different job specifications within an organisation. While in a real situation this is an important element that needs careful consideration, at this point in the development of the model any reasonable assumption will suffice. 12.5 per cent, or the equivalent of one hour out of each eight-hour day, will be assumed.

For example, if the average annual cost to the organisation for each employee is $60,000 and continuing with the assumption that 12.5 per cent of each employee's time is spent growing the tacit knowledge of an organisation, the cost to the organisation each year of acquiring tacit knowledge is $7,500 per employee. Earlier, it was assumed that the available period of employment would not exceed 47 years. Therefore, for each employee, the maximum value to an organisation of tacit knowledge is equivalent to the present value of $7,500 for each of those 47 years. Using the previous estimate for a real long-run rate of return of 5.34 per cent, the present value of a working lifetime's tacit knowledge may be estimated to be $128,270.

Even though employees may spend a regular amount of time throughout their working lives sharing knowledge, the acquisition of tacit knowledge does not have to follow the same path. During the first few years of employment tacit knowledge would accrue at a slower rate than normal. It is also likely that in the latter years of an employee's working life, the acquisition of tacit knowledge would also slow. Using an analogy, when putting together a jigsaw puzzle, the initial pieces are difficult to place. As the assembly progresses the ability to place other pieces improves until there are only a small number of pieces remaining. These do not always fall into place quite so readily. The acquisition of tacit knowledge, and hence its cumulative value to the organisation, may be considered in the same light.

A similar pattern may be found in the classic estimating and forecasting logistic curve, or S-curve. Implicit in S-curve forecasting are assumptions of slow initial growth, subsequent rapid growth followed by declining growth as saturation levels are achieved. This is so similar to the pattern of growth in tacit knowledge that this particular model has been used to determine its expected value resident in an individual depending on their years of service. By plotting the increase in value from zero to $128,270 over the 47-year period (see Figure 1) it will be possible to attribute a value to the tacit knowledge resident in each employee based on their length of service.

From this point, the value of an organisation's tacit knowledge may be determined in three steps. First, identify the number of employees with similar years of service. Second, multiply the cumulative value of tacit knowledge for each year of service by the number of employees established in the first step. Third, aggregate all of the values determined in the second step. The result should provide a reasonable indication of the value of tacit knowledge resident within the organisation.

Conclusion

In the quest to develop a learning organisation--a prerequisite for survival in the long run--the model has concentrated on seeking to fill the void of performance indicators that assess the growth of organisational knowledge. Unfortunately, all measures can be manipulated. Those proposed in this model are no different in that respect. The stock of knowledge may be increased by providing more training or taking on more employees. In so doing, an organisation may acquire inappropriate knowledge and skills and this model, on its own, will not identify that. Such acquisitions are likely to have an adverse effect on some other area of organisational performance. Nor does the acquisition of highly skilled employees guarantee that those skills will be used effectively. Not all companies that recruit graduates make effective use of them. Of course, where graduates leave through frustration at not being provided with opportunities to use and develop their skills, the model will help to show this up but, unless the mo del is closely linked to strategy, cause and effect may still not be recognised. For reasons like this, the model would be better incorporated in an overall performance measurement system, such as the balanced scorecard, to facilitate an understanding of cause-and-effect relationships.

The utility of the model is that it establishes a practical framework for providing information on an organisation's knowledge and skills. The proposed measures are seen as complementary to traditional performance measures and provide a way of reducing the danger of a harmful short-term approach to the management of organisational knowledge. At the same time, use of the model is related to economy (7). Good economy means good resource management. Today's organisations are so much more than simply an investment in monetary capital. For many, how they manage talent and accumulated knowledge is just as important.

[FIGURE 1 OMITTED]

End Notes

(1.) Becker, in the 3rd edition of his book (1993), recognises that when the 1st edition was published (1964) many people were criticising this term and the underlying analysis because they believed it treated people like slaves or machines. Now, he suggests, the name and analysis are readily accepted by most people not only in all the social sciences but even in the media. He goes on to acknowledge that "the concept of human capital remains suspect within academic circles that organise their thinking about social problems around a belief in the exploitation of labour by capital" (p.16). This must be a phobia in western society for he indicates that, even before the recent reforms, economists and planners in Communist countries had no difficulty with the concept of investing capital in people and, indeed, his and other authors' books on human capital were extensively used in those countries.

(2.) Even if a market based measure were to be used to value organisational knowledge, it is worth remembering that the market value of an organisation as a whole is determined by the amount that a purchaser will pay for its shares.

(3.) In all cases no distinction is made between the quality of graduands. While some will always be better than others, the granting of an award assumes a certain level of knowledge common to all.

(4.) Where the training is conducted within the organisation the cost, per participant, of running the programme should be substituted for the external provider's fee.

(5.) This data has been determined from current estimates in an Australian context and all values are expressed in Australian currency.

(6.) The available years of employment are 47 if calculated from leaving school at age 18 to retirement at age 65.

(7.) Use of the word 'economy' here reflects a deeper meaning than the one carelessly used in everyday parlance.

References

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Geoff Turner

Geoff Turner is a senior lecturer in accounting and finance at the University of Sunderland, England and an adjunct senior lecturer in the School of Accounting and Information Systems at the University of South Australia. He has research interests and publications in global accounting issues, accounting for human resources, performance measurement in organisations and transfer pricing in multinational corporations. Geoff is a CMA and holds a BA(Acctcy), MBA and PhD.

Jacky Jackson-Cox

After working as an accountant for EMI Electronics Limited, Jacky Jackson-Cox has been involved for many years in teaching management accounting courses for accounting, management and industrial relations students. Virtually retired, she continues as a part-time lecturer at the University of Kent at Canterbury, England. Jacky is a FCA and holds a BSc(Econ).