The importance of organizational infrastructure (OI). (Intangibles).

"Intangibles at a Crossroads," (March/April 2002) argued that Phase I of the Intangibles Movement -- creating awareness of the vast magnitude and impact of intangibles, and of the serious information deficiencies and the resulting social harms related to these assets -- was largely successful. The Intangibles Movement, however, is currently at a crossroads, raising the crucial question of "what's next?"

This can be expressed as a series of questions: What should be done to improve the management and disclosure of intangible assets (at the corporate level), upgrade investment and analytical tools applied to the valuation of intangibles-intensive enterprises (capital market level) and measure accurately the value, impact and vulnerabilities of intangibles in national accounts (macro-economy level)?

The first article ended by contending that many intangible assets are inert -- by themselves, they don't create value -- and commoditized (competitors have equal access to them) and, thus, similar to most tangible assets. The major value-creator, and the genuinely true intangible, is organizational infrastructure, which this article will address.

Specifically, it will conceptualize organizational infrastructure, present a methodology for measuring its value, discuss major applications for managers and investors and propose an agenda for Phase II of the Intangibles Movement.

Conceptual Framework 

This author's notion of organizational infrastructure derives from macroeconomic growth theory, particularly from the "total factor productivity" (TFP) concept. Growth theory deals with the economic development of nations, with special focus on the drivers of growth. The drivers of economic growth -- measured by GDP change -- can be divided into: increases in factor inputs, such as growth of the labor force and capital investments (property, plant and equipment) and improvements in TFP, the productivity of the factor inputs.

For example, the gross product of U.S. corporate businesses increased in 2000 by $443.2 billion (relative to 1999), while consumption of physical capital increased by $57.9 billion and employee compensation by $289.1 billion. These numbers are in constant (real) dollars, derived from the Bureau of Economic Analysis, National Income and Product Accounts.

How did aggregate spending of $347.0 billion on capital and labor in 2000 increase gross product by $443.2 billion? Where did the $100 billion in value added come from? The answer: total factor productivity -- business processes, organizational designs and incentive systems, enabling the corporate sector to generate an output level substantially higher than invested inputs.

This author defines corporate organizational infrastructure, with required modifications, as the microeconomic analogue of TFP. Organizational infrastructure -- managerial processes, organizational blueprints, incentive and control (corporate governance) systems -- when operating successfully, enables management to generate excess product out of invested resources. This excess product relative to invested inputs reflects the productivity margin of the enterprise, the source of shareholder value and employee welfare.

Figure 1 depicts the central role of organizational infrastructure in the value-creation chain. It enables the enterprise to use its resources in a productive manner, which, in turn, enhances productivity, profits and shareholder value.

Note that the concept of resources in Figure 1 includes both tangible and intangible capital (R&D, customer-related intangibles), isolating organizational infrastructure from all other corporate resources, most of which, arguably, are inert and commoditized. This emphasizes the unique nature of organizational infrastructure. It's not an asset or capital, as many believe, but an enabler of all other assets, tangible and intangible, performing their intended roles in the value creation chain.

Measurement

What do we know about that all-important intangible -- organizational infrastructure (01)? Admittedly, we know very little. The management literature and business media frequently tout new managerial processes and organizational designs (think TQM, just-in-time, or Six Sigma), some of which fade away after the initial excitement. But systematic knowledge about OI is scarce.

To gain quantifiable insights into the value and impact of 01, Suresh Radhakrishnan and this author developed a methodology for valuing firm-specific OI. The estimation process is schematically depicted in Figure 2.

We estimate statistically for a sample of about 300 public companies the contribution to revenue growth of the four major resources: physical assets, labor, brands and research and development (R&D). The investment in each is derived from companies' financial reports. It is clear from the data that some companies are more productive than others, and generate higher revenue growth from a given level of resources. We attribute this firm-specific productivity to organizational infrastructure, and estimate it statistically by quantifying the contribution of the right-most factor in Figure 2 (OI) to product growth. The methodology thus equates the value of OI with the productivity of deploying the company's resources.

Managerial and Investment Applications

The contribution of organizational infrastructure to productivity is essentially a reflection of managerial capabilities and execution. Despite oceans of ink, the quantification of managerial capabilities remains elusive. Vague terms like "leadership," "focus" or "knowledge workers" abound, but they don't significantly advance our ability to evaluate managers' capabilities and success. The OI concept discussed here does just that.

A very simple example: if both companies A and B increase capital investment from 100 to 110 units, while A's product grows 10 percent and B's 20 percent, the inescapable conclusion is that B's management was more capable than A's. Thus, the extent of managerial capabilities and execution success can be measured by the OI approach of relating productivity growth to resource increases.

The ability to estimate the value of companies' organizational infrastructure provides new valuation and control tools for managers and investors. Given space constraints, here are three examples:

Example 1: The productivity of IT. The over-investment of the corporate sector in information technology during the 1990s -- and the almost complete cessation of investment in the past two years -- emphasizes the need for a rational assessment of the productivity (return on investment) of IT. Since IT primarily enables organizational infrastructure (the IT underlying supply chains or distribution channels), its productivity can be inferred from the relation between IT expenditures and the corresponding growth in the value of OI. For example, in 1995-97, Home Depot had a ratio of increase in OI to total IT investment of 0.51, while Wal-Mart's ratio was only 0.16, implying that Home Depot had a significantly higher return on IT investments.

Example 2: Management compensation. The contribution of organizational infrastructure to the company's product growth is, as argued above, a quantification of management's capabilities and execution success. It is, therefore, compelling to base part of managers' compensation on that value. While our research shows that there is a strong correlation between OI and stock performance, it's not a perfect correlation. OI is less susceptible to factors beyond management's control (interest rate changes, tax changes) than stock prices, and, therefore, is a more suitable driver of mangers' compensation.

Example 3: Investors' valuation of management capabilities and growth prospects. Surveys indicate that the assessment of management capabilities is at the top of the wish list of financial analysts and institutional investors. Traditional performance measures, such as earnings or cash flows, are subject to widely known limitations (prone to manipulations, biased by the expensing of intangibles, ignore the cost of equity capital, etc.) and are, therefore, noisy indicators of managerial capabilities and performance. The organizational infrastructure measure discussed above provides a sharp focus on managers' performance and the company's growth potential by indicating abnormal productivity gains derived from given company resources.

Indeed, the research by Radhakrishnan and this author indicates that when we form portfolios of companies with high and low OI values, the abnormal (risk-adjusted) returns on these portfolios in the two years subsequent to portfolio information are: 3.0 percent vs. 1.5 percent, and 2.5 percent vs. 1.3 percent, in favor of the high OI companies. Investment in good management, as indicated by the OI measures, clearly pays.

Intangibles Movement Agenda

Productivity of scarce resources is the top priority of nations and business enterprises. Increased productivity of resources (capital, labor, R&D) is the major driver of nations' welfare (standard of living, employment) and of companies' profits and shareholder value. A focus on productivity at the national and business levels appears appropriate, therefore, for research and applied work in intangibles, given that in modern economies and companies, intangibles are the major drivers of productivity.

Current concerns, such as the valuation of specific intangibles (patents, brands) or the codification of tacit knowledge, while useful, are of secondary relevance, subordinate to the overall productivity or efficiency enhancement goal.

Macroeconomic studies estimate that about one-third of the differences in income per capita among countries come from differences in capital; the remaining two-thirds comes from efficiency differences. Efficiency is also the major source of differences in the performance of business enterprises. The above-described concept of organizational infrastructure provides a measure of enterprise efficiency-productivity.

An intellectually stimulating and highly useful agenda for the Intangibles Movement is to "peel off" layers of the OI onion. Here are several concrete areas/issues for study:

* What are the organizational structures of R&D activities most conducive to success? What specific blueprints and underlying R&D processes yield the highest number of patents and innovations, and the largest share of revenues from recently introduced products?

* What systems successfully enhance brand values? Why do some brands (Coca-Cola, Marlboro) maintain their value, while others (Polaroid, Xerox), fall by the wayside?

* What is the impact of corporate networking -- alliances, partnerships and joint ventures -- on companies' productivity? What is the optimal structure of such networking for achieving specified objectives (conducting research, sharing risk, selling products)?

* Develop measurement and reporting systems for evaluating the productivity of resources, particularly intangible ones. Assess the returns on investment in R&D, brands, IT and human resources, and develop reporting modes for the productivity of these assets.

* Which compensation systems and work practices generate the highest productivity of human resources? How can employee productivity be measured, particularly in service organizations?

* How do successful enterprises develop their organizational structures and keep them unique? How do they prevent competitors from quickly imitating such designs?

* The pace of knowledge accumulation: How are new knowledge and technologies adopted and diffused within the organization? Under what circumstances are old technologies abandoned and new ones adopted?

* What are the organizational impediments to knowledge creation and the adoption of new technologies and operating systems? How can companies best overcome the forces of the status quo?

* The collapse of Nasdaq demonstrated the vulnerability of intangibles, particularly OI. How can companies protect their intangibles? How can the risks inherent in intangibles be shared and minimized?

Certain aspects of this research agenda are conducted in other areas -- economics, management, sociology and organizational behavior. It will be highly useful to assemble available research and new work under the umbrella of the Intangibles-Organizational Infrastructure undertaking.

The proposed Phase II of the Intangibles Movement -- the focus on organizational infrastructure and its role in enhancing the productivity of nations and business enterprises, as well as the welfare of citizens and shareholders -- offers a socially useful and intellectually stimulating agenda for people interested in intangible assets.

Baruch Lev is the Philip Bardes Professor of Accounting and Finance, Stern School of Business, New York University. He can be reached at 212.998.0028 or [e-mail]; www.baruch-lev.com.