The managers of a small knowhow company are generally well aware of how the day-to-day business is going. They do not need much written information. The bigger knowhow companies need more indirect ways to steer and control. The industrial companies have developed sophisticated steering systems using middle management and key financial indicators. Indicators such as profit mar- gin, return on investment, return on equity and cash-flow are important in the management reporting of every large industrial company.
Financial analysts and investors use the same key indicators as company management but on a more superficial level.
The management of the big knowhow company and its investors need the financial key indicators too but above all they need indicators which show the knowhow risk and track changes in the knowhow capital.
We shall not attempt to provide a detailed accounting system for knowhow companies in this book. This is a task for the experts. We shall merely point to a few key indicators which we believe are essential to the proper monitoring of a knowhow business.
The management need to monitor:
1. The knowhow capital; its size, growth and quality.
2. The return on knowhow capital.
3. Efficiency and productivity.
4. Stability (knowhow risk).
· Knowhow capital
A rough definition of knowhow capital is the total number of man years of professional experience. This increases automatically each year. Of course not all professionals are as valuable as each other and neither is it the case that knowhow capital really increases by a year per head each year. However, as a general indicator, the man years count is quite sufficient. It gives a much more accurate picture of competitiveness than a simple professional head count.
The quality of the knowhow is also important and can be measured as average knowhow capital per professional. This is an indication of how skilled and experienced the professionals are. A better indication can be derived from regular, systematic client research (ideally conducted annually). The external analyst seldom sees these reports and must rely on more indirect indicators.
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MANGING KNOWHOWApart from the conventional investment in hardware and machinery, the 'soft' investments in knowhow must be controlled. The first priority is to maintain the knowhow capital. Other investments in R&D must also be monitored. Total costs for R&D and education should be reported in absolute numbers as well as in percentage of turnover terms.
The R&D budget is a very important measure for knowhow companies.
Though seldom formalised it is quite common these days to see R&D budgets stated explicitly in the annual accounts of small companies. R&D needs a separ- ate budget because it gives management some control over the knowhow growth of the company.
It is not difficult to persuade a professional to increase his own knowhow, but it can sometimes be difficult to ensure that this kind of investment is always in the company's, as opposed to the professional's, best interests.
The process of drawing up the budget is more important than the budget itself. The management must win acceptance from the professionals that R&D is to be undertaken according to the plan. The budget process itself often helps to achieve this acceptance.
The education budget should cover costs associated with time spent inside the company by senior professionals transferring their knowhow to juniors and costs associated with external courses and travel. Again, it is the budget process itself which does most to concentrate the collective mind on the most appropriate areas for education.
Because the markets of most knowhow companies are rather esoteric and difficult to quantify, knowhow companies are seldom aware of their market shares. But this is very important information for assessing the company's competitive position so although the relevant data are hard to find they should at least be sought. Surprisingly good information can be found in databases, cata- logues etc.
Average age is an important variable. It should be calculated each year and trends should be plotted. A rapidly growing average age is good because it shows knowhow capital is increasing but, as we have already seen, there is a danger of a 'spare tyre' developing which may need to be addressed by a change in the recruitment policy.
It is important to recognise when calculating the knowhow capital represen- ted by the professionals in particular that there are two kinds of experience:
general professional experience and company-specific experience. The signifi- cance of the latter is often under-estimated. Knowhow managers tend to assume that professional experience is all that matters.
Take the example of a knowhow company which recruits from another finn a professional with 11 years' experience following the departure of someone who has been with the company for all of the 10 years of his professional working life. The managers will tend to assume they have gained an extra man or woman year of knowhow.
But what has really happened, of course, is that general professional experi- ence has increased by one man year while company-specific experience has fallen by ten man years.
PUTTING KNOWHOW COMPANIES TO WORK
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Attributing a relatively high weight to company-specific experience is one way of allowing for some of the problems that can be encountered when recruiting experienced professionals who are set in ways that may not be readily accommodated by their new company.
· Return on knowhow capital
A more realistic measure of a knowhow company's performance than return on equity is profit as a percentage of revenues. This does not change much as long as the company adheres to its business idea. A reasonable target might be 10- 15% of revenues.
Profitability ratios of more than 20% never last long. They fall because the company invests more in its invisible balance-sheet, thereby increasing costs or because, like SCL, it has invested too little in the past.
Added value is a more reliable indicator of current capacity and future po- tential than profit. The yield of the knowhow capital is measured as the total added value (see below for a definition of added value) divided by the total knowhow capital. This is a key indicator and is equivalent to the conventional return on assets measure of industrial companies. Since knowhow capital in- creases each year the yield will drop unless the company can add more value at the same rate.
· Efficiency and productivity
ADDED VALUE Added value generated by a knowhow company is the most important measure of its productivity. There are many ways to calculate added value. The most common is profit before net interest + salaries + social security costs + depreciation.
Since ordinary profit measures are inappropriate for knowhow companies, added value is the better yardstick for comparing knowhow companies in various industries. Using added value per employee, for example, we can compare the profitability of a law firm with that of an advertising agency.
It is not humanly possible for people to produce extreme added value indefi- nitely, especially if they work in a team. The added value produced by teams tends to even out over time. This makes added value per employee an excellent comparative measure. Since salaries, which are a component of added value, are the most important costs in knowhow companies the added value per employee measure has the additional advantage of indicating whether an organisation is draining the profits through higher salaries.
THE PROFIT PER CLIENT Since many knowhow companies use time ac- counting it is relatively easy to calculate the profit per client or per customer.
This is important information when it comes to deciding where to put the sales effort.
ADMINISTRATIVE COSTS AS A PERCENTAGE OF REVENUE Administrative support costs - the costs of administrative personnel, office space, telephones
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MANGING KNOWHOWetc - as a percentage of revenue, show whether the cost burden of administration is rising or falling relative to revenue earning departments.
THE PRODUCTIVITY INDEX The difficulty with measuring the productivity of a knowhow organisation lies in the equivocal nature of volume. Turnover in knowhow companies is not straightforward; it can seldom be stated with any certainty. There are ways round this problem however, if one is really deter- mined to find out about a company's efficiency.
One way is to construct an index. The interesting object of measurement is not the absolute level of efficiency but rather the trend. Is the organisation becoming more or less efficient? To establish an index one begins by calculating the ratio between last year's sales and this year's. Let us suppose one gets the figure 110, indicating a growth of 10%.
Then one calculates the figure for the number of employees. If this is 110 too and there have been no price increases the productivity index for year 2 is:
110/110 = 1 - no change has occurred in productivity. If, however, the price of services has been increased by an average of 4% it reduces the sales index which, in this example, would be 106. The productivity index for year 2 will thus be 106/110 = 0.96 - productivity has decreased by roughly 4%. This indexing system can also be based on added value per employee and on many other variables.
One interesting variant of the productivity index is the use of knowhow capital instead of the number of employees. This involves calculating the total number of man and woman years of experience in all four personnel categories and then attributing weights to the different categories and perhaps also to each individual.
The resulting figure will change each year as a result of the passage of an extra year and of arrivals and departures.
· Stability- the knowhow risk
Personnel turnover, the number of people who leave as a percentage of total employees, is an important indicator of knowhow risk. A high figure indicates dissatisfaction; a low turnover in a non-growth company suggests a lack of dyna- mism. The indicator may vary over time and between markets. It is thus important to track it so that trends can be analysed.
Average age is also important. A high average suggests high stability (low risk) and low dynamism (low growth).
Another important indicator of stability is the age and experience mix -the number of young and new employees in relation to the veterans. A high proportion of young and inexperienced professionals indicates relative insta- bility. The indicator can be calculated as: number of veterans (over five years of employment) as a proportion of total professionals or number of recently em- ployed (less than two years) in relation to total professionals.
STRUCTURING KNOWHOW
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SALARIES AS A PERCENTAGE OF ADDED VALUE Salaries are by far the largest part of the added value in industry. The same usually applies in knowhow companies but there can be huge differences. In some knowhow companies the salary share is only a small fraction of the added value because each employee handles large amounts of capital. The salary share is a good indication of how sensitive the company is to surprises like the sudden breakaway of a group of employees to set up their own company.
The salary share is also an important argument in pay negotiations. If the employees are to have higher salaries if they produce more added value they must be prepared to accept lower salaries if they produce less added value.