Learning organizations are being challenged to create learning that impacts business outcomes. The resonating response to the challenge is “What needs to be done?” Or, in the approach used so widely by the learning industry, “What are the best practices?” Some perspective is required to answer these questions.
Historically, economists have defined the two inputs to value creation as labor and capital. Accounting rules evolved around this duality. Capital is recorded on the balance sheet. Balance-sheet entries reflect the ability of assets to create future value.
Labor is accounted for as a current-period expense. Accounting does not account for the future value created by an organization expending funds on employee learning. The future value created by current-period expenditures on people is not a functional concept even though every decision maker intuitively knows that learning does indeed create future value. The mantra, “our people are our most important asset” reflect that intuitive understanding.
In the industrial era, the simple dichotomy of labor and capital was sufficient to guide management decision making. In the knowledge world of the 21st century, the dichotomy is not only inappropriate, it is dysfunctional to the creation of strategic value in the global economy. The lack of discipline in the language used within organizations is reflective of the dangers.
Management phrases are routinely used as though learning is managed as an asset that creates future value. The phrase “human capital” is used to express the concept that humans are important to the future of the enterprise. Conjoining human and capital is inconsistent with the original distinction created by the economists, yet the phrase is used routinely. Further, the concept that people are assets attempts to communicate future value, yet there is not a single balance sheet where humans appear as an asset. We speak of the concept of strategic value, but we measure and manage people as costs.
What then, does it take to manage a learning organization to create strategic value? The first challenge is to manage learning as an investment, not merely as an expense.
The consumption in the current period foregone in learning is the cost of the learning. The sacrifice is to subtract the learning expenditure from revenue, thus decreasing current-period reported income, a business outcome CEOs dread. Accounting rules are well equipped to measure costs, resulting in an intense focus on the expense of learning — a practical outcome reinforced by the original economic distinction between labor and capital. The missing part of human capital investment is the future return. Currently learning ROI is measured in the present only.
The importance of the future is at least partially being addressed under the accounting term of intangible assets. While giving lip service to them, accountants do not account for intangible assets. The one glaring exception is goodwill, which is a derived number “plugged” to assign value between acquisition cost and book value. To become strategic, the value creation from intangible assets, including learning, must be managed for future value, not merely current cost.
The evidence that intangible assets are the majority of value is all around us. On average, the ratio of stock value to tangible assets is currently six to one, up from one to one as recently as the early 1980s. What this means is that on average, company stock is selling for six times the book value listed on the balance sheet. The related conclusion is that 85 percent of the market value is explained by assets not on the corporate balance sheet. This is data captured by Dr. Baruch Lev of New York University and presented in his book, “Intangibles: Management, Measurement, and Reporting.” Increasing value is clearly related to investments in intangible assets.
The world’s greatest investor, Warren Buffet, confirmed that intangible assets are creating value during his opening remarks at the Berkshire Hathaway annual stockholder’s meeting May 6 in Omaha, Neb. In those remarks, Buffett stated, “I can make a whole lot more money skillfully managing intangible assets than managing tangible assets.” Buffett then went on to explain how he has been doing just that for more than 30 years. Early in his career, he shifted from a strategy of buying companies that were “cheap,” which he defined as having a low price to book (tangible asset) value, to buying companies with what he calls “a strong franchise.” In the Lev analysis examined earlier, a “cheap” company would be one where the ratio of the market value to the book value is less than one. Buffett moved away from that valuation approach decades ago.
The success of his focus on intangible assets is reflected in his successful creation of value for Berkshire stockholders. Relating the Buffett investment strategy back to the traditional accounting measurement of book value, in the period 1964 to 2005, Berkshire Hathaway has increased book value per share by 305,134 percent, while the Standard and Poor’s 500 increase in the same measure over the same period was 5,583 percent.
The compelling data on what creates strategic value does not end with the comments of the world’s most successful investor. U.S. Federal Reserve researchers have made an important contribution to the debate about what creates value at the national level. Though derived through a completely different research approach, the macro economic research published by the National Bureau of Economic Research comes to the same conclusion captured by Professor Lev in stock prices and in investment outcomes produced by Buffett. The conclusion is that in the post industrial era defined by the global economy of the 21st century, the overwhelming proportion of value is being created by investments in intangible assets, (including learning), not by investments in traditional items on the balance sheet.
With regard to value creation at the national accounts level, the National Bureau of Economic Research publication titled “Intangible Capital and Economic Growth” provides the data. “The fraction of output growth per hour attributable to the old ‘bricks and mortar’ forms of capital investment is very small, accounting for less than 8 percent of the total growth for the period 1995 to 2003.”
Making Learning a Strategic Value
So what does all this mean in practical terms to a CLO charted with the task of managing a learning organization for the purpose of creating strategic value for the organization? It simply means that the CLO is challenged to manage investments in learning as investments, not merely as a current-period expenses. To be of strategic value, learning activity must be evaluated in terms of future impact, not merely as a cost on this period’s reported earnings statement.
Easier said than done, you say. True, but do not despair. Learning executives love best practices, and there are best practices to be considered. It just so happens that those best investment practices are in finance and accounting rather than in the learning community. It is ironic but true that the very professionals who refuse to account for learning as asset-creation activity are the ones to supply the models for treating learning as an investment.
Three accounting principles provide a core set of best practices for consideration in the management of the intangible assets created by learning. The first is the definition of the future stream of incremental value created by the learning in the current period. The estimation of a future stream of value created by a current-period investment in a tangible asset is a standard approach accountants use. Every tangible asset requires the future stream estimation because virtually no tangible asset is expected to pay back the initial investment in the first year of the investment. It takes years for a major tangible asset to earn an attractive return. Yet, virtually every investment in learning is expected, at a minimum, to pay back the total investment in the year of the expenditure.
Some might object that future streams of value from learning have to be estimated. Indeed they must be, just as the future streams of value created by tangible asset investments must be estimated. The difference is that the best practices in tangible-asset investing have about a hundred-year head start in the estimation processes and methods. The challenge is for learning leaders to develop methods and tools to estimate the future stream of value created from learning. It will probably only take a comparable few hundred million man-hours of effort to create methods and tools comparable in accuracy to those that already exist for estimating value created from tangible asset investing.
The second best-practice principle available from standard accounting is the concept of depreciation. It is a standard practice of tangible asset investment decision making to account for the diminution of the original investment over time. In the case of physical assets on the balance sheet, buildings and equipment wear out over time. In the industrial era, the repeated use of equipment and machinery physically eroded the original functionality of the devices, making the concept of depreciation intuitively obvious. Learning outcomes do not erode away but, even assuming the learner is able to fully retain the skills and knowledge learned, the learning depreciation concept results from the fact that innovation is taking place at a feverish pace and on a global scale. What is learned depreciates in value because innovation is rapidly creating something of greater value in the market, diminishing the original strategic value created by the learning activity.
The last finance/accounting “best practice” we should consider is the way risk is managed in tangible-asset-investment decision making. To date, risk is not a management parameter that has been on the tip of the tongue of learning executives, yet it does exist. Investment decision making involves more than return as in return on investment. Financial experts state that return in the absence of risk assessment is virtually meaningless. The best practice is to consider the risk-return parameters.
In tangible asset management, the future risk to the tangible asset is the probability that the specific balance sheet asset (building, equipment etc.) will be destroyed in a future period. These market forces are already in play as the market radically increases the premium for insurance coverage on buildings along the Gulf Coast of the United States. Future return is being managed by accounting for the increased likelihood of a category 5 hurricane in the near future.
In the management of intangible assets created by learning expenditures, the risk to be managed is the probability that the asset created is not available to produce future strategic value for the company making the learning investment. And exactly what is the probability that a specific individual will be with the firm in future years? In the first year, the probability is one minus the company turnover rate (T), or (1-T). The probability that a specific individual will not still be with the firm two years out is (1-T) x (1-T). And in year n, the probability is (1-T)n.
Creating Future Value
So, what is the take away from the conversation about increasing the strategic value of a learning organization? In summary, the best practice is in managing learning as an investment that creates future value for the firm, not merely as an expense that negatively impacts reported earnings on the income statement.
The challenge is more than an academic exercise. The demographic data for the United States, indeed for much of the rest of the developed world, presents massive challenges for learning organizations. Managing into this future reality is key to success. In the 20 years between the year 2000 and the year 2019, the total pool of potential workers in the key pool of 25-to-44 year old will not grow at all in the U.S. economy. Competitive success will increasingly require the effective investment in learning to attract, develop and retain the key decision makers of the future. Companies that fail to implement best practices in the investment in those intangible assets will be left far behind by the emerging global competitors in their core markets. The threat is to the very existence of strategic value. On the other hand, because the conversation is so new, the opportunity exists to create competitive advantage.
Michael Echols, Ph.D., is vice president of strategic initiatives at Bellevue University and author of “ROI on Human Capital Investment.” He can be reached at email@example.com.