The New Drivers of Business Success: Profitability = Intellectual Capital x Price x Effectiveness. 3 Primary Components of Intellectual Capital.

May 26, 2010 by · 2 Comments
Filed under: Business Strategy 

The old business equation (Revenue = Capacity x Efficiency x Cost-Plus Price) is no longer relevant to the driver’s of success in the business of the future. Buckminster Fuller (designer, cosmologist, philosopher, mathematician, and architect—he designed the geodesic dome) once said, “You can’t change anything by fighting or resisting it. You change something by making it obsolete through superior methods.” It is time to replace the old equation with this new model:

Profitability = Intellectual Capital x Price x Effectiveness

Let us explore each component of the above equation; then we will discuss why it is a better theory for explaining the success of companies operating in today’s marketplace.

We start with profitability, rather than revenue, because we are not interested in growth merely for the sake of growth. As many companies around the world have learned—some the hard way, such as the airlines, retailers, and automobile manufacturers—market share is not the open sesame to more profitability. We are interested in finding the right customer, at the right price, consistent with our vision and mission, even if that means frequently turning away customers. I have coined a corollary to Gresham’s law (bad money drives out good) from monetary economics, affectionately known as Baker’s Law: Bad customers drive out good customers.

Adopting this belief means you need to become much more selective about who you do business with, even though that marginal business may be “profitable” by conventional accounting standards. Very often the most important costs—and benefits, for that matter—do not ever show up on a profit and loss statement. Accepting customers who are not a good fit for your firm— either because of their personality or the nature of the work involved—has many deleterious effects, such as negatively affecting team member morale, and committing fixed capacity to customers who do not value your offerings. This is why the new equation focuses on profitability, not simply gross revenue. When it comes to customers, less is usually more.

Intellectual capital is composed of three primary components:

1.Human capital (HC). This comprises your team members and associates who work either for you or with you. As oneindustry leader said, this is the capital that leaves in the elevator at night. The important thing to remember about HC is it cannot be owned, only contracted, since it is completely volitional. In fact, more and more, knowledge workers own the means of your company’s production, and knowledge workers will invest their HC in those organizations that pay a decent return on investment, both economic and psychological. In the final analysis, your people are not assets (they deserve more respect than a copier machine and a computer)—they are not resources to be harvested from the land like timber when you run out. Ultimately, they are volunteers, and it is totally up to them whether or not they get back into the elevator the following morning.

2. Structural capital. This is everything that remains in your company once the HC has stepped into the elevator, suchas databases, customer lists, systems, procedures, intranets, manuals, files, technology, and all of the explicit knowledge tools you utilize in order to produce results for your customers.

3. Social capital. This includes your customers, the main reason a business exists; but it also includes yoursuppliers, vendors, networks, referral sources, alumni, joint venture and alliance partners, and reputation. Of the three types of intellectual capital, this is perhaps the most overlooked and least leveraged, and yet it is highly valued by customers.

Wealth does not exist in tangible resources—such as timber, land, real estate, oil, and so forth—but in ideas and their creative expression. Oil was completely useless—in fact, if you were a farmer it was an absolute nuisance—until the combustion engine was invented. If it were not for the piston engine and the electricity needs of the industrialized world, the Middle East, which has been sitting on oil for thousands of years, would be nothing more than sand dunes, rocks, and caves.

To reiterate, there are four Ps of marketing: price, product, place, and promotion. Of these, price is the most complex component of the four Ps of marketing. Price is your company’s only opportunity to capture the value you create through your value proposition. Yet pricing has been a sorely neglected topic until recently. In fact, pricing in most industries has been neglected and usually relegated to some rule of thumb, or cost-plus pricing formula. Thankfully, this is beginning to change.

For too long companies have let their price be solely or largely predicated on some arbitrary rule of thumb, competitor’s prices, or on an overhead plus desired net income calculation. These pricing mechanisms are relics of Karl Marx’s Labor Theory of Value, and are completely obsolete in an intellectual capital, innovative, and dynamic economy.

In the business of the future, effectiveness takes precedence over efficiency. A business does not exist to be efficient; it exists to create wealth for its customers. An obsessive compulsion to increase efficiency (doing things right) reduces the firm’s effectiveness at doing the right things. The pursuit of efficiency has hindered most firms’ ability to pursue opportunities, and hence the organization spends most of its time solving problems. One cannot grow a company and continuously cut costs and increase efficiency.

It is not that efficiency is bad, per se; it is that it has been pursued at the expense of nearly everything else. To addinsult to injury, the efficiency measures that do exist in the modern organization tend to be lagging indicators that measure efforts and activities, not leading indicators that measure results and define success the same way the customer does. It is time for companies to develop testable hypotheses in the form of critical success factors and key performance indicators that measure the actual results of their output the same way customers do.

Effectiveness implicitly understands there is no such thing as a free statistic. Just because we can measure something accurately does not mean we should. Effectiveness understands that imprecise measurements of the right things are infinitely more valuable than precise measurements of the wrong things. This will no doubt shock some readers, especially those who were trained in cost accounting or possess MBAs. But controlling costs, and accounting for them, does not ensure success.

Companies are not machines subject to the laws of electromechanical engineering. They are composed of human beings who do not check their emotions at the door, and they are subject to fears, doubts, variable levels of self-esteem, uncertainty, anger, rage, and a whole range of other emotions that cannot be captured by traditional efficiency measurements. In other words, humans are messy. Focusing on effectiveness does not eliminate these issues, but it does take them into account far better than efficiency metrics, which can be desensitizing and inhumane at times.

This new equation comports with the realities of an intellectual capital economy, taking into account knowledge workers who use their hearts and minds, not their brawn and hands. This equation recognizes the importance of mind over matter, the price thereof, and the effectiveness of the workers who produce it, as well as the customers who purchase it.

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