Basic information on VAIC™

1. Value Creation – the Ultimate Objective of Business and Political Management

Intellectual capital management is not and can not be a means to an end in itself but must be
in the function of value creation that is the prime objective of any business. Therefore it is
inevitable to deal with this important issue too.

Nowadays, business logic is based on achieving growth and long term value creation. The
problem is, that the traditional indicators of business success, such as increase in revenue,
cash flow, profit, market share, and technological leadership in fact do not provide
information whether the companies really create value for the shareholders and owners or
not. Only when a company creates more than it has invested in resources can we speak of
value creation. With regard to that it is of vital interest to all stakeholders that business
strategy is directed toward that objective – value creation – and that the measuring systems
reflect the ability of management to achieve that objective.

However, increasing pressure and responsibility towards shareholders and employees imply
the focus on value creation as the new criterion for business success (research carried out
on stock exchange proves that there is a relationship between value creation efficiency and
the market value of the company). The ultimate objective is to enhance a company’s abilities
in the long term, which can be achieved by investing in intellectual resources (especially in
human capital, which is the key factor in value creation in modern business) and increased
mobilisation of the internal potentials of the company, first of all the intangibles.

The key premise for value creation in the company is that all the contributions to value
creation but also value destruction can be measured without ambiguity, which frequently
requires a new organisation scheme and new indices. In addition to this, the processes of
planning and decision- making must be focussed on value creation. At the same time,
responsibility and decision- making processes should be lowered, since value is being
created and destroyed both at the highest and the lowest levels (processes). Executive
management should, in addition to effective cost control, together with top management,
identify the possibilities of increasing value creation efficiency. Throughout this process all
the available intellectual potentials within the company can be mobilised in order to achieve
maximum value (both for the shareholders and the employees). Most of the companies,
which adopt new systems, are under stress, since they are facing problems. It is a pity, since
a timely orientation enables management to control the process of value creation, and
instead of curing the consequences it can focus on continuous increase of value creation
efficiency.

Intangible value creation has to be considered as well, since it has an enormous impact on
the overall performance of a company. Nowadays value is created through complex relations
between supply and demand, the supply being today much higher than the demand. Peter
Drucker describes traditional business activity as follows: «Buy cheap, sell at a higher price,
and the difference is your profit». In this approach the profits are lower because of costs: the
lower the costs, the higher the profits. This is why special attention was paid to costs during
the industrial era. Modern theory defines business activity as value added and wealth, which
is far more complex than ever before. In order to create earnings, it is necessary to raise the
relationship with the customers to a higher level. Moreover it is also important to realise that
the tangible form of value creation (income, value added) is dependent on intangible forms of
value creation (increased time and effectiveness of communication, better relationship with
customers, building up and keeping good reputation).
The key to success is in creating cause-and-effect relationships between these two forms of
value creation. It could be said that one of the main challenges for management is creating
conditions which will enable successful generation of intangible value (knowledge, services,
experience, benefits, speed, quality, image) and its transformation into tangible forms
(income, profit, value added, shares, market value). Systematic value creation management
is based on the premise that this concept is firmly embedded in the company as the ultimate
business goal of. It is important that it is “lived” on all the levels of business in day-to-day
activities, stimulated, rewarded, measured and communicated.

Such an orientation towards value creation is a long-term strategy, which by no means

includes increasing profits over the short term. On the contrary, the objective is to improve
the ability of a company to create value over the long term, which includes investments in
intellectual capital. In the course of this process it is necessary to analyse and constantly
improve the value added chain.

The logic of value creation is relevant for regions and nations as well, since the standard of
living, social well being,attractiveness as business location and place for living depend to a
large extent on the ability of nations and regions to create value. Therefore governments will
have to develop a stronger focus on value creation and issues tied to intellectual capital if
they want to be able to create nurturing environments for the development and optimal
utilisation of intellectual resources.

The necessity of a mental shift from cost control towards the logic of value creation can be
demonstrated by the image of a cake. Instead of fighting for the size of their piece (budget,
funds) all the economic subjects ought to join forces in order to achieve a synergetic effect
and thus increase the size of the existing cake. This way the size of the pieces will be bigger
and the satisfaction of the recipient too. The increase of the economic cake is in everybody’s
interest: the employees, employers, shareholders, partners, labour unions, local and national
government, cities and counties. Only if there is value creation - meaning that the cake is big
enough it will be possible to share it to everybody’s satisfaction. The bigger the cake and the
less resources were employed in creating it, the more will be for sharing – salaries and
wages, benefits, taxes, research and development, sponsorship. There will also be more
engagement, motivation, satisfaction and collaboration and less fighting, frustration and
dissatisfaction. This should be a valid argument in favour of introducing the logic of value
creation not only at corporate but also at regional and national level.

2. Value Creation Efficiency of Intellectual Capital – a New Index

Experts agree that the existing measuring system can not be considered adequate output
measures for IC-performance. As business processes are less and less based on tangibles,
which have been the base for traditional management systems, the question arises how to
manage not only processes and companies but also regional or national economies in the
case when intangibles have become the key factor of value creation. Trying to provide an
answer to that question many methods and approaches have appeared during the past 15
years.i

Peter Drucker states that “ The most important, and indeed truly unique contribution of
management in the 20th century was the fifty fold increase in the productivity of the manual
worker in manufacturing. The most important contribution management needs to make in the
21st century is similarly to increase the productivity of knowledge work and knowledge
workers. The most valuable asset of a 20th Century Company was its production equipment.
The most valuable asset of a 21st century institution will be its knowledge workers and their
productivity”.ii For the further development of knowledge economy it will be crucial to reach
the above stated goal.

I would like to introduce the VAIC™- Value Added Intellectual Coefficient (also known as
the Value Creation Efficiency Analysis) as my solution to the above stated issue. It meets
the basic requirements of contemporary economy of a “measurement system” indicating the
real value and performance of a company, region or nation, enabling benchmarking and
predicting future abilities in a relatively objective way. It is useful to all participants in the
value creation process – employers, employees, management, investors, shareholders and
business partners and can be applied at all levels of business activity.iii The basic parameters
are created value and the resources creating that value, intellectual and physical/financial
capital.

Value added is taken as the most appropriate indicator for the business result as does the
British Ministry of Trade and Industry, referring to value added as “the preferred measure of
the wealth created by activities of a company”.iv

Value added is calculated as the difference between output and input. The basic definition is
as follows:
VA = OUT – IN
where: VA = value added for the company; OUT = total sales; IN= cost of bought – in
materials, components and services

Value added can be calculated from the company accounts as follows:

VA = OP + EC + D + A

where: OP = operating profit; EC = employee costs; D = depreciation; A = amortisation

Value added is a totally objective indicator of business success and shows the ability of a
company to create value which needs to include the investments in resources including
salaries and interests for financial assets, dividends to the investors, taxes to the state and
investments in future development. After VA has been calculated the computation of the
efficiency of resources – intellectual capital and financial capital - is a matter of simple
mathematics.

Intellectual capital has two components, human and structural capital. All the expenditures
for employees are embraced in human capital. What is new about this concept is that
salaries and wages are no more part of INPUT.

This meets the demand for giving employees the status of key resource by treating
them as investment and not as cost any more. They invest their knowledge and skills,
which is valued by the market through the company’s activities and reflected in the created
value added. I have published this solution in a rudimentary form in 1993 and the
expenditures for employees definitively renamed into human capital in papers written in 1997
and 1998.v Today this is accepted by most of the authorities in this field.

Efficiency of human capital is calculated as follows:

HCE = VA / HC

where: HCE = human capital efficiency coefficient for company; VA = value added; HC =
total salaries and wages for company
Structural capital, as the second component of IC, is calculated as follows:

SC = VA - HC
where: SC = structural capital for company; VA = value added; HC = total salary and wage
duties for company

As the equation already indicates, this form of capital is not an independent size as human
capital. It is dependent on the created value added and in reverse proportion to HC. This
means that the bigger the share of human capital HC in the created value added (VA) the
smaller is the share of structural capital (SC). In some cases SC does not even has to occur
– e.g. if VA is less than the investments in HC. Because they have to be brought in the same
position towards VA the efficiency of HC and SC is calculated in a different manner. If SC
were calculated in the same way as in HC (VA/SC) an illogical result would be obtained,
meaning that the efficiency of SC would rise with the fall of efficiency of HC, which is just
impossible. Contrary to that it is logical that the efficiency of both, HC and SC rises as this
increases the total efficiency of IC.

Structural capital efficiency (SCE) is therefore calculated in the following manner:

SCE = SC / VA
where SCE = structural capital efficiency for company; SC = structural capital;
VA = value added

Intellectual Capital Efficiency (ICE) is obtained by adding up the partial efficiencies of

human and structural capital the.

ICE = HCE + SCE

where: ICE = intellectual capital efficiency coefficient; HCE = human capital efficiency
coefficient; SCE = structural capital efficiency coefficient

I believe that today ICE is for knowledge work and the knowledge worker what once were
productivity for manual work and the manual worker. In order to receive a full insight into the
efficiency of value creating resources it is necessary to take physical and financial capital into
account. Although loosing its predominant position in new economy its relevance can not be
neglected. Intellectual capital cannot create value on its own. Therefore we need information
on capital employed efficiency which can be calculated in the following manner:

CEE = VA / CE
where: CEE = capital employed efficiency coefficient; VA = value added
CE = book value of the net asset for a company

In order to enable comparison of overall value creation efficiency all three indicators need
to be added up.

VAIC™ = ICE + CEE

where: VAIC™ = value added intellectual coefficient; ICE = intellectual capital efficiency
coefficient (HCE + SCE); CEE = capital employed efficiency coefficient

This aggregated indicator allows us to understand the overall efficiency of a company and
indicates its intellectual ability. In simple words, VAIC™ measures how much new value
has been created per invested monetary unit in resources. A high coefficient indicates a
higher value creation using the company’s resources, including IC. We therefore have a new
way to understand organisational efficiency.
3. The benefit of such analysis
Apart from encompassing the concept of value added and enabling one to decipher the value
added efficiency of a company/nation’s FC and IC resources, several other major reasons
underscore the use of the VAIC™ methodology. First, VAIC™ provides a standardised and
consistent basis of measure thereby, better enabling the effective conduct of an international
comparative analysis using a large sample size across various industrial sectors. Alternative
IC measures are limited in that they: (a) utilise information associated with a select group of
company/nations (for example stock data); (b) involve unique financial and non-financial
indicators that can be readily combined into a single comprehensive measure; and/or (c) are
customised to fit the profile of individual company/nations.vi Consequently, the ability to apply
alternative IC measures consistently across a large and diversified sample for comparative
analysis is diminished. Second, all data used in the VAIC™ calculation is based on audited
information; therefore, calculations can be considered objective and verifiable. Other IC
measures have been criticised due to the subjectivity associated with their underlying
indicators. Additionally, concerns have been raised about difficulties in verifying information
used in calculating indicators comprising other IC measures. Third, VAIC™ is a
straightforward technique that enhances cognitive understanding and enables ease of
calculation by various internal and external stakeholders. Ease of calculation is a feature that
has enhanced the universal acceptance of many traditional measures of corporate
performance (such as ROA, market-to-book value). Alternative IC measures are limited as
they only be calculated by internal parties or rely upon sophisticated models, analysis and
principals. Finally, the VAIC™ methodology is utilised in more and more studies as it is
receiving increasing research attention.

However, VAIC™ is primarily a tool for scanning, like a blood picture or X-ray, which is
why it is best if combined with other IC/KM management and measurement tools.

i
Andriessen, D. (2004), Making Sense of Intellectual Capital, Elsevier
ii
Drucker, P. (1999), California Management Review
iii
Pulic, A. (2004), “Intellectual Capital – does it create or destroy value?”, Journal of Business Performance
Management – Measuring intangible assets – the state of the art vol. 8, No.1 2004
iv
UK Department of Trade and Industry: “2004 – Value Added Scoreboard”
v
Pulic, A. (1993), Elemente der Informationsekonomie, Wien,
vi
Roos, Roos, Dragonetti and Edvinsson, 1997; Sullivan, 2000