Knowledge Capital - its valuation aspect


Rakesh Anand
Sr. Faculty Finance
ICFAI University

Not only individual but group and team capital is now a buzzword. See how group work not only in service but in production industry also.

Growing need to raise knowledge capital:-

  • Power to influence profitability existence of an organization.
  • You need knowledge capital for collaboration contracts & implementation.
  • You need knowledge capital for carrying amalgamation & mergers.
  • Capacity to build brand.
  • Basis for other forms of capital.
  • High quality and international mobility possible.  

Groups & individual capital has great potential. It can achieve almost anything in this era. This is above anyone's imagination. Amazing, this form of capital is really great. This form of capital is the future of this century and we are going to witness its amazing performances. I can see how it will overshadow every activity including commercial one. So why not this should get place in the financial statements. The reason for not including knowledge capital in financial statements is due to money measurement concept. So the solution lies in finding a way of its measurement i.e. accounting of knowledge capital.

Its great analytical power has given it an extra edge over any other form of capital. This analytical power leads to new technologies, strategies, policies, principles, tactics etc. Understanding something & understanding it properly and then finding out way to work with it has made this capital great.

Models for measurement of knowledge capital in monetary terms:-

Cost models are based on the acquisition cost, including replacement and training costs and opportunity cost of human asset. The supporters of this model are Burmment, Flamholtz and Pyle.

The Lev & Schwartz model, more monetary-centric, is based on the likely future earnings of an employee till his retirement.

Methods for Valuation of Knowledge Capital

Historical Cost Method

This method was proposed by Brummet to measure a firm's investment in human resources. The current scarifies for obtaining future benefits is the cost of human resource. The method suggests capitalizing the firm's expenditure on recruitment, selection, training and development of employees and treats them as assets for the purpose of human resource accounting.

Capitalization of costs is  contrary to traditional accounting norms and  does not reflect value. Moreover the accumulated costs of human resource acquisition and development may not reflect its proper worth. Instead of this, the total performance needs should be assessed in relation to the total cost associated with human resource  to reflect their value.

Replacement Cost Method

This method involves assessment of replacement cost of individuals, and rebuilding cost of the organization to reflect human resource  asset value of both the individuals and the organization. However, the replacement cost may not reflect either the actual costs or the contribution associated with human resource .

Opportunity Cost Method

According to this method the  computation of monetary value and allocation of people to the most promising activity and thereby to assess the opportunity costs of key employees through competitive bidding among investment centers.

Behavioral Method

In this method  a set of casual variables through psycho-social test results reflecting the appreciating or depreciating condition of human organization as reflected by a set of intervening variables, which in turn, are likely to result in the achievement of the end result variables. The investment in human resource   value has been proposed to be amortized over the years in tune with the condition of the human organization.

Economic Method

Lev & Schwartz advocated the estimation of future earnings during the remaining life of the employee and then arriving at the present value by discounting the estimated earnings at the employee's cost of capital. The formula adopted for computation of the present value of the future earnings in an extension to the formula propounded by Lev & Schwartz.

Flamhlotz value  human resource  on the basis of  the roles which  the employees are to perform. The method also considers the present value of the future services at different service states and takes into consideration the migration of an employee from one service state to the other. However, the estimates of the employees occupying different service states in his career in the organization can be highly probabilistic and unreliable.

Harmonson advocated the human resource  value as the present value of the future wages payable for the next five years discounted at the adjusted rate of return. The adjusted rate of return is the average rate of return on the owned assets of all firms in the economy multiplied by efficiency ratio of the organization. This method attempts to bring into question the effectiveness of return on investment of the industry on the assumption that there are no extraneous factors and that the results were due to efforts of the employees.

Each model has its own negatives and positive when it comes to practical application. In an Indian context, the Lev & Schwartz model has an edge over the other models. Since the method has been widely adopted by Indian companies such as Infosys, DSQ Software Ltd., Satyam Computers, BHEL and SPIC, it enables the company to benchmark the performance and efficiency of their human resources with others. The assumptions in this model are realistic and scientific. The method has practical applicability when availability of quantifiable and analyzable data is concerned.

A Study of the Annual Reports of Infosys

The Lev & Schwartz model has been used by us to compute the value of human resources. The revaluation is based on the present value of the future earnings of the employees and on the following assumptions:

  • Employee compensation includes all direct and indirect benefits earned both in India and abroad.
  • The incremental earnings based on group/age have been considered.
  • The future earnings have been discounted at 13.63% (previous year-14.09%), the cost of capital for us. Beta has been assumed at 0.98, the beta for us in India.

    As of March 31,                               2005                                     2004          

                                      Employees                 value of         Employees            Value of
                                               (No.)    human resources                (No.)   Human resource
                                                                (in Rs. Crore)                            (in Rs. Crore)

    Software delivery                 34,747      26,550.12                    24,110          19,739.75
    Support                              20,003       1,784.13                      1,524            1,400.21

    Total                                 36,750       28,334.25                    25,634          21,139.97

    As on March 31                                                                       2005                  2004
    Employees (No.)                                                                     36750               25,634
    Value of human resources                                                    28334.25          21139.97
    Software revenue                                                                   7129.65           4852.95
    Total employee cost                                                               3539.11            2450.96
    Value added excluding exceptional items                                  6052.85            4184.96 
    Net profits excluding exceptional items                                      1846.48           1243.63
    Key ratios                                                                    
       Total software revenue/human resources value (ratio)                  0.25                 0.23
       Value added/human resources value (ratio)                                 0.21                 0.20
       Value of human resources per employee                                      0.77                0.82
       Employee cost/human resource (%)                                         12.49%           11.59%
       Return on human resources value (%)                                       6.52%             5.88%


Rakesh Anand
Sr. Faculty Finance
ICFAI University

Source: E-mail May 24, 2006


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