Developing Data Envelopment Analysis in to model for Intellectual Capital and financial performance

Synopsis for M-Phil thesis to be presented at the School of Business Administration National College of Business Administration & Economics 40/E-1, Gulberg III, Lahore – 54600, Pakistan, Tel: 92-42-5752716, 19

Muhammad Khyzer Bin Dost Cell: 92-313-4257864 E-mail:
Regn. No. M-Phil 2083267

December, 2009

human capital.) for the purpose of their capitalization. information. i. management control and management. less energy intensive. 1997.Statement of Topic At present DEA is in the form of non parametric equation and have many disadvantages like it does not allow direct hypothesis testing and derived measures of inefficiency are confounded with the effects of noise. organizational capital and customer capital. advertising. etc. Aim of the study The main aim of the study would be to enhance DEA in to parametric method for batter understanding the relationship between intellectual capital and financial performance.. research and development expenses. intellectual property. measurement error. 1997. and exogenous shocks beyond the control of the production unit. Roos and Roos. The results of IC on financial performance would be compared by using nonparametric and parametric methods. expertise and creative ability of human brain which . (2003) divide the perspectives of intellectual capital into three branches: accounting. The management control perspective emphasizes how these indicators can be used for management control purposes while the management perspective calls forth a new managing approach where intangibles are in the limelight. Introduction The world is viewed as becoming less labor intensive. The difference between the market value and book value of a company is said to represent its intellectual capital (Edvinsson and Malone. and a growing demand for effective management of intangibles. less material intensive.e. It is assumed that “knowledge” has a financial impact as knowledge intensive organizations are considered to feature a higher productivity level and innovation rate. customer satisfaction. which look backwards and at tangible assets only. goodwill. training costs. Petrash (1996) divides IC into three parts. Edvinsson and Melone (1997) define IC as knowledge.g. 2001). There are increasing criticisms of traditional accounting methods such as balance sheets. patents. This research would focus on developing DEA parametric method which will help for batter understanding the relationship of IC with financial performance. Stewart (1994) simplifies IC in his article in Fortune as IC is something that cannot be touched but still adds financial value. Guthrie et al. brands. The accounting perspective focuses on specific indicators of intangibles (e. Bukh et al. but more knowledge intensive.

Intellectual Capital Model: Strength of the model is its focus on creating value through improving employee efforts in combination with customer and organizational capital. 1999). the other study also indicates that 80% of the value of a company is intangible (Osborne. Kaplan and Norton (1992). On the other side it lacks financial and economic dimensions . structural capital (SC) and capital employed (CA). Market to Book Value: This method is popular. Thus DEA become a new tool in operational research for measuring technical efficiency. The services sector play a vital role in growth of economies around the globe and as the share in overall gross domestic product (GDP) of a country rise more rapidly than its production sector. (1989). Since intangible assets often represent more than two-third of corporate value (Van Buren. Balanced Scorecard: It is widely accepted method due to simplicity in covering components of IC. Charnes. (1996). which makes it difficult to use. Roos (2003) recognizes it totally wrong and inherently meaningless. 2006). needs more reliability. Stewart (1997). Cooper(1984) to include variable returns to scale. Luthy (1998). average number of employees in the future. He further argues that drop in M/V does not necessarily mean fall in IC. It does not provide assurance in application. It does not include some important IC resources. straightforward and fast to calculate.e. Roos. Cooper. Rhodes(1978) with CRS and was extended by Banker. DEA(Data Envelopment Analysis) is the optimization method of mathematical programming to generalize the Farrell(1957) single-input/ single-output technical efficiency measure to the multiple-input/ multiple-output case by constructing a relative efficiency score as the ratio of a single virtual output to a single virtual input. average increase in wages per year. Like Skandia’s IC measure it also considers number of PCs per employee as measure of structural capital which may not be properly utilized in value generation. IC measurement and management become extremely important (World Bank. which leads to highly fluctuating value of IC. It was not actually meant for IC measurement. Questions ask subjective answer rather than Likert-Scale quantitative response. assumes many things i. It hardly calculates value creating efficiency or IC of a firm and mixes up different components of IC into four perspectives. which may vary within days/hours. etc. Competitive success depends less on the strategic allocation of physical and financial resources but more on strategic management of intellectual capital. furthermore. (1997) consider sum of the knowledge of employees and practical translation of their knowledge as part of IC. Human Resource Accounting: Subjective and uncertain method. Literature Review Technology Broker: Technology Broker’s instrument helps to recognize IC components. Brooking. Translating everything into money can be superficial. Pulic (1998) viewing IC as integration of human capital (HC). value and leverage the IC in an organization. 1998). As the method attempts to measure IC through M/V. et al. It originally was developed by Charnes. A.could be converted into value. Sackmann et al.

1997). Lovell 1993. A typical statistical approach is characterized as a central tendency pproach and it evaluates producers relative to an average producer. Those observations found to be most efficient (and hence are located on the constructed frontier) are assigned a ‘score’ of 1. DEA is commonly used to evaluate the efficiency of a number of producers. a producer is usually referred to as a decision making unit (DMU). (2005) examined the relationship between value creation efficiency and market to book value ratios after controlling R&D and advertising expenditure which were considered as part of structural and relational capital respectively. One of the latest studies conducted by Appuhami (2007) using VAIC method on Thai banking. Tseng and Goo (2005). Lovell 1993. this approach has two disadvantages: it does not allow direct hypothesis testing (Ray 2004) and derived measures of inefficiency are confounded with the effects of noise. They empirical investigation found significant positive impact of IC on firm’s market value. Ray 2004). 2005). DEA compares each producer with only the "best" producers. conducted by Yalama & Coskun (2007) on intellectual capital performance of banking sector of Istanbul stock exchange. In DEA. there are a number of producers. visualized positive relationship between IC and corporate value. in the DEA literature. finance and insurance sector found very strong and significant relationship between firm’s IC and investors’ capital gains on shares. reveals strong association of VAIC with profitability using relatively new technique of Data Envelopment Analysis in IC. Abernathy et al. Ray 2004). and exogenous shocks beyond the control of the production unit (Fare 1985. By the way. return on equity and return on assets. a large number of papers used and extended the DEA methodology. In contrast. Later study. The production process for each producer is to take a set of inputs and produce a set of outputs. However. after adopting ICM in its factory has achieved 20% more productivity each year (Fruin. measurement error. DEA is a nonparametric method and has the advantage that it does not impose a functional form on the production function (Fare 1985. whereas output oriented approach looks for maximum output level with the given inputs. which had input orientation and assumed constant returns to scale (CRS). Toshiba Electronics Company. The term “Data Envelopment Analysis” (DEA) was invented by the paper of Charnes. using structured equation model to analyze the relationship between IC and corporate value on Taiwanese manufacturers. (1996). The input oriented DEA analysis aims the same output level with the minimum inputs.of firm. while the other observations in the sample are allocated a score less than one. McKinsey’s ranking of the top 10 Asian companies includes three Taiwanese companies. DEA is a linear programming technique that estimates an efficient frontier based on the observations in the sample. Each producer has a varying level of inputs and gives a varying level of outputs. Chen et al. (2003) estimate that investment in IC creates twice fruits as compared to the same amount of investment in physical assets. DEA analysis can be done with input or output orientation. Since then. Petrash. . The study also indirectly proves the relationship between capital gain on shares and corporate financial performance. Cooper and Rhodes (1978). which focused on human capital and network effect rather than on investing in physical capital (Tseng and Goo. These authors proposed a model.

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