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: khyzer_bin_dost@yahoo.com

Regn. No. M-Phil 2083267

December, 2009

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, measurement error, and exogenous shocks beyond the control of the production unit. This research would focus on developing DEA parametric method which will help for batter understanding the relationship of IC with financial performance.

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. The results of IC on financial performance would be compared by using nonparametric and parametric methods.

Introduction
The world is viewed as becoming less labor intensive, less material intensive, less energy intensive, but more knowledge intensive. It is assumed that knowledge has a financial impact as knowledge intensive organizations are considered to feature a higher productivity level and innovation rate. There are increasing criticisms of traditional accounting methods such as balance sheets, which look backwards and at tangible assets only, and a growing demand for effective management of intangibles. Guthrie et al. (2003) divide the perspectives of intellectual capital into three branches: accounting, management control and management. The accounting perspective focuses on specific indicators of intangibles (e.g. research and development expenses, training costs, goodwill, advertising, patents, brands, customer satisfaction, etc.) for the purpose of their capitalization. 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. The difference between the market value and book value of a company is said to represent its intellectual capital (Edvinsson and Malone, 1997; Roos and Roos, 1997; Bukh et al., 2001). Stewart (1994) simplifies IC in his article in Fortune as IC is something that cannot be touched but still adds financial value. Petrash (1996) divides IC into three parts, i.e. human capital, organizational capital and customer capital. Edvinsson and Melone (1997) define IC as knowledge, information, intellectual property, expertise and creative ability of human brain which

could be converted into value. Roos, et al. (1997) consider sum of the knowledge of employees and practical translation of their knowledge as part of IC. Pulic (1998) viewing IC as integration of human capital (HC), structural capital (SC) and capital employed (CA). Competitive success depends less on the strategic allocation of physical and financial resources but more on strategic management of intellectual capital. Since intangible assets often represent more than two-third of corporate value (Van Buren, 1999), furthermore, the other study also indicates that 80% of the value of a company is intangible (Osborne, 1998). 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, IC measurement and management become extremely important (World Bank, 2006). 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. Thus DEA become a new tool in operational research for measuring technical efficiency. It originally was developed by Charnes, Cooper, Rhodes(1978) with CRS and was extended by Banker, Charnes, Cooper(1984) to include variable returns to scale.

Literature Review
Technology Broker: Technology Brokers instrument helps to recognize IC components, value and leverage the IC in an organization. Questions ask subjective answer rather than Likert-Scale quantitative response. Like Skandias IC measure it also considers number of PCs per employee as measure of structural capital which may not be properly utilized in value generation. It does not include some important IC resources. Brooking, A. (1996). Human Resource Accounting: Subjective and uncertain method, needs more reliability, assumes many things i.e. average number of employees in the future, average increase in wages per year, etc. which makes it difficult to use. It does not provide assurance in application. Translating everything into money can be superficial. Sackmann et al. (1989). Market to Book Value: This method is popular, straightforward and fast to calculate. As the method attempts to measure IC through M/V, which may vary within days/hours, which leads to highly fluctuating value of IC. Roos (2003) recognizes it totally wrong and inherently meaningless. He further argues that drop in M/V does not necessarily mean fall in IC. Stewart (1997), Luthy (1998). Balanced Scorecard: It is widely accepted method due to simplicity in covering components of IC. It was not actually meant for IC measurement. It hardly calculates value creating efficiency or IC of a firm and mixes up different components of IC into four perspectives. Kaplan and Norton (1992). Intellectual Capital Model: Strength of the model is its focus on creating value through improving employee efforts in combination with customer and organizational capital. On the other side it lacks financial and economic dimensions

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

Methodology
The mathematical and statistical techniques would be use to enhance DEA in to parametric model. SPSS would be used for data analysis and LSE-25 companies would be use for this study.

References
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