David Crane, commentator and consultant on innovation policy

Knowledge capital underpins productivity gains

By David Crane

Understanding the innovation process remains a key challenge for policymakers and business leaders despite an endless stream of studies. Yet getting it right is even more important today as we struggle to generate good jobs and wealth, with emerging markets such as China, Brazil, Mexico and Korea climbing up the value-added ladder while the US moves to more firmly position itself as the centre for advanced manufacturing and high-tech industries within NAFTA.

A key issue may be that our understanding of the innovation process is not keeping up with the ways innovation works today. "Innovation is a key to business success, but where innovation comes from is changing," the OECD contends in a recent report, Supporting Investment in Knowledge Capital, Growth and Innovation.

"Today's firms are looking beyond research and development (R&D) to drive innovation. They invest in a wider range of intangible assets, such as data, software, patents, designs, new organizational processes and firm-specific skills. Together, these non-physical assets make up knowledge-based capital," the report says. But our focus may be limited to R&D.

This knowledge capital "is transforming what makes firms competitive." While R&D provides the basis for new products and processes, many other factors determine success, including design, marketing, training of employees and logistics. We're learning that all of these elements have to be in place for a successful innovation strategy.

R&D, to be sure, remains a critical part of the innovation process since it is the source of new ideas. But even here, Canada is not doing that well. As the OECD reports in its 2013 Science, Technology and Industry Scoreboard, "Canada is among the few OECD countries where R&D expenditure declined between 2001 and 2011. The decline was mainly due to reduced business spending on R&D." In fact, Canada ranks 21st among OECD nations in domestic spending on R&D as a percentage of GDP. So seeking ways to increase R&D spending remains important.

But a broader policy framework is needed. As the OECD report states, "policymakers should adopt an enlarged concept of innovation, beyond the conventional view in which R&D is pre-eminent. Other forms of knowledge based capital, such as design, data and organizational capital, should also be policy targets."

In effect, the report says, there are three key forms of knowledge-based capital. These are computerized information (including software and databases), innovative property (R&D, mineral exploitation, patents, copyright and creative assets, new product development, new financial services and new engineering designs), and economic competencies (such as brand-building marketing, market research, employee training, management consulting and internal organizational investment).

Building competitive advantage

The automobile industry provides a good example of the role of intangibles in building competitive advantage. Estimates indicate that 90% of the new features in cars have a significant software component, from start-stop systems and improved fuel injection to onboard camera systems for parking, safety systems and communications systems. "Valuable trade secrets now lie in the electronic controls that regulate the operation of motors, generators and batteries. Hybrid and electric vehicles require huge volumes of computer code," according to the OECD report. GM's Volt, for example, has about 10 million lines of computer code.

The best analysis of intangible or knowledge capital in Canada was published in a 2012 paper by John Baldwin and his colleagues at Statistics Canada (Intangible Capital and Productivity Growth in Canada).

They calculated that investment in intangible or knowledge capital by the business sector in 2008 was about 66% of the level of investment in tangible capital, such as machinery and equipment, and that investment in intangible or knowledge capital has been outpacing growth in investment in tangibles; in 1976 investment in knowledge capital was just 23% of the investment intangible capital. Investment in knowledge capital made a "significant contribution" to productivity growth, the statisticians said.

Total investment by business in intangible or knowledge capital in 2008 amounted to $151 billion, or 13.2% of GDP. Of that amount, investment in economic competencies (such as human capital through spending on management and training and spending, management consulting services and building brand equity) accounted for about 60% of the total or about $87 billion, followed by innovative property (including R&D and other science and engineering spending), which accounted for about 30% or about $47 billion, while investment in computerized information, including software, accounted for the rest, or about $17 billion.

R&D appears to account for about 25% of overall spending on innovation. Business spending on intangible or knowledge capital rose from $40.3 billion in 1990 to $96.8 billion in 2000 and $150.7 billion in 2008.

For good policies, we also need better information. Intangibles represent many of the core assets of a firm, but they are hard to identify on corporate balance sheets. Moreover, while private sector intangible assets such as human capital, knowledge or intellectual property and organizational capital such as brands and employee training, are important in assessing a country's competitiveness and capacity for innovation, they are poorly tracked.

Likewise, governments make major investments in knowledge capital — from education and R&D to statistical data, direct spending on knowledge networks and enforcing product safety standards — but that spending is also poorly tracked. Squeezing StatsCan means it lacks the resources to develop the information we need for better-informed policies.

As we know, competitive advantage comes from innovation, and innovation depends in large part on intangibles or knowledge capital. This matters to us because the future prospects for economic growth and good jobs will have to come from productivity-based innovation. For example, achieving the ambitious export targets in the government's new Global Markets Action Plan depends on developing innovative products and services the rest of the world wants to buy. We cannot build a future that depends simply on large export volumes and rising prices of oils sands oil.

David Crane is a commentator and consultant on innovation policy. He can be reached at crane@interlog.com.