5 Human Capital

Stijn Masschelein

In the previous chapter I introduced the notion of specific knowledge and mainly focused on how it complicates the transaction cost blueprint for the hierarchical notion. Because top management needs to rely on specific knowledge in the departments, they need to use management accounting tools and incur additional transaction costs. That part of the story focuses on the costs of specific knowledge. In contrast, this chapter focuses on the benefits of specific knowledge. Because specific knowledge is difficult to communicate, it is also difficult to imitate and thus specific knowledge is a valuable source of a difficult to imitate competitive advantage. In this chapter, I will extend this argument to human capital such as capabilities, specific knowledge, reputation and trust of employees and suppliers.

Human Capital as a Source of Competitive Advantage

An organisation’s strategy in this textbook refers to the crucial investments that give a company a difficult to imitate competitive advantage. In this section, I discuss a minimum requirement for a strategy to be difficult to imitate. A sustained competitive advantage requires that no other organisation can apply the same strategy and improve upon it. I argue that solely investing in technology or physical assets can always be imitated by other companies if these competitors can buy the same assets and technology. In contrast, human capital is more difficult to imitate because human capital takes time to develop and therefor can not be just bought. In other words, developing trust with employees or suppliers takes time. Over that time, the company has to maintain its impeccable reputation and not betray the trust. If the employees of the firm have specific knowledge, a competitor can pay the employees a higher compensation to lure them away, but it will take time for them to establish the same working relationship with these employees. In other words, it is the working relationship that gives a company competitive advantage.

The distinction between physical capital and human capital is not always easy but for accountants a good rule of thumb is that physical capital is much more likely to be found on the balance sheet while that is not the case for human capital [1]. Physical capital is assets such as stores, factories, and machines. In this category, I also include technology because most technological solutions need a physical representation. Human capital are assets tied to specific people such as capabilities, culture, reputation, specific knowledge, trust of employees and stakeholders.

Although there are some obvious exceptions such as the adage “location, location, location” for the tourism industry, there are striking examples of the importance of human capital over physical capital. One particular example is the rise of Japanese car manufacturers in the U.S. market. Recent studies have investigated why for decades General Motors was not able to copy the strategies of Toyota despite having closely worked together in an alliance. Several researchers have highlighted that General Motors made considerable investments in automation during the time they learned the best practices from Toyota but it still took them two decades to catch up. One team of researchers concludes that the difficulty for General Motors was to copy the relations that Toyota had with its suppliers and employees which allowed Toyota to fully exploit the improved technology (Helper & Henderson, 2014). For instance, Toyota involved suppliers in the design process of new models and employees in continuous improvement of the manufacturing process. General Motors tried to create the same efficiency gains through heavy handed monitoring and incentive contract. However, these formal practices prevented the development of cooperative relations between General Motors, its suppliers and its employees. As it turns out, it was the willingness to cooperate and communicate mistakes that made it possible for Toyota to become more efficient.

This example also has direct relevance for management accounting practice. One of the accounting practices that got popularised by Japanese manufacturers is Kaizen costing (see p. 203 in Horngren et al. 2014). With Kaizen costing, the budgeting process assumes that costs of production will steadily decrease over time because of continuous small improvements to the production process. In Toyota, the actual decrease in costs is driven by incremental improvements in the production process discovered by manufacturing employees. Despite the lack of explicit incentives for the employees, they trusted that management would reward them for all suggestions to the production process. In General Motors, employees lacked the trust in management and incentive systems were difficult to devise which inhibited the effective introduction of Kaizen costing and continuous improvement programs (Helper & Henderson, 2014). This example highlights that the successful introduction of new management accounting systems depends on other factors such as the culture of the firm. The case of Toyota reflects the importance of human capital in general. The next section discusses why human capital is difficult to imitate.

Strategy as Human Capital

So far, when talking about the strategy of the organisation I have implicitly assumed that top management knows and can explain the strategy of the organisation at least when they are able to collect all the necessary information to make strategic decisions. However understanding of what makes an organisation successful requires experience and deep knowledge of the industry in which the organisation is operating. It should not come as a surprise that we can think of strategic insight as a form of specific knowledge or human capital.

Strategy as Specific Knowledge

Top management often has difficulty to explain or quantify their own strategy in for instance a balanced scorecard. It is not that they do not know what they are doing. They have difficulty to communicate it to other employees or to the outside world. Management skills are difficult to transfer from one manager to another. Research has shown that one of the best predictors of bad management is whether the firm is led by a second generation owner-manager (Bloom et al., 2010). In other words, while the founder of a company might be an excellent manager, they will often not be able to pass that skill on to their offspring.

One role of management accounting is to transform this informal and subjective knowledge into general knowledge that can be communicated to everyone in the firm or be stored over time. For instance, a founder’s intuitive knowledge of who should be doing which work can be replaced by a formal hierarchy with clear job descriptions. The earlier mentioned role of balanced scorecards in communicating the firm’s strategy is another example. Cost price calculations based on value chain analysis can formalise implicit engineering knowledge. The engineers might have an intuitive idea of which products are difficult to produce and which ones are not. However, other divisions might not be aware of these insights or understand where that knowledge comes from. If the production difficulties are captured in the cost of producing a simple versus a complex product, the sales people can use that information in setting the price and the finance people can incorporate that information in decisions to scrap product lines (Wouters & Wilderom, 2008; Wouters et al. 2009). In other words, the formalisation of intuitive, subjective, specific knowledge in numbers can help to transfer that information across the firm.

Specific, subjective knowledge can yield a difficult to imitate competitive advantage for a firm because other firms cannot immediately build up the same knowledge. It is by definition difficult for firms to store and communicate that information throughout the whole firm. If specific knowledge is not formalised, firms risk to loose the knowledge when the employees leave the company. Management accounting systems such as performance measures are an attempt to make the subjective information more objective and general. Formal management accounting systems can serve as a memory for deliberate, top-down strategies. For instance, balanced scorecards are used to map a strategy and develop a system of measures to track the success of a strategy. When the executives who developed the strategy leave the company, the balanced scorecard can help their successors to implement the same strategy. In other words, formal system can help to communicate the strategy not only across divisions but also across time.

A Bottom-up Strategy

The introduction of specific knowledge and human capital in our framework puts the emphasis on bottom-up decision making. Departments and people in those departments have skills, relations, capabilities, and knowledge that cannot be replicated by top management. So far, I implicitly have followed the transaction cost economics view where top management decides the overall strategy of the organisation, that is which combination of investments can give it a difficult to imitate competitive advantage. I did acknowledge that sometimes top management will have to rely on the departments to make decisions on which investments are beneficial but we can go one step further. The definition I use for a strategy does not require it to be determined by top management.

It is possible that top management only has a vague idea of which direction the company should take but top management is excellent at nurturing and motivating people to come up with new ideas [2]. In this case, the strategy is more bottom up than top down because the rank-and-file employees effectively set the direction of the firm. In addition, we will see that top management often has difficulties in clearly formulating what the firm’s strategy actually is. The implementation of strategic management accounting tools are often hampered by that lack of knowledge but at the same time the process of implementing a management tool sometimes helps top management realise what their strengths and weakness are.

This emerging bottom-up strategy also benefits from management accounting tools. If nobody in the firm has an obvious grasp of the strategy, you might ask how the strategy can be implemented. A firm can use management accounting tools such as incentive contracts and targets to align the interest of employees with the interest of shareholders, i.e. creating long-term value. The joint effort of employees are now responsible for the emerging strategy. Budgets help to coordinate the needs of different divisions and allocate the limited funds of the company even when the firm does not know exactly how to execute the strategy. In other words, companies benefit from strategic management accounting tools even in the absence of a clearly formulated strategy because management accounting tools focus the attention of the employees and coordinate their efforts.


This chapter on human capital introduces another key component in my view on strategic management accounting. The human capital view emphasises the importance of the people in the organisation and their skills, capabilities, and knowledge. I have explained that these people can be a fundamental part of making an organisation’s strategy difficult to imitate exactly because the human capital is difficult to quantify. In contrast to what some might expect, this does not imply that there is no role for management accounting. Indeed, sometimes organisations will use strategic management accounting tools to formalise and quantify some of the unstructured knowledge of its people. Other organisations will use management accounting tools to coordinate and motivate the employees to work in the best interest of the organisation. Which brings us to the next chapter.


Bloom, N., & Van Reenen, J. (2010). Why do management practices differ across firms and countries? The Journal of Economic Perspectives, 24(1), 203–224. https://doi.org/10.1257/jep.24.1.203

Helper, S., & Henderson, R. M. (2014). Management Practices, Relational Contracts, and the Decline of General Motors. Journal of Economic Perspectives, 28(1), 49–72. https://doi.org/10.1257/jep.28.1.49

Wouters, M., Anderson, J. C., Narus, J. a., & Wynstra, F. (2009). Improving sourcing decisions in NPD projects: Monetary quantification of points of difference. Journal of Operations Management, 27(1), 64–77. https://doi.org/10.1016/j.jom.2008.07.001

Wouters, M., & Wilderom, C. (2008). Developing performance-measurement systems as enabling formalization: A longitudinal field study of a logistics department. Accounting, Organizations and Society, 33(4–5), 488–516. https://doi.org/10.1016/j.aos.2007.05.002

  1. One of my many, equal part frustrations and enjoyments in life is to see the recurring cycle of financial accounting colleagues struggling with designing general accounting rules on how to value the type of human capital that is in fashion at the time. In the chapter on the balanced scorecard, I will explain why I think that is impossible and why that is not a problem. Firms have developed robust management accounting solutions to deal with this problem.
  2. I think Alphabet (formerly Google) is an example of this type of bottom-up strategy.


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