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From Resource,
July 2005
Copyright by LOMA
Measuring Return on
Human Capital Investments
Many
different parties are now attempting to develop methods for measuring the impact
of human capital on corporate performance.
By
Jean C. Gora
Manager, Research, LOMA
Many
insurance CEOs would like to better understand how to manage their human capital
to boost their companies’ performance. Human capital represents the knowledge,
skills, and competencies of employees that allow them to be productive. It
contrasts with ordinary physical capital such as buildings and information
technology (IT) systems. When companies invest in physical capital, they try to
select alternatives offering the highest return on their investment. They would
also like to invest in human capital offering them the highest return. While
reliable methods for measuring the return of their investments in physical
capital exist, no similar methods have existed with regard to human capital.
As
a result, few North American companies have formal processes for measuring the
return on their investments in people and human resources (HR) programs. A
Towers Perrin survey of such companies (311 firms responded) in the summer of
2003 showed that only 12 percent of the companies had formal processes in place,
and only 13 percent plan to implement them in the next two years.1 A
survey of almost 200 chief financial officers by CFO Research Services and
Mercer Human Resource Consulting showed that although companies spent more than
one-third of their revenue (36 percent) on human capital expenses, only 16
percent said they had more than a moderate understanding of the return on their
human capital investments.2 Therefore,
they tend to treat employees as costs and to view the HR function as a cost
center. When executives want to know, for example, whether changing their
recruiting practices will have more of an effect on their bottom lines than
investing in training, no one can give them a clear answer.
Many
different parties are now attempting to develop methods for measuring the impact
of human capital on company performance.3 In
general, these attempts start in one of two directions:
*Some
attempts start with the firm’s financial performance and work back from there
to try to identify the portion of performance resulting from the firm’s
intangible assets, of which the skill of its employees is one.
*Other
attempts start with specific HR activities and work forward from there to
identify an effect on the firm’s financial performance.
Unfortunately,
the two approaches tend not to meet in the middle.
No
Consensus
The
approaches starting with financial performance are strong mathematically, but
vague in their treatment of specific activities associated with the HR
development life cycle. These approaches are receiving attention because a
significant part of a company’s current market value no longer arises from its
accounting book value but rather from something else.
In
1980, accounting book value represented more than 80 percent of the market value
of the S&P 500; the remainder was unexplained. By August 2002, after the
stock market crash, accounting book value had dropped below 25 percent of market
value.4 Where
did all of the unexplained value come from? It represents intellectual,
organizational and human capital that is not measured adequately by current
accounting systems. How these other factors should be measured is unclear.
Another
financial approach uses a return-on-assets method to calculate the value of
intangible assets. However, it too is very general in its treatment of the
specific activities responsible for the creation of value.5 These
methods are interesting from a financial reporting point of view. The
United Kingdom
, for instance, is moving toward requiring human capital management reporting by
listed companies. However, they are not particularly useful to managers making
decisions about such things as compensation systems and employee development
programs.
Even
methods that allow valuation of an individual employee’s contribution to the
business may yield little that is directly relevant to a company trying to
decide, for example, whether to hire new people or train old ones. Dow Chemical
uses two measures of return on human capital: expected human capital return (HCR)
and actual HCR. Expected HCR represents the break-even point that the company
expects on its investments in people above and beyond the salaries it pays them.
The company considers market conditions and other factors when it establishes
expected HCR. Actual HCR represents the value contributed by an individual
employee derived from the value created by the projects the employee works on.
The company is already able to calculate the net present value of projects. This
method allows it to identify what portion of the net present value is the result
of the performance of particular employees.6 This
information is useful when the company is trying to evaluate individual
performance. By itself, however, it does not offer the company much information
about what it needs to do to produce employees who have high levels of
performance.
In
contrast to approaches that start with financial performance as described above,
those starting with HR activities are strong in their treatment of the direct
effects of specific activities, but often vague in demonstrating how these
activities affect the firm’s financial performance or shareholder value. These
approaches are promising, however, and the remainder of this article addresses
them. Some background information is useful:
A
company’s HR activities are typically organized according to the
HR development life cycle (see Human Resource Development Cycle,
below). A firm has processes for each phase of
the life cycle. Many aspects of these processes can be automated and can
communicate with the firm’s other systems.
For
example, SAP, a major vendor of HR systems, offers employee life-cycle
management, including the management of recruiting, learning, performance, and
compensation; employee transaction management, including the management of
payrolls, benefits, time and attendance; and workforce deployment tools,
including project resource planning and staffing. The same system also offers
self-service access to HR systems by managers and employees and includes
workforce analytic tools. These systems can communicate not only with one
another, but also with other parts of a firm’s enterprise resource planning (ERP)
system, including its financial management, supply-chain management, and
customer relationship management systems.
The
attempts to show how a firm’s human capital affects its financial performance
typically start with the processes supporting the HR development life cycle.
They then try to establish a chain of cause and effect relationships that link
the processes to financial performance.
According
to this line of reasoning, a company with strategically focused state-of-the-art
processes supporting the HR development life cycle will hire the right employees
and put them to work doing the right things. The result will be happy customers
(who remain loyal and buy more) and high levels of quality and efficiency.
Together, these factors will produce the financial performance the firm and its
shareholders want. Or so the theory goes.
Finding
Proof
Proving
causation is difficult. Here is why: Typically, attempts to show causation
involve statistical analyses of data generated by the company’s own HR,
customer relationship management, and financial management systems plus the
results of surveys of customers, employees and business partners. These analyses
allow a company to identify correlations. For example, they might show that
stores with low levels of employee turnover report higher levels of customer
satisfaction than stores with high levels of employee turnover. Similarly, they
might show that satisfied customers are more likely to be repeat buyers than
dissatisfied customers are.
These
correlations suggest causation—that is, low employee turnover rates produce
high levels of customer satisfaction, which produce high levels of repeat sales.
However, other factors may also have important impacts on customer satisfaction
and repeat sales. One can only say conclusively that a causal relationship
exists if one conducts an experiment in which other possible causes are held
constant and levels of employee turnover are varied. In the real world,
limited-scope experiments are possible. For example, it is possible to determine
the effect of a training program by assembling two pools of people with similar
skills, experience, jobs, managers, and so on. People in one pool receive
training, while those in the other pool do not. The performance of the two
groups is then compared. However, complex experiments involving multiple
possible cause-effect relationships tend to be impractical in the business
world. Even if they were possible, such experiments are often too difficult to
accomplish or undesirable for business reasons.
Despite
the fact that absolute proof of a causal relationship may not be possible,
statistical analyses and predictive models deriving from the decision sciences
can improve the quality of decision-making by reducing the uncertainty
associated with it. These techniques allow one to identify and apply the
relationships between “available information and a question of interest whose
answer is uncertain.”7 In
the HR arena, correctly designed employee selection tests that have been
validated against a large number of employees can predict an individual’s
likelihood of performing a particular job successfully. LOMA’s selection
tests, for example, have been validated in this way and are extensively used in
the insurance and financial services industry.
In
the marketing arena, target marketing, which is based on data generated by
previous customer purchases, can identify individuals with a higher than average
likelihood of making future purchases. In auto insurance underwriting, credit
scoring, which is based on data generated by previous policyholders’ credit
and accident behavior, can identify individuals with a higher than average
likelihood of filing auto insurance claims. Thus, while it may not be possible
to prove that certain human capital measures boost financial performance, it may
be possible to identify which ones have a higher than average likelihood of
doing so.
Contact
center operations are well-suited to this kind of analysis because virtually the
entire customer-employee interaction is captured electronically. One of the best
known attempts to demonstrate the interaction between employee
performance—that is, the performance of specific individual employees—HR
systems, customer behavior, and sales comes from Harrah’s Entertainment, an
operator of numerous casinos.
Harrah’s
pursues a customer intimacy strategy. Its objective is to increase revenue by
increasing the number of satisfied customers. To this end, it captures a large
volume of data as its customers use each casino’s facilities (slot machines,
restaurants, and other retail areas). It stores this information in a data
warehouse, where it becomes available for statistical analysis. Thus, it has
profiles of its customers’ financial behavior and can identify which customers
are the most profitable. Harrah’s also surveys customer satisfaction
regularly. It has found that high levels of satisfaction among its most
profitable customers lead to high levels of revenue growth. These measures have
allowed it to structure certain activities, such as its human capital processes,
explicitly to meet the needs of its most profitable customers. For example, its
performance appraisal and reward system is explicitly designed to identify and
reward employees who receive high service quality ratings from customers.
The
firm’s large data warehouse has also allowed it to examine the relationship
between certain HR measures such as the employee turnover rate, individual
performance data, and customer satisfaction. Hence, when it discovers problems
in customer satisfaction, it can tell whether the problem results from
inadequate performance by particular employees or from flaws in its recruiting
and hiring practices. In one case, Harrah’s found that high levels of employee
turnover were responsible for declining customer satisfaction levels and sales
in one casino. It took steps to decrease turnover and saw customer satisfaction
levels and same-store sales levels rise. Thus, it was able to see very clearly
how its HR practices affected its profitability.8
A
number of consulting firms now offer tools designed to assist in the human
capital measurement process. These consulting firms make a valuable contribution
to the science of human capital measurement by maintaining multi-company
databases. In statistical analysis, the larger the sample size, the greater
confidence one can have in the validity of the results. The more companies that
contribute data to the consulting firms’ predictive models, the more valid
their models are likely to become. However, a particular consulting firm’s
client base may not be representative of an industry as a whole. For an
insurance company, the more insurance clients the firm has, the greater the
chance that the model will have predictive value when applied to that insurance
company.
Here
are the highlights in the public domain of selected consulting-firm HR models.
It should be noted that different firms disclose different information about
their models. Direct comparisons are, therefore, impossible.
Model
1—Accenture
Accenture
is developing a new model that addresses a wide range of factors contributing to
shareholder value creation. These factors include human, organizational and
relational capital as well as monetary and physical resources already addressed
by traditional accounting. To get data for the model, it surveys stakeholders
and links their perceptions to measurable company attributes and resources.
Using scenario analysis and sensitivity testing, it tries to predict the
consequences of different combinations of resources, value drivers, and
transformations. It attempts to show “what resources affect what attributes,
and what attributes affect what stakeholders, as well as the trade-offs that
might improve overall shareholder value performance.”9
The
HR part of Accenture’s model follows the cause-effect chain shown above.
Accenture tries to show that sound, strategically aligned, human resource
management processes produce desirable human capital capabilities, which, in
turn, produce high levels of customer satisfaction and retention plus high
levels of quality and productivity; these, in turn, produce desirable financial
results. Accenture applied this model initially to 19 global companies. As it
applies the model to more and more organizations, it hopes to improve its
predictability.10
Accenture
begins by assessing the maturity of a firm’s basic HR processes supporting the
HR development life cycle, their strategic alignment, and their use of the
competency model. This assessment borrows from measurement techniques used in
quality improvement and software engineering; it also involves benchmarking.
Data are collected through surveys of front-line and HR employees.
Next,
Accenture examines the human capital capabilities created by the HR processes.
It evaluates the proficiency and efficiency of the work force, employee
adaptability and engagement, leadership capability, and effective management of
the firm’s talent. Employee surveys are used to capture information on these
issues. It then examines the impact of these factors on quality, efficiency, and
customer satisfaction. Finally, it attempts to show how these factors affect
financial performance. It surveys finance and line executives to obtain the
information needed for this part of the model.
One
practical application of the model might be to help a company having problems
with profit declines and low levels of customer satisfaction. Accenture could
analyze the relationship among a variety of factors affecting customer
satisfaction and profitability. These factors might include recruitment,
competency management, learning/training, and workforce proficiency. It would
then be able to advise the company regarding the most promising methods of
boosting customer satisfaction in a manner that also appears likely to boost
profits.
Model
2—Watson Wyatt
Watson
Wyatt also reports developing a model that can predict the impact of HR
activities on a firm’s shareholder value. This model, derived from surveys of
750 North American and European companies, is embodied in its human capital
index. Watson Wyatt reports that companies with rising shareholder value are
more likely than their counterparts to show superior performance in three areas
of the HR development life cycle: recruiting, rewards, employee relations
(collegial workplace and communications integrity). It verified the
predictability of its results by conducting the survey twice, once in 1999 and a
second time in 2001. It was able to establish that companies with high scores on
its human capital index in 1999 achieved greater improvements in shareholder
value by 2001 than companies with low 1999 human capital index scores.
Presumably Watson Wyatt can use its index to identify companies likely to enjoy
superior growth in future shareholder value.
Model
3—
Gallup
The
Gallup Organization has developed a model called the Gallup Path that is
designed to show how improvements in a company’s human capital can improve its
financial performance. It uses a cause-effect chain similar to the one described
above, but includes 12 steps. It starts with identifying the strengths of a
company’s employees and ensuring they are in positions that allow them to
capitalize on their strengths. Then it tries to show that success in these areas
produces great managers, who produce engaged employees, who produce engaged
customers. Then it tries to show that engaged customers produce sustainable
corporate growth (as measured by such things as revenue per store or per product
or number of services used per customer), which leads to real profit increases,
which should cause shareholder value to rise.
Gallup
provides products that help companies improve their
performance on the first five steps along the path. For example, it has a set of
12 questions that measure employee engagement. It reports that its research
shows that high scores on these 12 questions are positively associated with five
outcome measures: employee retention, productivity, customer
satisfaction/engagement, safety, and profitability.
Model
4—HC Bridge
This
model, developed by a professor at the
University
of
Southern California
and an executive of an HR consulting firm, is designed to improve the quality
of corporate decisions regarding human capital. The model requires a company to
examine three issues: impact, effectiveness, and efficiency.
The
company first identifies the kinds of talent that have the greatest impact on
its competitive success. To gauge effectiveness, the company then examines the
relationship between its HR practices and the quality of its talent pool—in
other words, are the company’s HR activities bringing it the kind of talent
most necessary to its competitive success? To gauge efficiency, the company then
looks at the quality of its HR processes—in other words, is the company
receiving the best HR processes possible in light of the money it is spending?11
Model
5—Mercer HR Consulting
Mercer’s
disclosures about its model are sketchy. It says it uses applied statistical
methods and principles traditionally found in economics and organizational
psychology to evaluate the internal dynamic of an organization (internal labor
market analysis and employee sensing) and the impact of this dynamic on the
company’s business (business impact modeling). These methods allow a company
to link explicitly specific business effects to individual human capital
tactics—changing the mix of full-time and part-time workers, adjusting the
reward system, or changing spans of control, for example.12
MercerHRMetrics
offers two kinds of tools designed to create measurable links between a
company’s HR practices and its business performance.
Its
market alignment tools allow a company to compare business performance, human
capital practices and HR infrastructure to market conditions, performance and
practices. These tools allow a firm to understand the effectiveness of its
processes supporting parts of the human development life cycle (e.g.,
compensation, benefits, stock option rewards).
Mercer’s
organizational alignment tools enable a company to link its people practices to
its business performance. These tools allow a company to assess the relationship
of its human capital practices and its business design; assesses the human
capital implications of its current business design, and to identify financial
and operational drivers of shareholder value creation.
Model
6—Hewitt Associates
Hewitt
Associates, in collaboration with Michael Treacy, has designed a model that
describes the HR activities associated with double-digit corporate growth. It
examines the relationship between double-digit growth and the following:
broad-based pay, engagement, executive compensation, leadership, sales
organization practices, and strategic sourcing. It uses Treacy’s definition of
growth to compare double-digit growth companies with their counterparts. To
qualify as a double-digit growth company, a firm must have a CAGR five-year
average growth in profitability (revenue minus cost of goods sold) of 10 percent
or more and hit that target at least three of the last five years. The companies
used in Hewitt’s research come either from its engagement databases or from
surveys of businesses. Presumably this information could be used in a model that
predicts future corporate growth rates on the basis of a company’s practices
in the areas of pay, engagement, executive compensation, leadership, sales
organization practices, and strategic sourcing.
Just
as the quality of marketing decision-making has been boosted by the introduction
of target marketing decision sciences tools, the quality of HR decision-making
is likely to rise as decision sciences tools are applied to HR decisions.
Insurance companies will benefit as a result.
n
Editor’s
Note: For
information on how LOMA can help insurers and financial service companies with
their human resources challenges, see below.
Endnotes
1.
Towers Perrin, “Managing Performance and Rewards in a Challenging
Business Environment,” TP Track, August 2003, p. 14 (www.towers.com).
2.
CFO Research Services, “Human Capital Management: The CFO’s
Perspective,” February 2003, p.3 (www.mercer.com).
3.
See Stefano Zambon et al for the Commission of the European Communities
Enterprise Directorate General “Study on the Measurement of Intangible Assets
and Associated Reporting Practices,” April 2003, pp. 160–160. Zambon lists
the following intellectual capital and intangibles measurement models:
*Market-to-book value and Tobin’s Q.
*Stern et al (1991, 2001) for Economic Value Added™ .
*Lev (1999) for Knowledge Capital calculation formula.
*Edvinsson and Malone (1977) for the Skandia Navigator.
*Sveiby (1997) for the Intangible Assets Monitor.
*Kaplan and Norton (1992, 1996, and 2001) for the Balanced Scorecard.
*Lev (2001) for the Value Chain Scorecard.
*Brooking’s (1996) for the Technology Broker.
*Bontis (2000) for Quotations-important patents.
*Darroch and McNaughton (2002) for the “Measure of knowledge management“
method.
*McGraw, Bassi, and McMurrer (2002) for the Learning Capacity Index.
*M’Pherson (1999) for the Inclusive Valuation Methodology (IVM).
*Andriessen and Tiessen (2000) for the Value Explorer method.
*Sullivan (2000) for the Intellectual capital valuation method.
*Anderson and McLean (2000) for the Total Value Creation (TVC™ )
method.
*Nash (1998) for the Accounting for the Future (AFTF) method.
*Johansson (1996) for the Human Resource Costing & Accounting (HRCA)
method.
* Stweart (1997) and Luthy
(1998) for the Calculated Intangible Value method.
*Pulic (2000) for the Value Added Intellectual Coefficient (VAIC™)
method.
*Jac Fitz-Enz (1994) for the “human capital asset” method.
* Roos, Dragonetti and Edvinsson (1997) for
the IC-Index™.
*Viedma Marti (2002) for the Innovation Capability Benchmarking System (ICBS)
method.
4
. John
Ballow, Roland Burgman, Goran Roos, and Michael Molnar, “A New Paradigm for
Managing Shareholder Value,” p. 7.
5.
Stefano Zambon et al for the Commission of the European Communities
Enterprise Directorate General “Study on the Measurement of Intangible Assets
and Associated Reporting Practices,” April 2003, p. 160. This method requires
that the company subtract its ROA from the average ROA of the industry and
multiply the result by the average amount of intangible and fixed assets. “By
subtracting this result from net earnings, the percentage of net earnings
ideally attributable to intangible assets can be determined. Then, using the
average cost of capital or a given interest rate, the average expected earnings
flow attributable to intangible assets can be discounted to obtain an estimate
of their overall present value.”
6.
CFO Research Services, “Human Capital Management: The CFO’s
Perspective,” February 2003, p.28 (www.mercer.com).
7.
Stone Analytics, “Automated Analytics and Predictive Modeling,” (www.stoneanalytics.com).
8.
Gary Loveman, “Diamonds in the Data Mine,” Harvard Business Review,
May 2003, pp. 109–113.
9.
Ibid., p. 18.
10.
Peter Cheese and Bob Thomas, “Human Capital Measurement: How Do You
Measure Up” Human Performance Insights, Accenture, May 1, 2003.
11.
John W. Boudreau and Peter M. Ramstad, “Strategic HRM Measurement in
the 21st Century: From Justifying HR to Strategic Talent Leadership,” Cornell
University’s Center for Advanced Human Resource Studies, Working paper
02–15, August 14, 2002, p. 10 (www.hcbridge.com).
12.
Mercer Human Resource Consulting, “Creating new value through human
capital strategy,” April 4, 2003 (www.mercerhr.com).
Business
Solutions: Think of LOMA First!
LOMA
is committed to forming and strengthening business partnerships with its members
that help them to improve their management and operations. LOMA can help make
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To
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stage
1
Business Needs
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Stage
2
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*
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Stage
6
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As
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Information
Center
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Stage
7
Total Rewards
When
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For
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