Mounting evidence shows that good HR practice increases shareholder value.
But as competition drives management to use every lever it can to win business
advantage, the time has come for HR to prove its strategic worth beyond doubt.
Tom Lester reports
Measuring the effectiveness of the HR function has taxed the best business
brains for many years. The aim has been to prove the contribution of ‘people
assets’ to corporate success and the HR processes needed to increase it. But
new interest in the subject in the past couple of years focuses on the other
perspective – the company’s value in the market.
Given the growing part of HR that is intangible and derived from its people,
what HR practices are effective in increasing its value and growth rate, and
how can they be made more effective?
It may appear that the difference is a semantic one, but in practice, it
could transform the old question of HR measurement. If, as claimed, a 26 per
cent increase in the value of companies’ shares correlates closely with the
effective use of a number of key HR practices, then this is a message no chief
executive can ignore. If, further, it can be shown that one company is deriving
more value from its human resources than another, these points can help HR
prove its strategic worth.
These are big ifs. But increased competition and the growing emphasis on
shareholder value are driving managements to use every lever at their disposal.
The similar rise in the relative value of knowledge, experience and goodwill
compared to physical assets depends on the quality of staff. Further, in the
leaner organisation there can be few passengers, and the value added by each
individual is critical. If such vital dimensions remain unmeasured, however
crudely, the chief executive is relying on hope rather than verifiable fact.
Swiss banking group UBS, like all firms in the financial sector, depends on
the quality and deployment of its staff, and has recently taken radical steps
to measure them consistently across the group. Earlier this year it set up a
central Human Capital Performance Team. "Very few companies can say, as we
can, that metrics are right at the heart of what we do," says the team’s
founder and head John Mahoney-Phillips.
It will take time before the disciplines implied by the metrics are
universal and used effectively by management. Like all the big banks, UBS has
to span the cultural differences between retail banking and the more
entrepreneurial asset management and corporate finance (it embraces Warburg and
Paine Webber). "But we now have a single group-wide core framework,"
Attaching financial values directly to intellectual capital remains elusive,
however. In the 1960s, the well-known US academic Rensis Likert tried it with
research workers, but he found the obvious difficulties outweighed the
advantages. In the 1990s, Gerald Kaplan and David Norton produced the balanced
scorecard that added HR and other measures to the conventional financial ones.
At about the same time Leif Edvinsson, when working for Swedish financial
services group Skandia, published an analysis of the group’s intellectual
capital (IC) with the annual report. His aim was to demonstrate to managers and
shareholders alike what really made for success in financial services.
Skandia still uses Edvinsson’s analysis of IC, which it plans to include in
its next annual report after a three-year gap. Human capital is defined as the
competence and capabilities of the bank’s employees; organisational capital
covers systems, databases, and so on, plus customer capital – the value of its
relationship with customers. The group’s reward came this year when it was
ranked eight in the world’s top 20 most admired knowledge enterprises – above
McKinsey and Cisco.
Conventional metrics generally range from the very basic staff productivity
and turnover, through talent acquisition and retention to leadership,
innovation and other qualities. Which ones you choose, says Carolyn Nimmy, a
director of the global HR practice at consultancy Cap Gemini Ernst & Young,
depends on the answer to the question: "What does winning entail for your
company? Innovation? Brand strength? Quality? Globalisation?" "You
then ask," she says, "what can we measure against these?"
A number of consultancies are picking up the metrics baton. They see that linking
HR practices to business success can make sense, providing you allow for
economic and stock market fluctuations and different capital structures. PIMS,
the corporate performance benchmarking specialist, uses its worldwide database
supplied by more than 5,000 managers to calculate a client’s expected return on
capital employed based on a profile of its business.
HR characteristics such as an open management style or the number of days
managers spend training per year are then assessed for their impact on the
actual return on investment.
Watson Wyatt, being an HR consultancy, uses a much smaller database than
PIMS, but has developed what it calls a Human Capital Index (HCI). This is a
rating of an organisation’s HR practices on a single scale of 1 to 100. It has
shown that those scoring highly are, on average, more likely to have built up
greater intellectual capital (as measured by the ratio of market value to
tangible assets at replacement cost, known to economists as Tobin’s Q).
They also deliver more shareholder value. The IC ratio is susceptible to
market fluctuation, but is used as a means of comparison. Partner Steven Dicker
claims it to be "a robust method for determining whether you are managing
your human capital better or worse than your rivals".
There are other attempts being made to link people and results. In essence,
all are forced to use a subjective assessment of a company’s HR operations
(usually performed by the company’s HR staff), and most make no claim to have
isolated a causal relationship with the bottom line. PIMS comes nearest, with
its long-standing contention that 15 per cent of a company’s profit performance
"is driven by HR strategy", and singles out 10 of the characteristics
of HR policy as having the most significant impact (see left).
Watson Wyatt says its European list accounts for 60 per cent of the
difference in size of intellectual capital from one company to another, and 26
per cent of the increase in market value (in Europe, in the year of the survey
– 2000). It finds that a further two practices, the paternalistic retention of
staff and job security, actually decrease market value. Companies with high
HCIs, Dicker notes, have done better financially in the downturn this year,
"but a good financial performance does not lead to a better HCI".
How relevant is all this sophisticated measurement to the average company?
"Unless it provides information and support that enable senior management
to act," says Nimmy, "then the managers’ reaction is likely to be,
Laurence Handy, professor of international business at Tilburg University
near Eindhoven, makes a similar point. The need, he believes, is for "HR
to identify the business problems and the gaps, and address itself to the HR
component of these." Benchmarking may prove nothing more than successful
companies can afford good management.
Still, what gets measured gets managed. In the case of one client, ABB
Power: "The Watson Wyatt analysis," according to commercial manager
Ian Funnell, "pointed to specific action we could take – or stop doing –
to enhance shareholder value."
Eric Senesi, European HR director of Agilent, the two-year-old
Hewlett-Packard spin-off that specialises in electronic components and test
equipment, sees that "the metrics you put in place depend on the maturity
of HR in the company. Most companies are still in the lower quadrants".
He uses a lot of process measures at present, such as the attrition rate of
newcomers and the percentage of managers whose variable pay is on track and can
therefore be assumed to be performing well. He claims to have a "minimum
but robust system" in place, but "we’ll use higher levels of metrics
in the future – it is a way to mobilise people and focus attention on the
issues that matter."
On a practical note, Senesi warns that metrics will only work if the
infrastructure is suitable: comparability of data, ease of access and rapid
response demand a high degree of standardisation and good IT systems. It
remains true that the value lies in the use made of the information rather than
the sophistication of the system itself. If it helps to improve corporate
performance and the status of HR, it will be a sound investment.
Barometer of human resources
15% of profit performance driven by
the following HR factors:
– Management participation
– Open management style
– Take some risks, but not too many
– Top managers spend 20 per cent of time with customers
– About 20 per cent outsiders in top management
– The importance of management training
– Incentivising top managers
– Succession planning
– Good appraisal system
– Getting employee feedback
26% increase in market value (in 2000) driven by the following
– Use of knowledge and contract workers
– Recruiting excellence
– Consistent pan-European HR practices
– Top managers spend 20 per cent of time
– Good union-management relations
– Lack of hierarchy, clear leadership
– Teamwork, 360 feedback
– Customer-focused environment
– Remuneration and ‘Me plc’
– Sharing information with employees