Getting the measure of human capital

How can HR measure the contribution of its people to the company’s bottom
line? In the first of a two-part investigation based on joint in-depth research
by Personnel Today and Deloitte & Touche, we shed light on methods employed
to solve the human capital equation. By Sue Weekes

Human capital: what is it?

Human capital is the term used to describe the people within an organisation
and the value they create. ‘People’ covers everyone from the office cleaner to
the CEO and ‘value’ means the bottom-line contribution that such people make to
the company.

The first part is easy to understand and measure; the second far more
difficult – and therein lies the problem. Because it is so difficult to measure
human capital, it remains the most valuable asset not to appear on the balance
sheet.

Being able to successfully measure human capital represents one of HR’s biggest
opportunities to prove it has a strategic function. With this firmly in mind,
Personnel Today, in conjunction with Deloitte & Touche Human Capital
Advisory Services (HCAS), has produced a major research report, Measuring Human
Capital Value, that examines whether the approaches to measuring the
relationship between investment in people and business results are sufficiently
effective in allowing organisations to reliably measure their human capital. In
this first of a two-part examination of the research, we present a picture of
the current geography of human capital in the UK, how it is being measured and
what companies are hoping to achieve by measuring it.

From the outset it becomes clear that even the term ‘human capital’ is open
to wide interpretation by the HR profession. Asked what their understanding of
the term is, definitions ranged from ‘another term for human resources’ right
up to the more encouraging ’employee asset value of an organisation’. More than
50 respondents from the sample selection of 250 HR professionals said they
didn’t use the term human capital, and fewer than 50 didn’t give an answer at
all (Fig 1).

It may well be that just as ‘personnel’ became ‘human resources’, human
capital will be the new terminology for HR. As Stuart Crainer suggests in his
book A Freethinker’s A-Z of the New World of Business: "This [human
capital] encapsulates the concept of people as a vital corporate investment and
source of future profits." For the purposes of this article, however, human
capital is used to describe the people within a company and the value they
create for that organisation.

Why it’s important for HR

Embracing the concept of human capital and finding the right device to
measure it presents HR with its greatest chance to be demonstrably strategic to
the board. Clearly demonstrating the worth of the workforce in a way the board
can relate to, will, in turn, demonstrate HR’s worth as a strategic unit that
adds value to the business rather than simply providing a service. This doesn’t
mean totally trans-forming the HR professional from a touchy-feely person into
a bean-counting accountant, but it may mean borrowing some of the finance
department’s practices – or at least adopting part of its mindset on occasions.

"I’m a great believer in what gets measured, gets done and should be
rewarded," says Brett Walsh, head of Deloitte & Touche HCAS.
"When HR is asked for figures all it can do is look longingly at its feet
so human capital measurement provides a great opportunity.

"HR needs to dispel the myth that it is the organisation’s policeman.
It has the potential and capacity to leverage significant bottom-line
performance improvements." Measuring human capital effectively, he says,
is the "holy grail" for HR.

In many ways, it is not so much turning part-accountant as using a bit of
common business sense. Training, for instance, should directly benefit the
bottom line because it is making a substantial investment in an asset (an
employee) that should yield an improved performance. But unless it is measured
and demonstrated to the board, the HR professional will find it difficult to
secure funds for similar training in future, especially in a climate of cost
reductions.

Why human capital doesn’t make the balance sheet

The report tells us that human capital is generally excluded from the
balance sheet for three main reasons:

– it is an intangible and dynamic asset that is difficult to value

– there is no universal framework for valuing it

– companies don’t know how to track or account for movements in human
capital.

As a result, human capital has come a remarkably short distance since the
term appeared in the 1950s (see box, Roots of Human Capital). This is even more
remarkable considering that human capital has a bearing on all critical
business decisions made inside an organisation and how it is used directly
affects the ability of other organisational assets to realise their value.

But even if historically it hasn’t been deemed an asset, there is no excuse
for doing the same now. Barry D Libert, Steve MSamek and Richard E SBoulton,
the authors of Cracking the Value Code: How Successful Businesses Are Creating
Wealth in the New Economy, suggest: "In 1978 on average book value
represented 95 per cent of market value while 10 years later it was 28 per
cent. Today, it is estimated 80 per cent of stock market value is driven by
assets that do not appear on the balance sheet; assets like people, brand,
knowledge and relationships."

Walsh cites the original dotcom wunderkind, Lastminute.com, as a classic of
the kind.

"It has brand, people, relationships and all those type of things but
it has far fewer physical assets than a traditional organisation," he
explains. As a result "human capital and its relationship to business has
increased and it has a growing relevance to the balance sheet", he adds.

How do we measure human capital?

There are currently a number of methodologies in use for measuring human
capital which set out to help organisations make the right decisions when
investing in people so as to derive a quantifiable business benefit. They are:

1. HR benchmarking and metrics

The research shows that by far the most common of the approaches taken are HR
benchmarking and HR metrics, used by 50 per cent of the sample. One of the
reasons for the high ranking is that both of these methodologies are relatively
easy to implement.

Benchmarking is based on comparing HR policies and practices with those of
other organisations – in a benchmarking exercise a company might assess areas
such as retention rates, cost per employee to recruit, cost per employee to
train and compare the figures with other organisations inside and outside of
its sector.

HR metrics work by a company setting its own indicators which are measured
within the organisation, then compared with other organisations. It comes as no
surprise that HR benchmarking and HR metrics are the most commonly used
methodologies because they are the "most user-friendly," says Walsh,
who adds that some of the more accountancy-based models discussed later
"require almost micro-measuring of the business before you begin."

2. The balanced scorecard

The next most popular method of measuring human capital is the balanced
scorecard, used by 32 per cent of respondents. Originally developed by Robert
Kaplan and David Norton, the scorecard presents a holistic view of a company’s
current state of health by monitoring its activity across all areas via key
performance indicators (KPIs) – a series of tick boxes that measure financial
performance and company growth as well as assessing the value of business
processes, customer relationships, and investment programmes. Because the
balanced scorecard measures intangible as well as tangible values, it has
always been favoured by HR.

3. HR practice effectiveness models

HR practice effectiveness models assess the contribution of the HR function
and HR practices to business performance and are used by only 4 per cent of the
sample.

4. Accountancy-based Valuation and Economic Value Added (EVA) models

As their name suggests, these methodologies are rooted in traditional
accounting metrics and, given that they are harder to implement, are the least
used of all the measurement tools available. The accountancy-based valuation
model, which creates a numerical value for human capital using accountancy
terms and often values employees as assets, scored only 3 per cent. The EVA
model – which takes a company’s operating profit after tax and subtracts the
capital used to guarantee that profit – fared rather better at 10 per cent of
respondents.

5. Combined methodologies

Forty-eight per cent of the respondents use more than one methodology with
the most popular combinations being HR benchmarking and metrics together with
the balanced scorecard, benchmarking and metrics together with EVA, and the
balanced scorecard together with EVA.

Who uses what?

The research suggests that the bigger the organisation, the more likely it
is to use HR benchmarking, HR metrics and the balanced scorecard and this
probably comes down to resources. There may also be more stakeholder and
director pressure to drive the concept of human capital analysis. Walsh sees
the use of these methods increasing over the next 12 months given the current
environment of cost reduction and demands for improved service levels. Another
factor contributing to their growth in the larger organisations is the
increasing adoption of major enterprise-wide systems with their ability to record
and hold large amounts of data.

"As the HR functionality and data mining capability of the new
enterprise resource planning systems from the likes of SAP, PeopleSoft and
Oracle becomes more widespread, there’ll be a bigger capacity to automatically
record data, so there will be a lot more personnel data available," he
says.

When it comes to examining which methodologies are popular with which
sector, with the exception of construction, the use of HR benchmarking and HR
metrics is consistently between 40 per cent (the charity sector) and 69 per
cent (healthcare and IT/telecoms). Only 25 per cent of organisations in the
construction sector use these tools and this is probably due more to the
peculiarities of how the sector works than a reflection of human capital
measurement.

"Construction operates in a very different way to most other sectors
because staff never come into head office and most spend all their life on
site," explains Walsh. "Personnel management is naturally devolved to
the line and is controlled by central policy. So there tend to be more policies
and procedures and less HR people. It’s a different animal in lots of ways –
training, for instance is very technical and tends to be outsourced – so the
job of HR overall is much simpler."

Use of the balanced scorecard is more irregular, ranging from zero usage in
the charities sector to 75 per cent in hotels and catering. Perched somewhere
between the two are financial, banking and insurance at 69 per cent,
IT/telecoms at 62 per cent, and local and central government at 50 per cent. It
is no surprise that catering ranks the scorecard so highly given that ‘service’
– which organisations within the sector live or die by – is included on the
tickboxes.

"The scorecard is used by many organisations where there is a big drive
on the customer services front. The financial, banking and insurance sector,
for instance, has made huge technology investments in customer relationship
management, and client satisfaction ranks very highly," says Walsh. "Charities
probably rank zero here because service is not so important to them.

The scorecard encourages everyone in the company to be very
business-focused. Where there’s no financial imperative, the scorecard is less
relevant."

Percentage usage across the 14 sectors drops drastically when it comes to
the remainder methodologies, with EVA scoring marginally better than the other
two. Thirty-three per cent of organisations within the transport sector use EVA
and 23 per cent each within financial, banking and insurance, the service
industries and IT/telecoms.

EVA tends to be popular with companies that are heavily asset-based and this
explains the high usage in an area such as transport manufacturing, says Walsh

"EVA is all about giving everything a capital asset value. If you need
to spend a million pounds on a huge cutting machine to stay competitive, you
need to know the value you’re going to get from it. Methodologies like EVA tend
to be accountancy-driven and are done more out of requirement than desire, but
HR may as well use the figures as they are available."

The sector that uses measurement tools the least is the charities sector
with construction and media/publishing next. The main reasons for not using
measuring tools were lack of time/resources at 52 per cent, not being seen as a
priority for the business (41 per cent), lack of clarity as to the business
benefits (37 per cent) and lack of clarity as to what exactly should be
measured (31 per cent).

"Those that don’t use it tend to be more in ‘personnel’ mode rather
than interested in being a strategic HR function and perform an administrative
service for the organisation rather than attracting, retaining and motivating
top talent," says Walsh.

What do organisations expect from measurement?

The majority of respondents (46 per cent) asked that the approach should
measure human capital in a recognised way. One requirement that Walsh believes
might be missing from the list is that, in addition to the core reasons, an HR
department may want to measure human capital in order to raise its own profile
within a company. Ranked lowest was the ability to measure the value of human
capital during corporate transactions (at just over 20 per cent of
respondents). This can probably be explained by the fact there is less merger
and acquisition activity in the economy and it is only likely to be ranked
highly by someone who has recently been involved in the process.

If we look at the spread of other requirements across the options it indicates
a lack of consensus in what HR really expects from human capital measurement
and it is suggested that one reason for this is the lack of a universal
standard for measuring it.

The main methodologies for measuring human capital

HR Benchmarking and HR Metrics

What they do

– HR Benchmarking looks at the substance of policies and practices and
compares these across organisations

– HR Metrics takes some indicators and measures these within
the organisation and compares across organisations

Comments

– Establishes a baseline against which improvements and trends can be
identified

– Provides comparative qualitative and quantitative data for HR
processes

– Allows monitoring efficiency of HR processes

– Identifies HR practices that organisations want to measure

– Identifies key performance indicators of the HR processes

– Historic analysis of HR policy and practices

Balanced Scorecard Methodologies

What they do

– A suite of people-based key performance indicators that support the
organisation in achieving its corporate objectives

– Enables monitoring of the efficiency with which these targets
are met

Comments

– Links HR activities to corporate objectives

– Enables organisations to demonstrate how the HR function
contributes to their business performance

– Helps organisations manage people strategically

– Forward-looking in nature

– Identifies and directs attention to critical success factors
of the HR function

– Includes a significant element of assumption that elements of
the HR scorecard impact business performance

HR practice effectiveness models
(aligning HR practices to business performance)

What they do

– Assessment of the contribution of the HR function and HR practices on
business performance

Comments

– Regularly monitors and evaluates HR processes and policies

– Develops correlation between HR practices and business
performance (Correlation does not prove causality)

– Track changes to HR policy and practice over time

– Links HR strategy to business strategy

– Can be used as a baseline for business and HR strategy

– Establishes resource and budget requirements of the HR
function

– Determines the priorities and objectives of HR strategy

Accountancy-based
valuation models (including activity based costing and O&M methodologies

What they do

– Creates a numerical value for human capital using accountancy terms and
values employees, often as assets

– Some models break down individual activities

Comments

– Describes human capital in a quantitative way

– Has the ability to calculate the employee contribution to the
overall financial performance of the organisation

– Focuses on a cost based value of human capital

– Relies on predictions and probabilities about the future that
are difficult to make

– Provides data for contract pricing and service level
agreements

Economic
value-added approaches (including value-based management and return on
investment methodolgies

What they do

Process of measuring overall corporate performance based on the total cost
of capital employed in the business

Comments

– Identifies where organisations create the most value.  Based on this, decisions and assumptions
about where to focus investment can be made

Methodology

The survey was distributed to a total
of 3,265 Personnel Today readers, employed by organisations with more than
1,000 employees. Four hundred and twenty completed the questionnaire, giving a
response rate of 13 per cent.

The roots of human capital

A number of economists are credited
with helping to expand and develop the theory of human capital, namely Gary
Becker and Jacob Mincer, but perhaps the founding father of them all is
Theodore William Schultz, who along with the eminent St Lucia-born economist
Sir William Arthur Lewis won the Nobel Prize for Economics in 1979 for
pioneering research into economic development with particular consideration of
the problems of developing countries.

Son of a farmer, Schultz was born near Arlington, South Dakota,
US, in 1902, and grew up wanting to find a way of improving his parents and
fellow farmers’ situation.

He became an acknowledged expert on low income groups in
agriculture and during the course of his work after the Second World War, he
interviewed an elderly farming couple. They were poor, but contented and when
Schultz commented on this they replied that they did not see themselves as poor
because their farm had enabled them to put four children through college and,
because of their education, the children would go on to be productive. From
this, Schultz went on to apply methods of economic analysis to agriculture in
poor countries and deduced that human capital could be studied in the same
terms applied to the study of capital in the traditional sense. The result was
a theory of investment in and returns from human capital.

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