Wednesday, 02 September 2015 16:54

The Missing Link:

Written by Frank DiBernardino, Managing Principal and Founder, Vienna Human

Executive Summary

This paper is about context in the rapidly evolving field of human capital analytics. It offers a comprehensive, cohesive, and cascading method for chief human resource officers (CHRO) to analyze the financial performance of the organization’s investment in human capital. It also lays out a process to convert hard results into human capital strategy actions that will lead to continuous improvement in business results.

Frank DiBernardino recently published a book titled: Optimize Human Capital Investments: Make the “Hard” Business Case. Here is a link to a Meet the Author video: http:// youtube.googleapis.com/v/GTdpdWZbRms

Introduction

Companies spend financial resources on human capital (people and HR programs) to drive revenue, profits, and shareholder value. Unfortunately, common HR metrics are woefully insufficient in measuring the financial performance of this investment. CEO’s and boards really want a measure of effectiveness, in terms of ROI and impact on enterprise value.

Inadequacies of Current Approaches

Traditional methods for evaluating business performance— such as Earnings per Share (EPS) and Return on Invested Capital—are too broad to isolate and measure human capital performance to determine whether it is improving or eroding a company’s economic value. Business unit performance measures and functional measures (for Sales and Marketing, Operations, HR, etc.) have similar limitations. They are unable to isolate the economic impact of people, and are too segmented to explain what is driving the performance of the organization, as a whole.

Worse yet, some of the most common human capital metrics can actually mask an organizational performance issue. Time-honored measures of “Per Full Time Equivalent” (per FTE) and “Salaries and Benefits as a Percentage of Revenue” are incomplete and misleading because neither considers the aggregate of all internal and external human capital costs such as those related to outsourcing.

The Potential Impact of Human Capital Analytics

Two types of investments drive business results: human capital and financial capital (cash). While the latter is the lifeblood of the business, it is human capital that deploys the cash and ultimately determines whether the deployed cash increases or destroys shareholder value. For most companies, the costs of human capital surpass financial capital costs, as shown in graph 1.

Graph 1

Defining the Human Capital Investment

The investments that companies make in people (pay, benefits, training and development, and other support costs) are shown as expenses on the Income Statement. Nowhere on the Balance Sheet is the people investment shown as an asset but are instead dispersed throughout the general ledger in ways that disguise their scope and inhibit their comprehensive management. This is why the first step toward the next generation of human capital analytics must be defining and isolating the entire human capital investment. Only then can financial performance in terms of ROI, productivity, and liquidity—the common and useful financial measures of business vitality—be evaluated.

Table 1

Human Capital Investment

The human capital investment consists of employee costs, costs in support of employees, and costs in lieu of employees. Employee costs consist of wages, benefits, and payroll taxes, which are easily identified in a general ledger.

Costs in support of employees are the variable cost a company incurs to support its employees and would not be incurred, except for their presence. These expenses fall into the following categories: real estate or housing, communications, technology, training and development, supplies, and transportation. While also a part of the general ledger, all of these costs are not obvious. For example, Starbucks, a consumer retailer with locations world-wide, is made up of retail locations that exist for the purpose of selling its products and a headquarters in Seattle, WA for the purpose of housing its employees. Thus, in this example, the corporate office would be considered a cost in support of employees while the retail outlets are not human capital costs. This same process of distinguishing human capital versus costs of doing business would also be done for the other expense categories listed above.

Independent contractors and outsourcing represent costs in lieu of employees. The test is whether the expense replaces an employee that would otherwise perform the service. These costs are also part of the chart of accounts, though not always obvious. For example, charges for legal services may all be lumped under one category. However, when the question is posed: What portion of the legal fees incurred must be performed by outside counsel? The answer is typically less than 100%. The difference is the portion of cost that is outsourced. This scenario is often true when applied to accounting costs and IT costs as well.

A Financial Approach to Human Capital Analytics

Working with a group of finance and HR experts, we developed a financial approach to measure Human Capital Return on Investment (effectiveness), Productivity (efficiency), and Profit Sensitivity (liquidity). We chose these three measures for their significance to the value of a business enterprise: HC ROI drives enterprise value; Productivity drives the ROI; and Profit Sensitivity protects the ROI, thus protecting enterprise value.

Human capital financial performance results, both for the organization as a whole and segmented by business unit, can be measured consistently over time by applying accepted financial formulae found in any Finance textbook. These results can be assessed in comparison to each other, to goals set in the company’s operating plan, and to a standard of performance.

Human Capital Return on Investment (HC ROI)
HC ROI = (EBITDA – Financial Capital Costs) ÷ Human Capital Costs

Human Capital ROI measures the return on each dollar invested in human capital, after adjusting for financial capital costs. This approach is known, in the finance world, as a values-based formula. The formula’s premise is that human capital has added no incremental value to the enterprise unless it first generates enough profit to exceed financial capital costs.

Profit is expressed as EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), a credible, universal financial standard that works for both privately-held and publicly-traded companies. EBITDA reflects profit irrespective of financial capital structure, which can vary greatly by industry or organization.

Financial capital costs consist of Interest, Depreciation, Amortization, and Cost of Equity. Interest, Depreciation, and Amortization are items disclosed on the Income Statement. Cost of Equity is the expected return on equity for the business.

Productivity
Productivity = (Revenue – Material Costs) ÷ (Human Capital Costs + Financial Capital Costs)

Productivity measures the amount of revenue generated for each dollar invested in human capital, after adjusting for raw materials costs and financial capital costs. This formula normalizes all types of business models (those driven by products versus services) by controlling for raw material costs, which vary greatly by industry. Because material costs can distort the productivity value of human capital, it is necessary to normalize for raw material costs in order to capture how much value-added revenue are driven by people.

Profit Sensitivity
Profit Sensitivity = Incentive Compensation ÷ Profit Goal

Profit Sensitivity measures the ratio between incentive compensation and an organization’s profit goal. This formula is an adaptation of the quick ratio, also known as the acid test, is the most stringent method used by finance professionals to measure liquidity levels to determine if sufficient enough to protect an organization’s cash position.

The Profit Sensitivity metric has a laser focus on the organization’s compensation structure. Incentive compensation is the most agile business tool to protect profitability. This concept is implicit in the expensing of a typical incentive compensation program. The proof: watch what happens to incentive compensation accruals during the fiscal year as profitability emerges. If profits are tracking below plan, the incentive compensation pool accrual is reduced and vice versa

Translating Human Capital Financial Performance into Strategic Interventions to Continuously Improve Business Performance

Having “hard numbers” is good, but of little value unless one knows what to do with the numbers to improve business performance. Translating human capital financial performance data into beneficial changes in human capital strategy is a five-step process:

1. Analysis of HC ROI, Productivity, and Profit Sensitivity
2. Analysis of HR metrics
3. Analysis of human capital strategy
4. Strategy recommendations and priorities
5. Financial projections

As the process unfolds, a story will emerge, providing clarity about the human factors driving financial performance, and the human capital strategy actions that can improve business results.

Analysis of HC ROI, Productivity, and Profit Sensitivity Metrics

The following queries help dissect performance results and the factors driving the human capital financial metrics. See Table 1.

Analysis of HR Metrics

Each organization will have its own set of HR metrics which should correlate with the financial metrics. Relational observations can help identify some of the specific explanations for the financial performance data, and thus begin to identify a path toward improvements in human capital strategy.

Analysis of Human Capital Strategy

Based on the above observations, operating executives and HR staff should have a conversation about the current HC strategy, with emphasis on the drivers impacting financial results. The discussion should consider the four major elements and components of the human capital strategy:

• Talent—organization design, strategic staffing, performance assessment, succession planning, and leadership development.
• Rewards—compensation (base pay and incentives) and benefits.
• Culture—values development, behaviors definition, employee surveys, engagement, and communications.
• HR Services—HR organization and staffing, outsourcing, compliance, vendor selection and management, payroll, HRIS, and data.

Strategy Recommendations and Priorities
Based on the story that emerges from the above analysis, needed human capital strategy interventions will become apparent. At this stage, HR leaders develop a plan, defining the resources and time needed for implementation. Depending on the scope and scale of necessary changes, a phased approach to implementation may need to be taken.

Financial Projections
Financially credible formulae can be used to forecast the bottom line impact of improved human capital performance. For example, a percentage increase in HC ROI will create a dollar amount increase in shareholder value providing the business case for the recommended human capital strategy changes.

Implications
A standardized financial approach to human capital analytics can remove HR professionals’ most prevalent barrier to making effective contributions in the workplace: business intelligence. As observed in a recent review of current trends in human capital research and analytics, “Our challenge and opportunity is to move beyond the data to deliver compelling insight and influence. Organizations that can make this transition will gain significant advantages in their markets.” These exciting new analytic capabilities can close the empirical gap between Finance and HR, allowing them to speak the same language and collaborate as true strategic partners in the C-suite.

The Vienna™ formulae, metrics and Index are protected by U.S. Patent No. 7,983,945. Use of the formulae, metrics, and Index without express written consent from Vienna Human Capital Advisors, LLC is strictly prohibited. By Frank DiBernardino, Managing Principal and Founder, Vienna Human Capital Advisors, and Lyle Hanna, President/CEO, Hanna Resource Group

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