Humanizing Human Capital: Financial Performance Measurements
Welcome to the second blog in our “Humanizing Human Capital” series. The focus of the series is to define the human capital measurements associated with different parts of the worker journey and provide HC practitioners useful approaches in HCA to interpret your organization’s experience related to human capital so that more effective decisions can be made. The goal is to make investments in people and people programs that will directly contribute to the economic value generated by the company, and provide the financial rationale for continued investments in specific HC programs. Read the introductory blog here.
If you’re an HC practitioner, you have probably never thought about creating a “financial rationale” for your budget requests. As a former CHRO, my CFO would give me a budget, and I had to work within the boundaries of that budget. If I needed additional funding for any specific program, I would submit my request and usually get a “not this year” response. The reason HC budget requests usually get rejected is because the request doesn’t highlight the short- and long-term impact/benefit to the organization, and therefore, there’s no way for a CFO to determine the Return on Investment (ROI) for that budget allocation.
The CFO’s job is to optimize the organization's ROI and without this information, s/he will allocate funds to requests where the ROI is provided. HR has not traditionally provided a “business case” for their budget “ask” because predicting human behavior is hard, and quantifying the cost/benefit is even harder. However, with new analytic approaches, we can quantify the financial impact of human capital initiatives. Since every other function in the organization (sales, marketing, operations, manufacturing, technology, etc.) provides a “business case” for their funding request (which is why they usually get their requests approved) it’s time for HC practitioners to do the same thing!
What makes HC an exciting function today is the opportunity to be a significant driver of corporate performance through optimizing the ROI of HC programs (or HCROI). The confluence of these events put more focus (and power) on the HC function:
The US is predominantly a service economy with more than 80% of GNP coming from services. The only way to deliver services is through people, so HC becomes the significant driver of our economy.
Investors and other stakeholders are now focusing on effective and efficient HC to drive economic value creation. In the past, investors focused on other variables (financial engineering, innovation, products, etc.) in their investment decision-making. Now they are examining HC performance (attrition, productivity, diversity, workforce composition) as a basis for their investment choices. The SEC and other governance agencies are requiring human capital performance disclosures. This puts HC in a new domain space.
The discipline of human capital data analytics has given practitioners new approaches and tools to be able to quantify human capital performance and impact.
All these events have transformed the function and provided an opportunity for HC practitioners to lead value-creation for their organizations. The best way to create a context for understanding human capital performance impact is to start with the highest-level indicators of human capital’s contribution to financial performance. We call these “macroeconomic” indicators because they reflect the aggregate of human capital impact (people and programs) and not any single HC initiative. These metrics can be compared over different periods or benchmarked against competitors, and include productivity measures, human capital return on investment (HCROI), human capital value added (HCVA), and human capital investment intensity (HCII). Below are the definitions, algorithms, appropriate application, and relevance, as well as potential “signals” of human capital health for each measurement in the “Financial Performance” category:
Human Capital ROI (HCROI) is an efficiency measure of human capital.
How to calculate: Revenue - Operating Expense (excluding Human Capital Costs) ÷ Human Capital Costs. Human capital costs include compensation, benefits, training, recruiting, and all labor costs and expenses.
How to use it: Similar to its financial counterpart, ROI, which measures the total cost to generate each dollar of revenue, HCROI captures the gross operating margin generated for each dollar of total human capital expense.
Why does it matter? This measure captures an employee’s contribution to overall corporate costs and payback since the metric looks at staff productivity in ways that complement ROI analysis.
Human Capital Value Added (HCVA) is an indicator of the financial value (profit) an average employee brings to an organization.
How to calculate: Revenue - Operating Expense (excluding Human Capital Costs) ÷ Total Full-time Employee Equivalent (FTE)
How to use it: This metric can be used in conjunction with other indicators of profit contribution, including investment in plant, property, equipment, marketing, and R&D, to better understand the contribution that human capital makes to earnings.
Why does it matter? This measure shows the average profit per employee or the extent to which the average employee contributes to the bottom line.
Human Capital Investment Intensity (HCII) represents the percent of total expense (or total operating expense) allocated to human capital and human capital programs.
How to calculate: Total Cost of Workforce ÷ Total Expense (or Total Operating Expense)
How to use it: This metric, when compared to HCROI can provide an indication of the effectiveness and efficiency of human capital budget allocations.
Why does it matter? Board Directors and Management should monitor the percentage of the budget allocated to human capital/programs to ensure an appropriate and expected level of return. If HCII goes up and HCROI goes down, there may be a problem. However, when the opposite is the case, it means that human capital budgets are optimized to financial returns.
Human Economic Value Add (HEVA): is a measure of the contribution of human capital performance to adjusted profitability.
How to calculate: [Net Operating Profit After Tax - (Invested Capital X Weighted Average Cost of Capital)] ÷ FTE
How to use it: This metric represents the economic value created per employee. It should be measured over time and correlated to market capitalization value.
Why does it matter? When HEVA goes up over time, at a rate greater than HCMV, then investments in human capital are generating a benefit greater than other investments.
Human Capital Market Value (HCMV) is a metric that indicates the per-employee equivalent market value.
How to calculate: (Market Value - Book Value) ÷ FTE
How to use it: Tracking performance against this metric can provide insights about the change in value in this intangible asset and its contribution to market capitalization..
Why does it matter? This metric shows how investments in human capital are driving market value.
Productivity (or Revenue) Factor is the Revenue Per Employee
How to calculate: Revenue ÷ FTE (including contracted employees calculated as FTE)
How to use it: A fundamental measure of the productivity of employees – how much revenue is attributable to each full-time employee unit. This can be combined with an Expense Factor to understand the relationship between revenue and expense per FTE.
Why does it matter? A decline in productivity may signal either that revenue has declined on the same number of FTEs or that the composition or number of employees should be reviewed
Expense Factor is the Expense Per Employee
How to calculate: Expense ÷ FTE (including contract employees calculated as FTE)
How to use it: A fundamental measure of the expense attributable to each employee. This can be combined with a Revenue Factor to understand the relationship between revenue, expense, and income per FTE.
Why does it matter? An increase in expense per employee may be due to labor or other expenditures. Investment in business processes or capital may be justified even if this factor increases.
These metrics should then be correlated to selected financial performance indicators over the same period. For example, you might want to compare HCROI with profitability performance trends over the same period to gain insights into how these two indicators move – together or apart – and their relative performance. For example, we have seen that a 5% improvement in HCROI in an organization where HCII is more than 60% is correlated to a 40% improvement in profitability performance. This is the kind of information you can use to build your financial rationale for your budget allocation “ask” as your CFO can now quantify the ROI of that investment. We’re finding that in organizations where HCII is more than 50%, investments in HR generate ROIs greater than any other function in the organization.
In the next post, we will focus on Talent Acquisition Measurements.
To learn more about ways to bring evidence-based practices to your organization, read Humanizing Human Capital: Invest in Your People for Optimal Business Returns.