Your financial statements only partially reflect your company’s overall performance. The return on investment (ROI) in “human capital”—the knowledge, skills and experience of the people who produce your results—is easy to calculate but difficult to maximize. There is no line item for “people” on your balance sheet, so managers tend to focus on reducing employee compensation and development costs. This bean-counting strategy can harm work force motivation and productivity.
Also, people are unpredictable, capable of choosing to conform to or defy company policies and procedures, and their productivity and attitudes are inconsistent, making them your most difficult asset to manage. Calculating a return on this human capital is not a simple task.
What is human capital?
In the 1960s, economist Theodore Schultz created the term “human capital” to reflect his belief that human beings were similar to any other form of business capital—i.e., their capacities could be measured. Investments in benefits, training and educational programs would theoretically produce a return in the form of improved labor productivity and product quality.
This concept expands on the idea of measuring production input where all labor is presumed to be equivalent by recognizing that all people are not the same and investing in them can improve the quality of their performance. Employees’ natural talent, education and experience are essential components of calculating the value they add to the bottom line. On a broader scale, the overall economy improves as the value of company investments in human capital is recognized.
ROI on human capital
A common formula for calculating ROI in human capital (HCROI) is based on operating expenses, which include general and administrative expenses not related to production; therefore, direct costs (such as labor and material) and financing expenses (such as principal and interest payments on loans) are not considered. Deduct expenses for salaries and benefits from the remaining operating expenses. Subtract the resulting amount from your revenue. Then divide the number you now have by the total of salaries and benefits. Remember you just subtracted these amounts from the operating expenses.
Revenue – [Operating Expenses – (Compensation + Benefits)]
(Compensation + Benefits)
A variation on the formula takes the total profit before tax plus compensation plus benefits and divides it by compensation plus benefits:
(Profit Before Tax + Compensation + Benefits)
(Compensation + Benefits)
You might add another calculation to analyze revenue (the sales line item listed at the top of your income statement) per full-time employee (FTE):
No. of FTEs
Also, you can track the cost of remuneration (compensation and benefits) as a percentage of revenue:
Compensation + Benefits
These kinds of calculations can also be applied to investments in selecting the right people, training, professional development, benefits or incentive systems. Unless you have enormous profits, each of these purchases must create value for the company beyond enhancing your image as a great boss.
Human resources was traditionally viewed as a cost center, and only recently have metrics been used to enable these professionals to justify their internal role in creating ROI. Whether you are struggling to attract enough qualified people or to filter an overabundance of applicants, your system must be thoughtfully created to ensure candidates are carefully vetted for cultural “fit” as well as a defined skill set. If you don’t select the best candidates, your turnover costs will rise, and excessive turnover affects the morale of the people you want to retain.
Even if you hire the best candidates, your chance of retaining them improves considerably if you understand what they know, what they want to learn and how they can best add value to the company in the long term. Employees who feel undervalued, unprepared or pressured into positions that don’t match their skills and interests will be less likely to improve your ROI and more likely to leave.
There is more to strategically investing in human capital than tracking a formula or reducing costs. To obtain the highest potential HCROI, your talent management strategy must align with your overall business strategy; consider your future needs and assign people to the roles that best fit their interests and capabilities.
Next month, we’ll consider some examples of the factors behind the numbers that should form part of your talent management strategy.