Six Key Principles for Measuring Human Capital Performance in Your Organization Sep27


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Six Key Principles for Measuring Human Capital Performance in Your Organization

By: Brian E. Becker
State University of New York at Buffalo
Mark A. Huselid
Rutgers University
Dave Ulrich
University of Michigan


We would like to share this article on the ^ key Principles to measure human capital performance.

To view the full article, click here.

We hear a lot about the importance of intangibles as sources of competitive advantage, and in particular the importance of human capital. But if human capital is such an important asset, why don’t we do a better job of managing human capital like an asset rather than a cost to be minimized. Organizations often trumpet that “people are our most important asset”, and they may even believe it, but they have no way to translate that slogan into organizational practice.

Properly valuing human capital starts with understanding how to measure human capital’s contribution to the success of the organization. Based on more than a decade of research, we’ve demonstrated that when organizations enable, develop and motivate human capital, the result is improved accounting profits and shareholder value [see inset]. While this research provides a compelling business case for managing human capital like a strategic asset, we find that both HR professionals and line managers often have difficulty translating this academic research into practice. Managing human capital performance effectively requires new perspectives and new competencies on the part of both line managers and HR professionals. We have summarized this new approach in six key principles that can be used to guide human capital performance measurement in any organization. Drawing on both our research and our work with senior HR professionals and line managers, these principles will enable your organization to transform human capital potential into significant drivers of firm financial performance.

#1 Focus on the strategic impact of human capital. Human capital is an illusive concept. Managers are not used to thinking in terms of human capital because accounting systems make it difficult to capitalize investments in skills and other intangibles. So what is
the best way to measure human capital? First of all we have to remember that measures are answers to questions, not ends in themselves. Determining the appropriate measure depends on the question one is trying to answer. If your organization is looking to drive out costs and the HR function is being asked to justify its performance based on efficiency, you might focus on the cost of human capital (i.e. annual expenditures on training or cost per hire). If we compare human capital to another intangible, research and development, focusing on cost and efficiency would be equivalent to valuing the R&D function by the size of the annual R&D budget. Alternatively, if we are interested in questions about how intangibles drive strategy so we can do a better job managing firm performance, efficiency measures of this kind are a blunt instrument at best.

Another possible measure is the stock of human capital where the level is compared against a desirable benchmark. This approach might include measures such as hours of training per year, leadership competency levels, or other measures designed to capture the
level of human capital in the firm. After all, we’ve been told there is a “war for talent” so presumably it’s important to know how much talent you have. The R&D equivalent of focusing on stocks might be the number of new products developed per year, or even the
number, education and experience level of the R&D staff. This has been a very common approach among HR professionals where the emphasis is on counts and activities such as number of employees trained per year, number of courses offered, etc. These measures
capture a type of functional performance, but they tell us nothing about the value of those outcomes. At best they are the first step in a long value chain that culminates in improved firm performance. At worst, they turn out to be well-intentioned initiatives with no evidence of any influence on the firm’s strategy drivers. Line managers see them as overhead to be controlled, while HR professionals are hard pressed to demonstrate their contribution to the bottom line.

By contrast, the real focus should be on the “productive results” of human capital. Consider the illustration of a college education. It is a classic example of human capital. The “value” of a college education is not the cost of the tuition, or the number of years of education, but the increased earning power one derives from that education. Similarly, we should value human capital in the organization based on the performance of that human capital. By human capital, therefore, we mean the productive efforts of an organization’s workforce. By performance, we mean employee performance that effectively implements the firm’s strategy. In short, the relevant human capital measures are the performance behaviors that influence the key strategy drivers in the organization.

Returning to our R&D analogy, the equivalent focus on “productive results” is to value R&D performance by the annual change in revenue attributable to new product ideas. A simple example from the retail sector illustrates what we mean by human capital
performance. Imagine that a retail business determined that one of the drivers of future sales growth is improved customer satisfaction, which is in part driven by the quality of the buying experience. Where does human capital performance enter the picture? As a leading indicator, it is the foundation of subsequent revenue growth by the impact it has on the customer buying experience. In this industry, the buying experience is in part driven by frontline staff who are knowledgeable, timely, helpful and courteous. Those performance behaviors represent the “productive results” of human capital because of their impact on the performance drivers (customer buying experience, customer satisfaction, wallet-share) that ultimately drive revenues. Managing human capital in this context means managing those performance behaviors.

#2 Beware of Human Capital Alchemy. An organization cannot simply begin to collect different measures and all of a sudden expect to reveal hidden value where employees are traditionally viewed as a cost to be minimized and the HR function is focused on administrative efficiency and transactions. There are three steps to managing human capital as a strategic asset: the right perspective, the right HR system and the right performance measurement system. First, HR professionals and line managers both need a new perspective on the management of human capital. Line managers need to view HR as something more than administrative overhead and HR professionals need to take a shared responsibility for driving those business outcomes that have a significant human capital
component. Second, HR professionals and line managers need to take a shared responsibility for developing an HR system (hiring, rewards, development, etc.) that is aligned with the human capital requirements of the firm’s strategic drivers. Third, measures
designed to reflect human capital performance should focus on how well the HR system generates the employee performance behaviors required to drive the firm’s key business outcomes (Principle #1).

The first two steps provide the foundation for human capital value creation that is revealed in the third step. Management of human capital has to go hand in hand with measuring human capital performance. Consider the example of Hi Tech, a software manufacturer headquartered in the Western U.S. Its innovative products have earned it recognition as an industry leader. Like many companies, HiTech for several years had emphasized the importance of people as a source of competitive advantage. However, although the company had prominently emphasized a host of “people policies,” it had never articulated how human capital might drive its business outcomes. Nevertheless, HiTech’s CHRO commissioned a feasibility study to measure the strategic impact of HR. Because HiTech had not committed to articulating the mechanism by which people create value throughout the business, it did not manage (and therefore measure) the relevant drivers within that value chain. Not surprisingly, the measures it did have available were designed for other purposes. The company used people measures from the traditional annual employee survey, for example, and financial measures such as budget variance. The CHRO focused his feasibility project on a service call-center operation, not because it was part of HiTech’s core business, but simply because it was one of the few business units that currently collected data on all three components in the value chain. Not surprisingly, the results of the study were disappointing. There was little relationship between the available “human capital” measures and the limited measures of financial impact. Disappointed and frustrated, the CHRO abandoned the project.i In retrospect, it was obvious that the foundation of human capital performance measurement was missing.

#3 Need to Measure both Human Capital levels and Relationships: Principle #1 is so important because it reminds us that human capital has value when it drives business results. This doesn’t mean that human capital performance will always, or even often, have a
direct influence on bottom line measures of financial performance. Using the Balanced Scorecard terminology, human capital is a leading indicator. Its influence on financials is indirect via its influence on the strategy drivers in the organization. This indirect line of sight poses a challenge for measuring human capital performance. It means that organizations have to focus on more than the levels of human capital. They also have to focus on the relationship between human capital and the drivers of firm financial performance.
The experience at GTE (now Verizon) illustrates the importance of focusing on relationships rather than levels. Their Network Services unit (approximately 60,000 employees) “hypothesized” that market share was driven by customer valuation of their service, which in turn was driven by customer service quality, brand advertising and inflation. The driver (the leading indicator) for customer service was a set of strategic employee behaviors focusing broadly on employee engagement. GTE HR created what they called the Employee Engagement Index based on a subset of 7 questions from the GTE employee survey as a measure of these strategic behaviors.
The traditional management of “people measures” might have compared the level of the Employee Engagement Index to previous levels, or perhaps if an outside survey firm had collected the data they could have been benchmarked against industry norms. But neither of those performance measures directly addressed the business problem facing GTE. Instead, the analysis focused on the relationships between human capital performance (EEI) and strategy drivers in the Network Services unit. They found that a 1 percent increase in the EEI resulted in nearly a ½ percent increase in customer satisfaction with service, demonstrating clearly not only how human capital drives business performance, but by how much. Perhaps the most systematic effort to quantify the relationships between human capital and firm performance was undertaken at Sears. First they developed a very clear strategic logic linking human capital, customer service and financial performance. What set the Sears approach apart, however, was that they were able to calculate the quantitative magnitude of those links in a way that allowed them to forecast future financial performance based on current human capital measures. As an example, they found that “a 5 point improvement in employee attitudes will drive a 1.3 point improvement in customer satisfaction, which in turn will drive a .5% improvement in revenue growth.”

#4 Recognize the limits of benchmarking. Interestingly, the traditional focus on levels based measures has a corollary. If there was no obvious internal relationship between measures like cost per hire and firm performance, an organization had to look outside and compare its levels to those at other firms. This has been particularly true for the HR function, where the line of sight to the firm’s bottom line has traditionally been difficult to unravel. As a result, the HR function is often managed as an administrative cost center so using efficiency metrics appropriately described their performance. However, as HR professionals increasingly take responsibility for human capital management, these efficiency metrics are inadequate and misleading. Managing human capital as a strategic asset  implies measuring the performance of human capital in terms of its impact on strategy implementation. Looking to external benchmarks for measures of strategic performance would imply that every firm had the same strategy and the same implementation system. Effective strategy implementation is not a commodity and the human capital drivers of strategy should not be measured as commodities. External validation that is appropriate for efficiency-based measures is inappropriate for human capital’s strategic performance. This follows from the new perspective on human capital required of both line managers and HR professionals. The unintended consequences of benchmarking are illustrated by the experience of a large multi-national firm where line HR professionals were under increasing pressure from line managers to define HR performance by efficiency measures such as cycle time to fill jobs. HR responded by significantly improving their performance on these measures compared to industry benchmarks. Unfortunately, the consequences for the firm’s business performance were both unanticipated and unacceptable. HR had reduced cycle time by shifting from recruiting channels that emphasized college graduates and experienced professionals to temporary agencies and job bank applicants. The result was higher training costs, higher turnover and, of more concern to line managers, lower customer service levels among front line employees. The reliance on benchmarking for performance metrics was entirely inconsistent with the strategic human capital requirements of the business.

#5 Don’t start with the measure When we discuss these ideas with managers, the most common question we hear is “do you have a list of measures I can use”?. By now it should be clear that no useful list of “best practice” measures does exist, or for that matter should exist. The best practice is a measurement process, not the measures themselves. Beginning with the measure is putting the cart before the horse. Just as the particulars of your firm’s strategy implementation process should be unique to your company, or at least your industry niche, it follows that the really meaningful measures of human capital performance are equally unique to your firm. So where do you begin? Measuring human capital performance is about measuring the contribution of human capital to the firm’s strategy implementation process. In order to measure that contribution an organization needs to begin with the story of the how its strategy will create value. Where are the strategy drivers that culminate in successful firm performance? This means starting at the top, with your strategy, and working backward, to identify the appropriate human capital measures. The best tool for linking the human capital measure to firm performance is the strategy map developed by Robert Kaplan and David Norton.iv This follows from our earlier point; namely, that measures are answers to questions. There is no strategic question that is answered by knowing the rate of return on training or or the cost of this year’s HR initiative. The question is, how does human capital drive business performance? The answer is by enabling the strategy drivers in the organization. Consider the example of Petro Pipeline Petro competes in an industry where hard assets are considered the principle source of competitive advantage, and people metrics tended to be efficiency oriented or attitudinal employee surveys. Human capital performance might traditionally emphasize turnover rates or even pipeline repair times. But there was no attempt to understand how such human capital performance might ultimately drive firm success. By contrast after a strategy map exercise Petro discovered that a principle revenue driver was heavily influenced by customer satisfaction, which in turn was largely a function of pipeline reliability. Pipeline reliability had traditionally meant minimizing repair time once a problem developed. Understanding the strategic importance of reliability now highlighted a critical new role for preventative maintenance. This required a shift in the development and reward systems at Petro, but also pointed to a whole new set of human capital performance measures such as: use of life cycle cost analysis in maintenance decisions, effective analysis and diagnosis of relevant data to predict failure and maintenance actions, and evidence that new learning is incorporated into maintenance process. This illustrates how the concept of human capital is not so much a function of the level, such as years of education, but rather the impact on key strategy drivers in the firm. In this industry, pipeline workers with little formal education had the potential to represent valuable human capital when their performance was appropriately aligned with the firm’s strategy. Measures that tracked this type of human capital performance were much more valuable to Petro Pipeline than any efficiency measure, and they wouldn’t have shown up on any list of “best practice” measures.

#6 Think in terms of the human capital “architecture” Managing and measuring human capital in an organization is such a challenge because there is often confusion about what it is, who should have responsibility for managing this important asset, and how it should be managed? Is it a characteristic of individual employees? Is it the responsibility of the HR function? How is it influenced by the HR system and other organizational policies? We’ve said that both line managers and HR professionals need a new perspective on human
capital and we believe this perspective should begin with central role of the human capital architecture. It is important to think in terms of an architecture because the creation and management of human capital, as well as the measurement of human capital performance, are by necessity an interrelated process. Firms need to manage the component parts with an eye on these interrelationships or they can’t expect to transform that architecture into a strategic asset.