Human Capital— The Elusive Asset, Measuring and Managing Human Capital: A Strategic Imperative for HR Oct03

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Human Capital— The Elusive Asset, Measuring and Managing Human Capital: A Strategic Imperative for HR

In this issue, we would like to share an article about Human Capital— The Elusive Asset, Measuring and Managing Human Capital: A Strategic Imperative for HR by Leslie A. Weatherly.

To view full article, click here http://www.ispi.org/pdf/suggestedReading/6_Weatherly_HumanCapital.pdf

HUMAN CAPITAL IS ARGUABLY THE MOST VALUABLE ASSET HELD BY AN ORGANIZATION TODAY. It is also the most elusive asset to manage for a variety of reasons. The primary purpose of this article is to describe the terminology associated with human capital and its context within an organization. Its secondary purpose is to discuss the implications for the HR professional. HR practice leaders who are serious about making a difference must be able to “measure” the business impact HR-driven programs have on their organizations in order to demonstrate the merit and worth of these programs. Only by ensuring that HR metrics are recognized and valued on an equal footing with other business metrics routinely used by the CEO and management can the HR practice leader be assured an equitable position as a key member of the senior management team. These metrics must, of course, measure the value and return on investment in human capital to the organization. This is both a challenge and a strategic imperative for today’s HR professional.

Calculating the value of human capital (HC) is not easy—because human capital is not like other capital. With rare exception, HC simultaneously represents the single greatest potential asset and the single greatest potential liability that an organization will acquire as it goes about its business. While there are other intangible assets, HC is the only intangible asset that can be influenced, but never completely controlled, invested in wisely, or wasted thoughtlessly, and still have tremendous value. These distinguishing features are what make HC unique, and also what makes it an elusive asset. “Although we would agree that most CEOs are acutely aware of their investments in their most valuable asset (salaries, benefits, training, recruitment programs and the like), almost none could tell you what their most valuable asset is worth.”

Perhaps the best place to begin this discussion is to outline the business elements that create value in an organization in order to lay the groundwork for understanding the context within which human capital carries out its work. Organizational value is comprised of three major classes of assets that are integral to an organization’s ability to produce goods and services. These are:  Financial Assets: Financial assets include assets such as cash and marketable securities, and may also be referred to as financial capital;  Physical Assets: Physical assets include such tangible assets as property, plant and equipment, and other furnishings; and  Intangible Assets: Examples of intangible assets, also called intangible capital, include intellectual capital  (patent formulas, product designs, and process technology, i.e., the methods that delineate the steps in a process), goodwill, and human capital.

Definition of Human Capital

Surprisingly, human capital is not the people of an organization per se. That’s because people exercise control over their human capital and are free to invest it as they see fit in different aspects of their lives: family, community interest groups, observance of religious beliefs, physical fitness pursuits, other outside interests, and work. As such, the following definition of human capital is offered: A company’s human capital asset is the collective sum of the attributes, life experience, knowledge, inventiveness, energy, and enthusiasm that its people choose to invest in their work. Clarifying Intangible Capital
So, what is intangible capital, really? Intangible capital or intangible assets are as valuable as financial and physical assets; you just can’t discern them by touch, i.e., they are without physical substance and are non-monetary. They are held by an entity to produce or supply goods or services, to rent or lease to others, or for administrative purposes. For reasons already described, they can be difficult to measure and are not always addressed in concrete terms in the typical public accounting disclosure.

Intangibles also comprise other forms of capital (see Figure 1). From a pure accounting perspective, financial assets and physical assets are generally easier to classify and value than intangible assets. For example, intellectual property is legally defined and includes such things as patents, trademarks, and copyrights, which are included under the general definition of intellectual property. However, these assets are the only form of intangible assets that are precisely defined for accounting purposes. All other forms of intangible assets are loosely defined, open to interpretation, or are simply handled as costs. To compound this situation further, patents, trademarks, and other intellectual property rights are recorded at their registration cost rather than their market value, which may or may not be higher than their price at purchase. For the purposes of this article, our primary focus is human capital. While some might say we could define human capital as the accumulated present value of our employee investments (salaries, benefits, training and development programs, etc., invested on behalf of the organization), the question still remains, how would you go about putting a definitive value on that investment? Transition to a Knowledge Society. This is where things begin to get complicated, because up until the early 1980s, the book value of a company’s “tangibles” accounted for almost all of its market capitalization. At that time, a shift started to occur, and the market and book value for publicly traded companies began to deviate from past pattern and practice.

“This disassociation of market and book value meant that companies were now able to generate excess earnings—that is,
earnings higher than what would be expected for their tangible assets alone. Indeed, research has shown that the earnings
on tangible assets are generally no greater than the product of a company’s weighted average cost of capital and the book value of these assets. Investors and economists reasoned, therefore, that something other than tangible assets must be
producing the excess earnings behind the disassociation of market and book values. In due course, the root cause was discovered to be intangibles, a whole other class of assets.” This shift has had a particularly significant impact on the valuations of corporate entities formed due to the mergers and acquisitions of the last decade, as these organizations began
to make quantum leaps in growth almost overnight. As can be imagined, this shift has also resulted in growing support for the establishment of new rules for the disclosure of intangibles. Tom Stewart, author of the recently published book, The Wealth of Knowledge, writes: “It is incontrovertibly true that present financial and management accounting does not give investors, directors, the public, or management the information they need to make informed decisions.”3 In further support of this
position, Jamie Ivey, in a recent article of Corporate Finance states, “A balance sheet provides a snapshot of a company’s assets at any one moment in time, but how useful is such a snapshot when a company’s currency is its knowledge and that knowledge can be transported in a split second? Enron is an example of the problem. An investor could have looked at his balance sheet in late November and have been perfectly satisfied as to the security of his investment, but by December 2 his investment had vanished in smoke.” Even still, the Financial Accounting Standards Board (FASB) has been reluctant to effect a change to a system of accounting that reflects the magnitude of this shift and provides a clearly delineated standard method of accounting for human capital as an intangible asset. The investment community appears to be reluctant to initiate change as well, in part due to the failure of so many new economy (dot-com) companies, coupled with concerns about the interpretation and application of generally accepted accounting principles (GAAP) by large corporations over the last year (e.g., Arthur Andersen, Enron, WorldCom). Apparently, the feeling is that the dust should settle before reform takes place. What we do know at this time is that it is not unusual for the value of a company’s intangible assets to exceed its book (tangible) assets by two- or threefold. In extreme cases, this ratio can be quite significant. For example, in 1996 Microsoft’s ratio of intangible assets to book (tangible) assets exceeded 11 to one. So what is the basis for this paradigm shift, i.e., the routine use of the phrase “intangible assets” in a company’s vocabulary? In brief, we have moved from an industrial society, where the primary source of wealth was machinery, to a knowledge society, where the primary source of wealth is human capital. In essence, we have undergone a metamorphosis. “In the closing years of the 20th century, management has come to accept that people, not cash, buildings, or equipment, are the critical differentiators of a business enterprise.” The reality of the situation today is that 60 percent to 70 percent of a company’s expenditures on average are labor related. Data from the Brookings Institute will help to put the importance of the measurement and management of human capital/knowledge assets into perspective. In 1982, hard assets represented 62 percent of a company’s market value on average. By 1992, this figure ad dropped to 38 percent.7 More recent studies place the average market value of hard assets in many companies as low as 30 percent. In other words, up to 70 percent of a company’s expenses may be related to human capital. It would seem nothing less than a business imperative, therefore, that the challenge of a taxonomy and a valuation of human capital be pursued. The Dynamics of an Organization’s Total Capital Environment It is important to note that a business is not just a storehouse for knowledge, but a viable, dynamic environment. Vital relationships exist throughout an organization and interactions occur with varying degrees of intensity to ensure that knowledge (the tacit knowledge of the group found in the form of organizational culture, the explicit knowledge of an individual, or the structural knowledge of a data warehouse) gets converted from one form to another through, perhaps, multiple transformations, all for the purpose of adding value. These interactions result in the creation of new knowledge, organizational learning, and, on occasion, innovation. Whereas human capital represents the knowledge, experience, and attributes of employees, additional types of capital have emerged in the literature. Structural capital represents the codified knowledge that resides within an organization (policy and procedure manuals, databases, corporate files, departmental and organizational processes). Social capital represents the value that can be found among the relationships within the organization to facilitate the transfer of knowledge. Examples of social capital could include mentor/mentee relationships, informal networks of long-term interdepartmental work associates, and peer relationships. Finally, customer capital (also referred to as organizational and/or relational capital) is the corporate memory possessed by those who have relationships with suppliers, customers, and any other outside entity that interacts with the firm for the purpose of accomplishing the work of the organization. It is the successful amelioration of each of these forms of capital and their effective blending that forms the basis for improving organizational value. The predominant objective of any investment is to minimize risk and maximize return. So,how should this statement be interpreted in relation to human capital, the elusive asset?

What Gets Measured Gets Managed

What should be apparent at this point is that the measurement of human capital will never be as straightforward as calculating the value of a tangible asset; there are simply too many variables involved to make this practical. However, it should also be obvious that we can no longer fail to recognize the importance of seeking to develop, test, and refine appropriate methodologies to measure the value of what has become for all intents and purposes our primary asset. To give an old adage its due: “what gets measured gets managed.” Simplyput, what gets measured stands a better chance of becoming successful within the context of an applied strategic business plan. If we are not capable of measuring the true value of human capital in our organizations, then we cannot begin to appreciate in quantifiable terms its true potential. It would follow then that we are not able to envision and reap the full measure of the benefits that this essential asset can afford our organization(s). We cannot afford to let that happen.

Why is it Important to Know
How to Value Human Capital? Human resources, like other resources, are finite. What makes them especially unique, however, is that they are intangible. Human capital can be developed and cultivated, but it can also decide to leave the organization, become sick, disheartened, and even influence others to behave in a way that may not be to the advantage of an employer, thus usurping or siphoning off resources intended for use elsewhere in the organization. In other words, the performance of an organization’s human capitalis not always predictable and/or within the control of the employer. So, the measurement and the management of human capital becomes part art and part science. Senior management requires a reference index, therefore, for valuing human capital within the organization. With the right tools and context, management will be in an enhanced position to make decisions that will drive how this resource, along with other finite financial, product, and customer resources can best be allocated.