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Can human-capital financial statements allow companies to measure the value of their employees?
David McCann, CFO Magazine
November 1, 2011
If a company's most important assets are indeed its people, as corporate executives parrot endlessly, that's news to investors, analysts, and even, as it turns out, many companies.
It is hardly a secret that the industrial economy that prevailed for two centuries has evolved into a talent-driven, knowledge-based economy. Still, extant accounting standards define "assets" mostly in terms of cash, receivables, and hard goods like property, equipment, and inventory, even though the value of many companies lies chiefly in the experience and efforts of their employees.
Public companies are required to disclose virtually nothing about their human capital other than the compensation packages of top executives, and most are happy to report only that. The furthest most companies will go in reporting on human capital within their public filings is to mention "key-man" risks and executive succession plans.
More than two decades ago, Jac Fitz-enz and Wayne Cascio separately pioneered the idea that metrics could shine a light on human-capital value. From their work grew the notion that formal reporting of such metrics could add value to financial statements. That discussion simmered quietly for many years, but recently it has grown more bubbly, as some of the best minds in human-capital management and workforce analytics work hard to influence the acceptance of such reporting.
Some are crafting detailed structures for what they generally refer to as human-capital financial statements or reports, which would complement (but not replace) traditional financial reporting. Their goal is to quantify a company's financial results as a return on people-related expenditures, and express a company's value as a measure of employee productivity.
To be sure, finance and human-resources executives alike have long considered many important aspects of human-capital value to be unquantifiable. That's why an effort by the Society for Human Resource Management, less-granular than some similar efforts but very well organized, shows promise to have a sizable impact. SHRM's Investor Metrics Workgroup, in conjunction with American National Standards Institute (ANSI), is developing recommendations for broad standards on human-capital reporting. The group plans to release its recommendations for public comment early in 2012. Should ANSI certify the standards, the next phase would be a marketing campaign aimed at investor groups and analysts, encouraging them to demand that companies provide the information.
If demand for that data were to reach a critical mass, then presumably accounting-standards setters would eventually look at adopting some type of human-capital reporting, and the Securities and Exchange Commission and other regulators would subsequently get involved. Of course, that's a grand vision, and even its most optimistic proponents admit that it will take at least a decade, and probably twice that long, to fully materialize.
But the SHRM group's chair, Laurie Bassi, is confident that the effort will succeed, however long it may take. "It's going to serve as a catalyst for change," says Bassi, a labor economist and human-capital-management consultant. "When investors start to demand this information, it's going to be a wake-up call for many, many companies. For some well-managed, well-run firms it won't be a stretch, but others will be hard-pressed to produce the information in a meaningful way."
Bassi says that the driving forces behind the effort boil down to two things: "supply and demand, or, you might say, opportunity and necessity."
On the supply/opportunity side, advancing technology and lower computing costs have greatly eased the collection and crunching of people-related data, enabling companies to get their arms around what's going on with their human capital in a much more analytic, metrics-driven way than was possible a few years ago. The demand/necessity side is that, driven by macroeconomic forces, human-capital management is emerging as a core competency for employers, particularly those in high-wage, developed nations.
Something for (Almost) Everyone
Investors and analysts aren't demanding human-capital reporting yet, but they might not need much prodding. Upon hearing for the first time about SHRM's project, Matt Orsagh, director of capital-markets policy for the CFA Institute, says that "it sounds fabulous. I want all the transparency and inputs I can have. Quantifying the worth of human capital would be fantastic, because right now you have to take it on faith, and I don't know if I can trust it."
Predictably, some CFOs are less enthusiastic. "It's a fair point that the balance sheet doesn't recognize the value of human capital, and certainly not the full value of your intellectual property," says John Leahy, finance chief at iRobot, a publicly traded, $400 million firm. "For a high-growth technology company like ours, there is significant intrinsic value in the know-how and innovation of our people, which is why we've traded over the last couple of years at a fairly attractive multiple.
"But I cringe when I hear talk about more reporting requirements and disclosure. Those requirements are very burdensome for a small-cap or midcap company. Further financial reporting and disclosures would just add to that burden."
It will be a difficult task to measure, quantify, and report on human-capital value, observes Mike Lehman, the former longtime CFO at Sun Microsystems who now heads finance at Palo Alto Networks, a large and fast-growing private company. And, he opines, companies won't actually begin doing such reporting for many years, if ever. Still, he calls SHRM's effort "worthy and valiant."
While finance understands the true demands of reporting like no other department within a company, some say there is no reason to resist or fear the advent of human-capital reporting, even in the short term. In the same way companies like to be on best-places-to-work lists because it helps attract talent, says Siow Vigman, an interim division CFO and vice president, finance, for musical-instrument retailer Guitar Center, they should strive to be ahead of the pack in human-capital transparency. "If you know that what you're showing will bring investors, why shouldn't it be a standard that companies would want to shoot for?" she says.
Such transparency would benefit any company that's involved on either side of an acquisition, observes Sanjeev Singhi, a controller at $1.9 billion, publicly held B/E Aerospace who is currently working on his fourth M&A deal. Like Vigman, Singhi serves as an advisory board member for the Human Capital Management Institute, a for-profit consulting, research, and software firm.
A Deeper Dive
There is, of course, a very sizable elephant in the room: Whatever its ultimate value, how, exactly, do you report on human capital? More pointedly, is there a way to go beyond the broad type of information that the ANSI standards will stipulate and create human-capital financial statements that match the rigor and precision of traditional financial statements?
Absolutely, says Jeff Higgins, who has almost certainly created the most scientific, detailed solution to that challenge. His work illustrates how a metrics-driven approach can capture human capital's impact on financial performance.
Although Higgins now considers human-capital metrics his life's work, his résumé is steeped in finance. He is a former divisional vice president of finance for Johnson & Johnson and a former CFO of Klune Industries. In those jobs he became so interested in effective people management that he eventually took a job running compensation and human-capital analytics for IndyMac Bank. Most recently he launched the Human Capital Management Institute, where he is CEO.
His sample "Human Impact Statement" (shown here) is, he says, analogous to the traditional income statement. Higgins has also created two other documents: a human-capital asset statement (parallel to a balance sheet) and a human-capital flow statement (cash-flow statement), but he considers them somewhat less important than the impact statement.
An underlying premise of the impact statement is that the average business gets a return of one dollar for each dollar of non-human-capital spending, and that profit is created by human effort. As Higgins frames it, how much money does an empty room make? Zero. Ditto for a bank branch with no bankers, or a plane without a crew.
"Executives should accept and act on the idea that financial-performance metrics need to focus on returns on talent rather than solely on returns on financial capital," Higgins says.
Much of today's investment marketplace is based on metrics and ratios derived from traditional financial statements. Human-capital financial statements can be a tool for achieving similar standardization, measurement, and identification of best and worst, improving investors' ability to assess a company's potential long-term performance.
For example, Higgins's human-capital impact statement includes a "human-capital ROI ratio" and a "return on human-capital investment," or RHCI (which can be found at the bottom of the "Workforce Productivity Impact" section in Part I of the sample). The former measure compares return on revenue (net of non-workforce costs) with the total cost of workforce (or TCOW, a term coined by Hewlett-Packard). TCOW includes all salaries, other wages, cash or equity compensation, and benefits for all employees, including temporary or contract workers. On the sample statement, for the current year the hypothetical company's human capital returned $1.30 for every dollar spent on the workforce.
RHCI involves a similar equation but compares TCOW with a selected operating-profit metric, like net operating profit after taxes or profit after tax and minority interests. In the example, for the current year the hypothetical RHCI is 18.5% of every dollar spent (or, when expressed like the other metric, a return of $1.185 on the workforce).
The two calculations often produce similar results, but they tend to diverge depending on how human-capital-intensive a business is. For example, telecommunications firms and some utilities generate revenue with fairly little human involvement once infrastructure is in place, pushing the human-capital ROI ratio higher.
The total shown at the bottom of the Workforce Productivity Impact box takes into account TCOW as well as revenue, profit, and market capitalization per full-time-equivalent employee. (It is a complex calculation; Jeff Higgins welcomes requests for further information on this and other calculations in his sample statement.)
The Management Dance
The Talent-Management Impact section of the sample statement (see Part II) is presented as a series of scorecards, each based on a set of advanced metrics linked to financial results, that quantify value creation or destruction. As shown at the bottom of the page, the statement concludes that $40.17 million of the $41.29 million Workforce Productivity Impact (from Part I) is a result of talent-management policies and activities.
For example, the Recruiting and Hiring segment looks at such things as how long it takes to fill key revenue-producing positions, lost revenue attributable to such openings, and the cost difference between hiring internally and externally. The total recruiting and hiring impact adds up the value of those calculations, with a multiplier factor based on quality of hire (something few companies measure).
The quality-of-hire index is based on five factors: the 90-day new-hire turnover rate; the percentage of job requirements met by new hires; satisfaction surveys of new hires and their supervisors; the percentage of new hires that become high performers; and the number of qualified applicants per open position.
Similar calculations are used to quantify the financial impact of other major components of talent management, which also employ indexes as multipliers that help determine the financial impact:
Mobility. "Career-path ratio" is the ratio of promotions to total movements (including transfers, sideways moves, and demotions) within the organization. If the ratio is too low, you're not doing enough promoting from within, which can impact the bottom line if you've already identified in the Recruiting and Hiring segment that it is less costly to grow talent internally. If the ratio is too high, you're doing too much promoting, which also costs money because it puts too many people into high-income positions. The mobility-impact calculation also factors in the differential in compensation costs for internal versus external hires.
Leadership and Management. The "talent-management index" is like the quality-of-hire index, except it measures leaders' performance in finding high performers and optimizing mobility. The "managerial bench strength" index measures the percentage of managerial positions for which at least one other person is qualified. "Management span of control" measures the number of direct reports per manager; the lower the number, the higher the costs.
Training. The "training-effectiveness index" takes into account the retention rate of high performers before and after training, productivity or performance before and after training, training investment per employee, and employee satisfaction with training.
Performance and Engagement. The "employee-engagement index" is really just a score; here employers can plug in the results of employee-engagement surveys. Regarding the "employee-engagement revenue-linkage impact," Higgins says it is "probably the most difficult one for an average company to figure out." He relies on established bodies of work that estimate what, say, a 10% increase in engagement is worth to a business. By contrast, high-performer productivity impact is easier to figure out.
Turnover and Retention. This entails a more straightforward calculation than any of the other talent-management metrics, and it is the only one that shows a consistently negative impact.
Despite its detailed methodology, it seems clear that even Higgins's impressive effort to calculate the financial impact of human capital can't avoid the fact that there are subjective elements of talent management that defy quantification. But don't try to get him to admit it. "I don't live in that world," he says. "I get up every day trying to quantify everything. I would acknowledge that there are things great leaders and managers do that we cannot yet quantify. But over time, good ones leave a track record of how they manage people that is very quantifiable."
Experts in the field increasingly see Higgins as a dominant force and an advocate for change. "Jeff has merged human-capital analytics and financial accounting into a new configuration," says Fitz-enz. "As a result, we can at last unequivocally connect human effort to business results."
Too Much Detail?
Not all who are close to the subject of human resources are so sure that breaking down financial results in terms of human-capital investments would be a valuable addition to financial reporting.
"I'm of two minds on that," says Ellen Hexter, senior adviser on enterprise risk management for The Conference Board and co-author of a recent white paper on managing human-capital risk. While she likes the idea of shining a light on the impact that human-capital issues have on organizational success, she sees "a danger that if it all gets boiled down to numbers, it could become a compliance exercise, and you wouldn't necessarily be dealing with the big issues that needed to be dealt with."
Also, Hexter notes, financial statements by nature are backward-looking, whereas her work lies in anticipating and planning for risks. She is familiar with and complimentary of Higgins's work but says she doesn't see that it much addresses human-capital risks.
But to Higgins, risk management and the disclosure of human-capital risks are at the heart of all efforts to connect people-related metrics to financial results.
"The risks and disclosure sections of companies' public filings are huge, with everything under the sun in there to minimize liability," he says. "But with no visibility into the efficient utilization of the typical firm's largest expense, one need not be an expert to recognize that some organizations have significant unreported human-capital risks."
David McCann is senior editor for human capital & careers at CFO.
Note: Jeff Higgins is happy to describe the methodology behind his impact statement. He can be reached at email@example.com.