Measuring Return on Human Assets in Companies Keith Bradley, London School of Economics, Business Performance Group February 1993

INTRODUCTION

Described below is a way in which companies might consider reporting on their human assets. We outline a straightforward technique of measuring the return on human assets. The technique has three stages: (i) human asset value (ii) performance indicators and (iii) return on human asset investment.

Stages (i) and (ii) are important on their own. Each provides new management information, each provides management with a measured outcome or indices which can be reported at regular intervals, each is a basis for management action to improve and sustain competitive advantage. Descriptions are sufficiently detailed to provide a flavour of the techniques and how they might be operationalized. This, however, should not be viewed as a road map for companies.

STAGE I HUMAN ASSET VALUE

A necessary pre-requisite of an assessment of a return on human assets is an ability to assess a human asset value. The technique described below explains how this can be achieved and how the asset is depreciated. Human asset value provides comprehensive information on human assets. Specifically it: (i) quantifies asset loss, (ii) identifies trouble spots, (iii) targets management resources, and (iv) transfers best practice.

All organizations have assets. Assets are used to produce output - either products or services. Standard accounting techniques allow monetary values to be put to many of these assets - buildings, machinery, transportation, stock and so on. Management uses this and other information in order to make the most efficient and productive use of their assets. The employees of an organization represent an additional asset - they too are there to produce output and they too have an inherent value. For many good reasons, a human asset value does not appear on the balance sheet - it is intangible and it cannot be sold to raise cash. But for managers to run human assets as efficiently as they can other assets, they need equivalent information. In many businesses, this does not exist -in fact there is often a complete vacuum in this area. Far sighted companies, however, are increasingly using human asset value.

Human asset value is a tool which provides managers with new information which can improve decisions on how best to optimise the firm's human assets. It produces two key pieces of information about human asset which, for sake of comparison, in accounting terms are: (i) book value; and (ii) depreciation.

The basis of the methodology is to quantify the cost of replacing employees. The book value of the human asset is defined as the total cost of replacing all the employees. Conceptually, this is equivalent to the standard way of measuring the book value of machinery and buildings: the cost of replacing them in the marketplace. Furthermore, the annual depreciation of the human asset is the annual cost of employee turnover. In other words, it is the cost of replacing all the employees who quit or retire during a year. Again, this is synonymous to the depreciation cost of a normal fixed asset

Key Assumptions in Methodology

Company-specific vs. Industry-standard. It is assumed that it is always possible to find a replacement with equivalent industry-standard skills. For example, if a welder leaves, then it is assumed that the replacement will be an equally good welder. However, the welding job may require company-specific skills, which cannot be bought in the job market. The replacement will not have these skills and needs to accumulate them in the job or via training. Meanwhile he is working at sub-optimal efficiency. So elements ii, iii and iv above refer only to company-specific training and learning, not industry-standard. Internal Promotion vs. External Recruitment. There are two ways of replacing a leaver - by external recruitment and by internal promotion. There are different costs associated with each of these, and so there are always two replacement costs. It is assumed that if the position is filled by internal promotion, then someone is recruited externally to fill the gap left at the bottom of the corresponding career ladder. For example, if the machineshop manager leaves and is replaced by the shift supervisor, then it is assumed that the domino-effect works all the way down, creating a vacancy for a new machine operator. Accumulated On-the-job Training - Critical Career Path. A managerial or supervisory position sometimes has a critical career path. This is a list of positions that must be held before that person is qualified to be promoted to manager. For example, a mouldshop supervisor must always have been an operator and a setter. If a new supervisor is recruited externally, then he must become skilled at each of these jobs as if he had come up the ranks. In other words, it is not sufficient to quantify the learning curve solely for the supervisor's role - instead all the learning curves for the positions leading up to supervisor must be accumulated. Opportunity Cost. One of the themes in the human asset value analysis is the quantification of opportunity cost. For example, the cost of lost productivity while a new recruit is rising up the learning curve, or the cost of the time spent by a manager in doing on the job training on a new recruit. Opportunity cost is essentially the employee's salary, grossed up to include associated labour costs.

Human asset value information has many uses beyond giving a value for the human asset. It quantifies the cost of staff turnover in each department, at each level and for the organization as a whole. It therefore highlights problem areas where staff turnover is costing the business most. Managers can realise actual cost savings by accurately deploying resources and know-how to these hotspots and reducing the turnover. More generally it can feed into all areas of personnel policy and related cost-benefit investment decisions.

The process to arrive at a human asset value has two stages: (i) Intelligence Gathering and (ii) Analysis: For the former, interviews are conducted with all the employees in a particular function, say supervisors - plus the production, finance and personnel directors. In addition, certain data on salaries, recruitment costs and training programmes are collected from company records; and for the latter, all the data collected in Stage I is inputted into a spreadsheet which then calculates, in this case, supervisor replacement cost, and finally human asset value and depreciation.

The fundamental basis of the human asset value is the analysis of the cost of staff turnover - or in micro terms, the cost of replacing an employee. Consider a single employee that resigns from his/her position. The human asset value quantifies the cost of replacing that employee with someone of equal productivity. There are four elements to the replacement cost:

1. Recruitment Cost, for example, advertising, employment agencies, interviewing, personnel administration;
2. Formal Training, courses that are necessary for the job and hence the new employee;
3. On-the-job Training, time spent by colleagues and managers training the new employee in the tasks relevant to the job.
4. Learning Curve, the job definition may require skills or knowledge that are specific to the company. Hence the new employee operates at sub-optimal efficiency while he/she is accumulating this experience. See figure 1.

Figure 1 Elements of Employee Replacement Cost

A Brief Case Study

Here we report some evidence from a case carried out in three facilities of a British manufacturing company employing some 8,500 workers, operating in three sectors across three continents. For the past three years it has made about £40 million profit on a turnover of £0.5 billion. The three UK business units are relatively small, low to medium technology manufacturing plants. We report on the human asset value of the supervisor. The results reported here are indicative of the technique. If the value of the technique can be proved under these conditions its value in a leading company will be obvious.

The total asset value of the supervisor layer at Company 1 is £226,857, working out to be £16,204 per supervisor. This compares to £218,460 and £18,205 at Company 2 and £262,779 and £16,425 at Company 3. In other words, if one supervisor leaves, then on average it costs between £15,000 and £18,000 to find and bring the replacement up to similar skills and knowledge levels. Given that five either resigned or retired last year at Company 1, the human asset depreciation at Company 1 is £81,020. Similarly, taking 1991 figures, the depreciation at Company 3 is £49,275 and zero at Company 2 (no-one has left). Obviously the higher the turnover (and hence depreciation), then the more important this cost analysis becomes, see table 1.

Table 1 Human Asset Value of Supervisors in Three Companies

Figure 2 Human Asset Depreciation in Three Companies

From data collected within these companies, it was found that the cost of replacing all the supervisors by internal promotion is consistently lower than if they are replaced by external recruitment. The difference is £87,000 at Company 1, £54,000 at Company 3 and £171,000 at Company 2 and is caused by the additional learning that a new recruit has to go through about the Company's products, systems and people - ie company specific knowledge. Also it is more expensive to recruit supervisors than it is to recruit someone at the bottom of the organization (which is assumed in the case of internal promotion). The difference is so large in Company 2 because most of the learning and on- the-job training occurs at one level below the management level that was examined. Hence replacement by internal promotion is relatively easier.

Variance by Cost Item

The highest cost items for both internal and (especially) external replacement tends to be the invisible costs: the learning curve and on-the-job training, see table 2 and figure 3. This is especially true at Company 1 where very little money is spent on external courses. Company 3 has less on-the-job training and a correspondingly higher learning cost curve. Internal courses are the smallest portion of the replacement cost - varying between 7 and 15 per cent across the three companies. The recruitment cost is relatively low in all except Company 1, which, being in the south of England, suffers from having to pay employment agencies, see table 2 and figure 3.

Table 2 Human Asset Value: Variance by Cost Item

Figure 3 Human Asset Value: Variance by Cost Item

In addition to variance within a specific function there is also variance across departments and positions. In Company 1, for example, the highest weighted average (of external and internal) is £40,800 for the Service Engineering Manager and the lowest is £10,200 for the Head Buyer. Other high cost departments are Design and Materials, and other low cost ones are Drawing, Assembly and Machine Shop. In Company 2 the highest weighted average (of external and internal) is £29,400 for the Fencing Manager and the lowest is £9,900 for the Transportation Manager. Other high cost departments are Engineering and Sales (Manager), and other low cost ones are Arches, Sales (Supervisor) and Loading. And in Company 3 the highest weighted average (of external and internal) is £33,300 for the Sales Manager and the lowest is £4,200 for the Assembly Manager. Other high cost departments are Mouldshop and Wireline (Managers), and other low cost ones are Purchasing and Warehouse, see figure 4.

The most expensive positions to replace are those that require a high degree of company-specific knowledge and skills - both technically and managerially, see figure 4. The human asset value technique allows us to distinguish the positions which are most costly to replace. A Service Engineering Manager at Company 1 or Technical Manager at Company 2 are good examples of where the ideal person has thorough knowledge of all aspects of the products, customers, processes and people. It is worth noting that the internal replacement cost for these type tend to be much lower, because the next person down would have much of the specific knowledge already and hence would start significantly further up the learning curve.

Figure 4 Company specific knowledge

In the middle are positions where the manager requires either (but not both) a high degree of company specific technical skills, or managerial skills. Examples are the Assembly Manager at Company 1 who must know the machines well, or the Mouldshop Supervisor at Company 3 who needs to be familiar with all the jobs in his division - neither have such a key managerial functions (at least that are not general interpersonal skills).

At the bottom are the positions that require little company specific skills, and only general management expertise. Purchasing, Warehousing and Transportation tend to be in this category, see figure 4.

This example is indicative of the technique and provides some idea of the methodology and data obtained. It must be stressed that we purposely chose three relatively small business units engaging in relatively straightforward tasks and technology. The strength of our case is that if it can be made under these relatively adverse conditions, then it would be relatively easy to make the case in conditions which prevail in each company.

STAGE II PERFORMANCE INDICATORS

The human asset value technique is both straightforward and visible. It can be employed to assess the value of an entire workforce, a division, a business unit, a specific layer or function etc. The human asset value is the first stage in assessing a return on human assets. The second stage is to determine a performance indicator for the human asset. Like the human asset value, performance will be measured with indices which can be regularly reported. The technique employed to assess performance is by way of a customer audit. Each of these units provide outputs in the way of goods or services.

Let us now illustrate how this might be achieved with reference to a specific function within a company. For our illustration let us consider the services of a division. Let us assume that a division provides three services: A, B and C. Let us assume further that the division has a number of specific customers: the MD's of business units.

The object of this stage is to assess the performance of the division as viewed by its principal customers and devise indices of performance for the division. Indices combine assigned weights with satisfaction scores and can be reported at regular intervals. Let us show how this is achieved.

Example and Use of Data

Let us consider the services of a division in relation to its business units. Assume that the managing directors of the business units have agreed the following performance criteria in assessing Service A: (i) lack of bureaucracy, (ii) responsiveness to ideas, (iii) speed and (iv) accuracy. Assume further that three different business units weight these criteria differently, see table 3, where 1 is low and 10 is high.

Table 3 Weights assigned to Performance Criteria for Service A

Weights can be assigned to performance criteria at the same time as the customer survey solicits the level of satisfaction with Service A with regard to the customers' chosen criteria of performance, where 1 represents a low and 10 represents a high level of satisfaction. Data from tables 3 and 4 will allow overall performance indices to be reported for Service A and each business unit. The formula to do this is:

where	I = index
	C = criteria of performance
	W = weight

These indices are benchmarks of the current performance, but are also a basis for future targets, see figure 5. The higher the score, the better the overall performance.

Table 4 Satisfaction with Service A according to Performance Criteria

Figure 5 Financial Control Indices

Faced with performance targets the divisional head will be charged with improving his/her service. The indices provide a road map of how improvements might be achieved. This is clearly demonstrated in figure 5. The shaded area in the bar graphs represent each business unit's satisfaction with the Division's Service A with regard to a specific performance criteria. The non- shaded part of the bar graph represents the weight business units give to different performance criteria. It can be seen that this representation suggests different strategies for different business units, see figure 6.

Figure 6 Enhancing Performance in the Division's Service A

These indices provide an indication of the performance of a service by specific suppliers. Their strength is that they can be assessed at regular intervals. Trends in performance can therefore be easily identified. The index will demonstrate how performance can be improved and they also facilitate the careful targeting of company resources to improve performance. The indices can be used to measure the effectiveness of these management resources.

STAGE III RETURN ON INVESTMENT IN HUMAN ASSETS

By relating the human asset value to the performance indicators (benefits) we can deduce a return on investment for human assets, see figure 7.

Figure 7 Return on Investment of Human Assets

If we consider the indices of performance as a kind of benefit, and we know the human asset value of the delivery system: Service A = $1, Service B = $2 and Service C = $3, we can set the benefit against the costs to estimate the return we are achieving from our human asset value.

$1: (1+2+4)
$2: (3+6+8)
$3: (5+7+9)

These ratios can be reported and monitored over time.