Measuring Employee Value Added

The world is involved in a global crisis and executives are trying to manage Organizations through the downturn without destroying its long-term success. Many of the giant corporations, most of which were subjects to many case analysis, are cutting costs frequently through lay-offs. Some companies need vitally reducing their headcount, but some others are just following the others expecting that they can rehire once the economy improves; what a pity...

We live in a world where yesterday is a distant memory and tomorrow is an uncertain dream. The only reality is now. However it is easy to understand that the talented, qualified workforce will be the scarcest resource in less than ten years for Organizations. All survey results point out this reality which can be foreseen from today. The important question is: Are Organizations ready for this challenge? Are they really aware of that? How did they reduce the size of the workforce? Are talented people downsized just to reduce costs? What role did HR department play? These are critical in order to address people issues and to establish people strategy in an Organization and should be addressed especially when the global economy recovers.

Today, the HR function sits at a pivotal place. It is the link between a company's long-term strategy and its human capital strategy. HR professionals should be able to understand how their company's overall business strategy drives the demand for people and how short term reductions in the workforce might threaten the achievement of long-term success. Although this should be the case, only 15% of the companies-covered by the survey conducted by BCG covering responses of 3.348 executives throughout the Europe, strategically plan their workforce more than three years in advance.

Rummler and Brache draw on their experience in process improvement to state "we believe that measurement is the pivotal performance management and improvement tool and such deserves special treatment". They go on to point out that without measurement we cannot:

• Communicate specific performance expectations.


• Know what is going on inside the Organization.


• Identify performance gaps that should be analyzed and eliminated.


• Provide feedback comparing performance to standard or a benchmark.


• Recognize performance that should be rewarded.


• Support decisions regarding resource allocation, projections and schedules.

In short, if we don't know how to measure our primary value producing asset, our human capital, we can't manage it.

According to Boston Consulting Group 2009 Creating People Advantage Survey, at most companies the links between HR and strategy and those between HR and metrics are broken or nonexistent. Measuring the performance of people and the HR department is a key issue. Few companies track the quality of the HR processes. In the same survey one of the top seven HR topics stated by HR executives is to measure employee performance; determining how to measure the value of each employee in order to create a more efficient and more productive workforce. I would like to add that, on the 2008 survey, the item was on the medium need to act zone. There is an increasing trend and interest on the subject.

That is why I have chosen this topic on this article.

How to Show Employee Impact on Value Added?

First of all, I would like to differentiate productivity and value added performance metrics as HR executives are confusing these two from time to time. Added value metrics are those that measure the relationship between profit from operations in relation to human capital employment cost. However productivity metrics look at the relationship of employment cost against net sales and total costs separately.

My focus will be the value added metrics and productivity will be a separate topic on my forthcoming article which will be published on October 2009.

There are 3 main value added performance metrics that are explained in the literature and used by consultants. I will be trying to explain these from my point of view and will show both the theoretical and the practical calculations by using examples.

Human Economic Value Added (HEVA)

Economic value added (EVA) is a financial performance method to calculate the true economic profit of an Organization. It is an estimate of the amount by which earnings exceed or fall short of the required minimum rate of return for shareholders at comparable risk. In short, it shows how much true profit is left not only after paying all expenses, including taxes, but also after subtracting the cost of invested capital. It is defined as net operating profit after tax minus the cost of capital.

EVA can be given a human capital perspective by dividing it by the average headcount within the calculation period. So the formula can be re-stated as: HEVA = ( Net Operating Profit After Tax - Cost of Capital ) / Average Headcount. Another simple method described by PWC Saratoga Institute, naming HEVA as Wealth Created per Employee, HEVA= ( NOPAT - 10% Shareholder's Equity ) / Average Headcount.

Both calculations are correct. However, I think that with this method of calculation, EVA may not be a true benchmark metric simply because of the use of net operating profit after taxes. For example, NOPAT is after depreciation, amortization and financial expenses. For those companies running in countries where fx losses are higher than any other country in the world, NOPAT will be significantly lower in comparison with developed countries. Or, companies that do not reinvest capital to maintain its plant or equipment can improve its depreciation line and will have a positive effect on EVA.

What I suggest is to use profit from operations namely operating profit in calculating value added performance metrics. I believe that it will be a true benchmark not only within the same industry but also between different sectors. Foreign exchange losses or interest losses are constraints that Organization management may have the least impact on and is highly dependent on external economic conditions. So do corporate tax rates. Management should find ways to add value in managing working capital.

Accordingly the formula will be; HEVA = ( Operating Profit - 10%Shareholder Equity ) / Average Headcount

With the help of this simple calculation you will be able to show how much wealth is in reality being created by the employees, including an allowance for shareholder dividends are taken into account. Let's take for an example XYZ Company financial data ( I will be using the same data for other metric calculations).

HEVA = ( $45.000.000 - 10% X $70.000.000 ) / 3.100 = $12.258 wealth per head created within the period of time. Data will be meaningful if and only if benchmarked with external data and trend is followed throughout the years.

Human Capital Value Added (HCVA)

Value Added is the difference between the cost of materials and labor to produce a product, and the sale price of a product. HCVA generates an adjusted profitability figure by each employee in the Organization.

PWC Saratoga Institut suggests to calculate HCVA by subtracting all corporate expenses except for pay and benefits from Revenue and divide the adjusted profit by the average headcount. HCVA = Revenue - (Total Costs - Employment Cost ) / Average Headcount. As total cost item is not mentioned in none of the financial statements, it is defined as the difference between the Revenue and Profit Before Taxes.

As I explained earlier, to me profit before tax figure is not a correct benchmark item as foreign exchange losses are included on it. The benchmark may be reasonable in developed countries where devaluation do not exist. Instead, I propose to calculate total cost as the difference between the Revenue and the Operating Profit. The formula then will be; HCVA = [ Revenue - ( Revenue - Operating Profit - Employment Cost ) ] / Average Headcount. And for simplifying the calculation; HCVA = ( Operating Profit + Employment Cost ) / Average Headcount.

Applying the formula to XYZ Company; HCVA = ( $45.000.000 + $55.000.000 ) / 3.100 = $32.258.

Human Capital ROI (HCROI)

Another relationship of human capital investments to profitability can be made visible through a ratio that follows from the formula for HCVA. HCROI looks at the ROI in terms of profit for monies spent on human capital employment costs. It drives human capital practitioners to the conclusion that they can have as direct an impact upon revenue and non-people related costs as any other business partner. HCROI represents the leverage of human capital employment cost within an Organization.

HCROI = ( Operating Profit + Employment Cost ) / Employment Cost

XYZ Company has a HCROI of = ( $45.000.000 + $55.000.000 ) / $55.000.000 = $1.81

In XYZ, every dollar invested in human capital employment gave a return of $1.81.

Conclusion

In this turbulent times of global economy, the recovery will last longer than it is expected. Effective organization management, productivity, efficiency, performance have critical importance, so do talent. HR has a critical role in these times. Showing the employee performance, added value per each employee are important more than ever. HR should excel on measurement and increase the ability of creating many other performance related metrics and to come up with external benchmark data. That is how HR will be treated as strategic business partner and add value to sustainable competitive advantage.

Sources Used:

1- The ROI of Human Capital - Jac Fitz-Enz

2- http://www.valuebasedmanagement.net/methods_eva.html

3- Creating People Advantage,2009 Survey - Boston Consulting Group