24 Apr. 2013 | Comments (2) Share Follow @Conferenceboard
Some of the thought leaders in the human capital analytics space have referred to human capital ROI as the Holy Grail measure. Hyperbolic claim perhaps; but, it does make the point that human capital ROI is the most significant metric, and the most elusive, for measuring the financial outcome of the resources spent on human capital. I agree… here’s why.
Shortly after launching Vienna Human Capital Advisors in 2004, I met with the CEO of a pharmaceutical company who asked a straightforward question on every CEO’s mind: “What is the best way to measure HR’s performance?” She went on to say that her company invests a lot of money in people and programs, and HR seems to have an endless appetite for more of the company’s limited financial resources. Yet, how could she be assured those precious financial resources were producing bottom-line results? In short, the CEO wanted to know the return her firm was getting on the money it spends on human capital. She didn’t ask about turnover, or cost per hire or employee engagement or any of the hundreds of other HR metrics. She simply wanted to know the return on the investment in people.
Boards and C-suite executives take great pains to measure and monitor returns on their company's investments, and they share a common frustration: how to measure the financial impact of human resource investments, both people and programs. Controlling the money going into human capital is one thing; measuring and maximizing the value coming out is quite another.
So, how does one measure the ROI of the human capital investment?
Before I suggest some formulas to do just that, I want to establish an important premise: All financial results (profits or losses) are the results of how people (human capital) utilized the financial capital of the business, and the decisions they made during the time period measured. As we noted in the previous blog, Human Capital Investment: Driver of Enterprise Value, Circuit City was a highly celebrated, financially successful company until it liquidated due a series of disastrous management decisions. Conversely, Google continues to be highly successful precisely because of how its human capital successively deployed their financial capital.
Measures of Profit
There are several definitions of profit against which the human capital investment can be measured, including:
- EBITDA (pronounced EE-bid-dah) or earnings before interest, taxes, depreciation, and amortization. EBITDA is a credible, universal financial performance measure that works for all kinds of business enterprises – both privately-held and publicly-traded companies. EBITDA is a good metric to evaluate profitability and works well in all cases because it reflects profit irrespective of the financial capital structure (debt vs. equity) of the business, which can vary greatly by industry/organization or business units within an organization.
- Earnings before Interest and Taxes (EBIT), is often referred to as operating profit. Operating profit includes amortization and depreciation, and shows the profit made from running the business. This measure of profit excludes the impact of Interest and federal income taxes.
- Net Income before Taxes is EBIT, less Interest. This measure of profit reflects all financial capital costs reflected in the income statement.
- Net Profit is the bottom line of the income statement – what’s left after all costs and expenses are subtracted from revenue. It’s operating profit minus interest expenses, taxes, one-time charges, and any other costs not included in operating profit. Some of the key numbers used to measure a company, such as earnings per share and the price-earnings ratio are based on net profit.
While there are derivations of the above measures of profit, these are the most prevalent measures used to assess the profitability of companies.
In order to answer the CEO’s question therefore, HR should ask which measure of profit to use to calculate the ROI of the human capital investment. The denominator of the equation, as I explained in my previous blog post, is the human capital investment.
There is another dimension of measuring ROI, known as value-added formulas. I will describe this concept in my next blog.
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