14 May. 2013 | Comments (0) Share Follow @Conferenceboard
Companies invest in human capital to drive revenue and profits for the business, and, as we noted in the previous blog, Human Capital ROI – The Holy Grail, CEOs and boards understandably want to know how much of a return is generated from this investment. We also included several definitions of profit through which the human capital investment could be measured to determine ROI.
However, the deeper, and more discerning, question is whether the level of ROI of the human capital investment is adding to or destroying the value of the business enterprise. This is the land of so-called value-added formulas or economic profit. As described by Dr. Alfred Rappaport in his book, Creating Shareholder Value, economic profit is a measure of return on residual income – income generated after financial capital costs. Financial capital costs are interest, depreciation, amortization and cost of equity which I’ll define later.
Here is an example of what is meant by residual income. Assume a company borrows $10 million at an annual interest rate of 10%. Under the terms of the agreement, each year the company owes the lender $1 million in interest. Now, assume the company invests the $10 million and earns a profit on the investment of $750,000 each year. What is the ROI? At a gross level, the ROI is 7.5%. That is $750,000 divided by $10 million. On a value-added basis, the ROI is -2.5% because the residual profit was -$250,000. The profit or income was $750,000, which is reduced by the financial capital costs (interest) of $1 million for a net gain of -$250,000. In this example, the investment return is destroying the value of the business because the residual income/profit is less than the cost of capital.
Financial Capital Costs
Before we apply the value-added ROI concept to the human capital investment, let’s review financial capital costs. Financial capital costs consist of:
- Interest: The amount paid to lenders for money borrowed through bonds or notes.
- Depreciation or depletion: An amount charged as an expense for amortization of tangible assets over its useful life.
- Amortization: An amount charged as an expense for the depreciation of intangible assets such as a patent or copyright.
- Cost of equity: The expected return on shareholder equity which a CFO would readily know.
Interest, depreciation, and amortization are shown on the Income Statement, whereas shareholder equity is shown on the Balance Sheet.
Value-Added Human Capital ROI
Putting these concepts together, the formula for measuring the value-added ROI of the human capital investment is:
Human Capital ROI = EBITDA – Financial Capital Costs
Human Capital Costs
The result will leave no doubt whether the human capital investment is adding to or destroying the economic value of the business.
In What the CEO Wants You to Know, author Ram Charan emphasizes the importance of the value-added concept: “If the return on investment does not exceed the cost of capital, there will be discontent among the investors because management is destroying shareholder wealth.”
The underlying premise of this formula is that all profits are the result of how management has deployed the company’s financial and people resources. However, human capital has added no incremental value to the enterprise unless it first generates enough profit to exceed the financial capital costs of the business.
What should be the level of Human Capital ROI?
This is a natural and obvious question indeed. The answer is the response to the following question: what ROI, above the cost of capital (financial capital costs), does your company expect to generate on its investments? A CFO, CEO, or board member will readily know the answer.
As this blog, as well the prior blog shows, there are several definitions of profit that can be used to calculate the human capital ROI, but the value-added approach to calculating human capital ROI demonstrates the highest order of business acumen.
The above Human Capital ROI formula was developed and patented by Vienna Human Capital Advisors and is protected by U.S. Patent No. 7,983,945. Use of the formula without express written consent from Vienna Human Capital Advisors, LLC is strictly prohibited.
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