22 Jul. 2013 | Comments (4) Share Follow @Conferenceboard
Answer this question! Which one is the better productivity number – $2.28 or $1.79? If you answered $2.28, you’d be wrong. Surprisingly, the $1.79 productivity level generated a 31% ROI, while the $2.28 productivity level generated a 4% ROI. How could this be? Different business models.
These results are from a company that measured productivity and ROI for two of their business units as part of a pilot project, using the productivity formula Revenue/(HCC + FCC). This equation is the human capital/financial productivity formula I described in my last Measuring Productivity blog.
Types of Business Models
For purposes of measuring productivity, there are two types of business models:
- Value-added resellers (VARs)
- Human capital-centric organizations (HCOs)
VARs buy stuff, repurpose it, and then sell it. They are product companies: manufacturers, distributors, wholesalers and retailers, among others. Conversely, HCOs primarily sell services.
With VARs, a significant portion of their revenue recovers the cost of the items they purchased. For example, the sale price of an automobile takes into account the costs for the parts the manufacturer purchased that were used to build the car. In an income statement, these are referred to as material or raw material costs and are included in costs of goods sold (COGS). Human capital centric organizations, by and large, don’t have material costs.
If you don’t account for material costs in a productivity formula, comparing the productivity results of VARs and HCOs can be misleading. That’s why you can have anomalous results (higher productivity, yet lower ROI) as shown above.
Business model-neutral productivity formula
Here is a productivity formula that has the benefit of capturing and reporting material costs, a significant factor which impacts both the productivity and profitability of the business. It also normalizes for those material costs.
Productivity = Revenue - Material Costs
HCC & FCC
HCC: Human capital costs
FCC: Financial capital costs
Normalizing for different business models is especially appropriate for companies with multiple business units, some of which are product companies and others service companies. Otherwise, productivity comparisons among business units can be deceiving.
And the results are…
When we apply the above formula to the business unit that had the $2.28 productivity level, the productivity value dropped to $1.51. Now, which is the better productivity number, $1.51 or $1.79? You would be correct in saying $1.79, because it generated a 31% HC ROI compared to the 4% HC ROI generated from the $1.51. The relationship of productivity to HC ROI makes more sense, don’t you think?
Observations on the Productivity/Human Capital ROI relationship
As we posited in my Human Capital Analytics: Foundational Concepts blog, companies spend financial resources on human capital to drive revenue and profits of the business. As I’ve also shown in this and previous blogs, in order to measure how much revenue is generated by human capital, one needs to calculate a productivity value.
Now, you would expect that the higher the productivity value the greater the HC ROI. We have found this to be generally true. However, our experience has also shown that:
- Productivity can increase over time while human capital HC ROI declines. This occurs when companies sacrifice profit to grow revenue.
- The same level of productivity can generate different levels of HC ROI. For instance, a client with comparable business units, with the same level of productivity, had significantly different HC ROI (19% v. 24.5%).
- Each company and each business unit is unique in its relationship of productivity to HC ROI.
- External productivity comparisons can be deceptive and counterproductive.
From these observations, we’ve concluded that organizations and business units need to strive for a productivity level that will result in a HC ROI that meets the CEO’s and boards’ expectations. It is in this context that human capital productivity should be assessed.
In the next blog, I’ll weigh-in on using FTE as a denominator for profitability and productivity measures. Some in the human capital analytics community are fond of this approach.
The above Human Capital Productivity 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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