CFO + CHRO = POWER PAIRBy
There’s a global groundswell of interest in human capital management (HCM). A 2013 Conference Board report cited it as the number one challenge CEOs face. More recently, in a March 2015 Harvard Business Review article, “The 3 Things CEOs Worry About the Most,” talent-related issues were the top concern. And don’t forget the competency crisis in accounting (www.competencycrisis.org).
Human capital analytics is an area of critical importance to strategic CFOs and the finance organization. Why? Because the company bottom line depends on the quality of people who determine business results and long-term value creation.
In financial reporting, the investment community is also interested in human capital metrics as a way to better understand how a company will create future value. Meredith Miller, chief corporate governance officer of UAW Retiree Medical Benefits Trust (composed of global institutions with $1.2 trillion in assets), recently said at a CFA Institute event in Chicago: “Investors have been looking for the proxy for human capital investment, and pressing for public disclosure is key—especially in making the connection to return on invested capital (ROIC).”
To help show the past, present, and future of the use of human capital analytics in measuring, managing, and predicting business performance, we focus on the value of aligning CFO (chief financial officer) and CHRO (chief human resources officer) goals to strengthen execution and accountability. Later in this article we describe a version of an employee turnover measure converted to a more predictive financial metric by capturing compensation. We developed this metric we call Investment-Based Pivotal Employee Turnover (IBPET), and almost any organization can adapt it.
THE CFO/CHRO CONNECTION
A 2014 study by Ernst & Young, “Partnering for Performance Part 2: The CFO and HR,” found that high-performing companies feature a strong CFO/CHRO connection. CFOs and CHROs say that improving their working relationship led to significant improvement in workforce productivity and company earnings.
A 2009 study by CEB drew on interviews from nearly 500 executives and combined the information with a large data set assembled on long-term corporate performance. The study found that more than 80% of the time the key controllable factor of revenue stalls—declines in growth rates—was entirely or disproportionately about talent.
The CEB study examined companies that had 10-plus years of growth in revenue followed by a remarkable 10-plus years of decline. A multivariate regression conducted across more than 200 variables explained the stalls of these companies. Most of the reasons had a “talent underlay” whether they were strategic choices, talent bench shortfall, or incorrect performance metrics. It was always just people making the wrong decision in the wrong way at the wrong time.
The Return Driven Strategy framework, developed by Mark Frigo and Joel Litman, describes the strategic activities of sustainable high-performing companies (for more information, see the book Driven: Business Strategy, Human Action and the Creation of Wealth). And it highlights the importance of employee engagement and human capital as well as disciplined performance measures that link with long-term shareholder value creation and the stewardship of capital. It also includes a key tenet “Communicate Holistically,” which involves executive communication internally and externally that reflects how the company intends to create long-term value and the critical role of human capital in creating this value. Laura Rittenhouse, CEO of Rittenhouse Rankings, Inc., notes: “At Rittenhouse Rankings we continuously search for clues in executive communications to ferret out a company’s priorities. CEO words matter. Words and actions that reward, inspire, and motivate employees—especially pivotal employees. In the age of Big Data, much can be gained by applying analytic intelligence to rewarding and valuing employees and also balancing the needs of all stakeholders. Fostering accountability in the manner set forth [here] is at the core of Capital Stewardship.”
HUMAN CAPITAL METRICS AND MONEYBALL
We use the label “Moneyball” for human capital analytics. It’s based on Moneyball—both the book and the movie about Billy Beane, Oakland Athletics general manager and now executive vice president of baseball operations—which revealed how data on individual and collective performance came to be used to statistically predict outcomes and guide decisions in Major League Baseball for optimal player acquisition and utilization.
These concepts can be used in human capital management when they are standardized for basic cross-company comparison. Reliable human capital data analytics are critical to further a CFO/CHRO alliance. How can someone judge the effectiveness of these human capital metrics? The Human Capital Management Institute (HCMI) Human Capital Metrics Handbook mentions more than 600 human capital metrics, including “Total Human Capital Cost,” in relation to revenue, profit, investment, and per full-time employee (FTE). Companies monitor headcount turnover, employee engagement, and functional efficiency in recruiting, hiring, safety, and more. These are useful metrics, to be sure, but they rarely predict business results.
HUMAN RESOURCE MEASURES
Unlike finance and accounting, HR doesn’t have basic measures such as in Generally Accepted Accounting Principles (GAAP). But it does have all the data it needs internally, and, through access to HR administration and consulting firms, it has or can develop the capabilities to produce tremendous insights and information in benchmarking and understanding how human capital metrics drive business performance.
HR already does benchmarking for executive compensation and other management programs. Hewitt Associates (now Aon Hewitt), a leading compensation and benefits consulting firm, sought to provide its clients useful comparative human capital analytics, so it analyzed the data covering 20 million employees from 1,000 companies spanning a 10-year period for exactly this purpose. Working with eight pilot companies—ALCOA, Siemens, JCPenney, Eli Lilly, Nationwide, Verizon, MeadWestvaco, and Hewitt itself— Hewitt explored the data to define human capital metrics that would predict business results. This study led the company to develop a new key human capital metric: Talent Quotient™ (TQ™).
HOW TALENT QUOTIENT WAS DETERMINED
To conduct the study and develop the Talent Quotient metric, Hewitt de-identified individual data, replacing Social Security numbers with other unique numbers. This enabled Hewitt and Global Analytics researchers to track employee movement out of one company and into another. They wanted to determine if employees who were leaving were top performers, high potentials, or in critical roles or not. All pilot companies defined these characteristics differently but collectively settled on top-quartile percentage pay progression as the definition of “pivotal employees” for comparison of one company to another and over time. It was a proxy to identify employees in whom the company was investing the most.
Percentage pay progression was adjusted for age, pay, and tenure to make sure top quartile was applied reasonably. Using the metrics that most connected shareholder value (as discussed in “An Economic View of the Impact of Human Capital on Firm Performance and Valuation” in The Valuation Handbook: Valuation Techniques From Today’s Top Practitioners, 2009, pp. 508-524), they found that a disproportionate loss of pivotal employees predicted declining business performance. This finding was after adjusting for reverse causality—that is, poor business performance leading to more pivotal employees leaving—accomplished by factoring in prior years’ financial performance.
Hewitt determined the Talent Quotient for companies over time and its impact on cash flow return on investment (CFROI) and other financial results. The outcome was that a 10% increase in TQ for a $10 billion investment added an estimated $70 million to $160 million to the bottom line for industrial and financial companies, respectively.
In 2008, Hewitt conducted a joint conference with Credit Suisse about the impact of human capital on investment capital. Half the attendees were investment professionals invited by Credit Suisse, and the other half were corporate HR managers invited by Hewitt. After Hewitt issued a press release about the findings, investors expressed interest in the TQs of companies so they could be considered in their stock valuation models. The most recent conference at which these results were presented was the 2014 HRPS Strategic HR Forum, “Practices that Drive Organization Results,” in the keynote address, “The Convergence of HR and Finance.”
An April 2015 study, “The Materiality of Human Capital to Corporate Financial Performance” by Aaron Bernstein and Larry Befferman from Harvard Law School, adds further support with its findings, specifically the conclusion that “the evidence for human capital materiality is sufficiently compelling to warrant investor requests for companies to report systematically” and “one way to start thinking about desired reporting (at least internally) is to draw upon policies found to be linked to financial results.”
THE VALUE OF HUMAN CAPITAL ANALYTICS
Using human capital analytics to predict business financial results gives organizations the ability to use them in internal strategic decision making and for connecting finance and HR. Here are some brief case examples:
Company A—Big-Box Home Improvement Retailer. This company found that a form of Investment-Based Pivotal Employee Turnover predicted the financial impact of store profitability just as it does for overall corporate results. This led the retailer to adopt a new regional manager training program designed to retain pivotal employees and to use internal reporting of IBPET at the regional level along with financial results.
Company B—Major Food Company. This company used human capital analytics to design its performance management program. At this company, the definition of pivotal employees was based on those having received top-quartile percentage pay increases, and a form of IBPET was used to evaluate the company’s performance management program. Analysis at the company provided quantitative justification for refining this HR practice, and the result was a worldwide conference of the performance management staff and a refinement in the level of differentiation of employees to provide better human capital alignment within the organization’s business and financial performance.
Company C—Large Pharmaceutical Company. This company used human capital analytics to guide the relative emphasis on fixed salary vs. commissions for its sales force. It found that to do better in retaining pivotal employees and get the financial benefit of a higher IBPET for its sales force, more emphasis was needed on base pay rather than incentive compensation. The company made the change because this counterintuitive result was supported by analysis of human capital analytics and financial analysis.
Company D—Large Processed & Packaged Goods Company. This company designed a unique long-term incentive plan that included all employees in its research and development (R&D) group. The plan featured a compensation fund created by 5% of revenue for the first three years, 10% of profits for the next three years, and 15% of the economic profit (profit in excess of a minimum return on investment) for the next four years. This is a 10-year-long interest in the business patterned after the natural economics of a start-up that must first position itself to compete in the market, then migrate to generate profit and then return on investment. The business thrived and became a precedent for strategic HR management at the company.
The connection between financial results and human capital analytics reinforced by accountability reporting and compensation is common to these companies. Evidence-based research shows the importance of HR metrics like IBPET as a crucial performance metric that companies can adapt and implement. (For more information, see “An Economic View of the Impact of Human Capital on Firm Performance and Valuation” in The Valuation Handbook: Valuation Techniques From Today’s Top Practitioners.)
THE IBPET METRIC
In April 2015, the Society for Human Resource Management (SHRM) Metrics & Measures Task Force developed its standardized definition of turnover. It includes how to consider (define) part-time employees, those on leave for various reasons, conditions of termination, and the like in the calculation. This is a major accomplishment because deciding who is to be considered an employee in a standardized manner across companies is much trickier than it might seem on the surface. Furthermore, the precise calculation of turnover varies from company to company.
IBPET is similar to the Talent Quotient, except it accommodates the definition of pivotal employees tailored by a company. One reason is that it is more than just a headcount turnover metric. It provides a way for companies to experiment with HR metrics and analytics to identify those that will work best.
IBPET and TQ take the traditional definitions of employee turnover to another level because they are “dollar weighted” by employee compensation. TQ measures the relative loss of the investment in pivotal employees, defined as top-quartile percentage pay progressors, vs. all employees. IBPET enables a company to define pivotal employees according to internal labels such as high potentials, top performers, and those in critical roles. By incorporating compensation in their metrics, the CFO and CHRO get a useful measure of the loss of dollar investment in people leaving.
RETENTION RISK SCORE
Another important area where human capital metrics are relevant is enterprise risk management (ERM). Omitting human capital risk in risk assessment would be a crucial mistake. A Retention Risk Score (RRS) can be a useful tool here. The RRS predicts the probability of an individual voluntarily leaving the company within 12 months. It reflects all the information available about an employee, and every employee is scored. A higher score means a higher risk of leaving. The methodology for this metric is modeled after that used in assessing credit risk with FICO scores.
Combining a retention risk assessment with the determination of pivotal employees reveals who is at risk of leaving the company. Through employee engagement surveys and other means, many companies are also studying why these employees are at risk.
STRATEGY MAPS BRIDGE FINANCE AND HR
Strategy maps are another valuable tool and can be used as a bridge connecting and integrating finance and HR and strategy and risk management. The four perspectives and architecture of strategy maps (Financial, Customer, Internal Processes, and Learning & Growth) provide a natural platform for connecting finance and HR. In the November 2014 Strategic Finance article “Mining the Past to See the Future,” Gary Cokins describes using strategy maps with embedded analytics. Strategy maps describe the “what” and “how” of the business strategy, which leads to some key questions management teams should ask regarding human resources: “Who is doing it?” and “What is our human capital at risk?”
The strategy map in Figure 1 shows how management can describe and prioritize its activities and embed human capital analytics. It also includes strategic objectives directly related to HR metrics and risk management.
This strategy map includes four strategic themes:
- Operational Excellence,
- Create Value with Technology,
- Grow High-Value Customer Relationships, and
- Organizational Alignment.
The Human Resource Dimension: Related to HR, the Organizational Alignment strategic theme includes a “Strategic Human Capital Analytics Initiative” (see p. 33). The Learning & Growth perspective of the strategy map includes a strategic objective, “Develop Human Capital Metrics and Analytics,” which in turn shows key strategic talent metrics (e.g., Investment-Based Pivotal Employee Turnover and Talent Quotient) and retention risk metrics (e.g., Risk Retention Score). Management can develop this type of strategy map as a road map for understanding how and where human capital analytics and metrics can be useful.
The Risk Management Dimension: The strategy map also includes strategic objectives relating to risk management in each of the four strategic themes. The Organizational Alignment theme includes a strategic objective related to a Strategic Risk Assessment (see Mark Frigo and Richard Anderson, “Strategic Risk Assessment: A First Step for Improving Risk Management and Governance,” Strategic Finance, December 2009). And the Learning & Growth perspective includes the strategic objective “Develop Strategic Risk Management Skills and Culture,” which has both HR and risk management implications. (For more information about using strategy maps in risk management, see Chapter 9 in The Balanced Scorecard: Applications in Internal Auditing and Risk Management by Mark L. Frigo, Institute of Internal Auditors Research Foundation, 2014.)
CFO and CHRO interests intersect when it comes to internal and external reporting of human capital and financial performance. Internal reporting can be done now. This includes benchmarking against other companies over time. The Center for Talent Reporting (CTR), a not-for-profit organization, has created Talent Development Reporting Principles (TDRP) modeled after GAAP. In addition, CEB uses its Metrics That Matter™ for benchmarking in this area. The Sustainability Accounting Standards Board (SASB) is also pursuing broad nonfinancial disclosures that include material human capital dimensions.
Even though reporting fosters accountability, there is resistance to public disclosure of human capital metrics—and for good reason. Worries about legal and other misinterpretations abound. Standardized disclosures being advocated by many groups may involve risks and will turn out to be counterproductive. Nevertheless, standards are being developed to guide internal reporting in a manner that can facilitate benchmarking with other companies.
THE ROAD AHEAD
CFOs and finance organizations can play a vital role in the evolution of human capital metrics and in understanding how human capital drives business and financial performance. To be truly valuable, human capital analytics and metrics need links to business results and reinforcement through compensation, communications, training, and ongoing reporting. This is an area where collaboration between the CFO and CHRO can create strategic value within an organization.
Internal reporting for strategic decision making can benefit greatly from the further development and integration of HR analytics within companies. Internal reporting to the board of directors—making use of the mountain of data under HR’s control—is essential and can position a company for evolving to external reporting. External reporting is quite a ways off, but benchmarking against others can be done now through compensation and administration firms’ databases—just as in areas of executive compensation and benefits.
The road ahead in developing HR analytics and metrics can provide CFOs and the finance function a pathway for creating greater strategic value within an organization and the opportunity for creating new capabilities for management accounting professionals that will allow organizations to make the connection between HR metrics and financial results.
SIDEBAR: WHAT MATTERS MOST AND TO WHOM?
By Robert G. Eccles and Tim Youmans
What role does the board of directors play in human capital metrics? It has a responsibility to determine the limited number of significant audiences that can help a corporation create value over the short, medium, and long term. These audiences will be favored for resource allocation purposes and will determine what information is material for corporate reporting purposes. For example, if the board decides that only short-term shareholders matter, then only short-term financial results are material. But if employees and long-term shareholders are significant audiences, then human capital and other issues also become material.
By first deciding “what is material to whom,” directors can make their decisions using a concept called “The Statement of Significant Audiences and Materiality,” The Statement, a simple one-page annual declaration by the board, is values-neutral. While many companies pay lip service to their “people,” few provide material disclosures regarding how they are managing and developing their human capital. If employees are a significant audience, then the corporation should provide this information, and this should be reflected in its external reporting.
Robert G. Eccles is a professor of management practice at Harvard Business School, and Tim Youmans is a researcher at Harvard Business School. The Statement idea was first published in Chapter 5: “Materiality” in Eccles’ 2014 book, The Integrated Reporting Movement: Meaning, Momentum, Motives, and Materiality, to which Youmans was a significant contributor. They are research collaborators and global experts in materiality. Also, Eccles was the founding chairman of the Sustainability Accounting Standards Board and is chairman of Arabesque Partners. They can be reached at firstname.lastname@example.org and email@example.com.