Some organizations prefer to invest in human capital when there is evidence that it is providing benefits. They often compare monetary benefits with the costs of human capital programs. This strategy is becoming more popular following the increased interest in accountability, particularly the use of return on investment (ROI) as a business-evaluation tool. With this strategy, all HR programs are evaluated and a few key programs are evaluated at the ROI level—the monetary benefits compared to the cost of investment—the same way the ROI is calculated for an investment in buildings or equipment.
The ROI strategy focuses on implementing a comprehensive measurement and evaluation process for the human capital expenditures in an organization. This involves capturing up to seven types of data when a human capital program is implemented, as shown in table 5-1.[1]
Table 5-1. Types of data collected with the ROI strategy.
Human Capital Program Measures |
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Using this philosophy, only a small number of programs are taken to ROI, whereas every program is evaluated with reaction and satisfaction data. Also, when business impact and ROI are developed for an HR program, one or more techniques are used to isolate the impact of the program on the business data.
Wachovia Bank is the fourth largest banking organization in the United States (the largest bank in the southeast United States), with $464 billion in assets, 14 million customers, and 3,100 branches in 15 states. Wachovia takes a comprehensive approach to evaluating human capital initiatives. Data is collected for each program implemented by HR. All learning and development programs are evaluated for employee reaction and satisfaction. Sixty percent of the programs are evaluated to determine if the appropriate skills and knowledge exist to make HR programs work. Thirty percent of the programs are evaluated on a follow-up basis to determine if employees are using the skills and knowledge and that the programs are implemented effectively. Ten percent of the programs are measured for their impact on business in such a way that improvements linked to the HR program are isolated from other influences. Finally, about five percent of the company’s HR projects and programs are evaluated at the ROI level, where the actual monetary value of an HR program is compared to the cost of the program. Table 5-2 shows the breakdown in terms of percentages of programs evaluated at each level.
Table 5-2. Evaluation targets for Wachovia Bank.
Level of Evaluation | Percent of HR Programs Evaluated at this Level |
|---|---|
Level 1—Reaction | 100% |
Level 2—Learning | 60% |
Level 3—Application | 30% |
Level 4—Business Results | 10% |
Level 5—ROI | 5% |
To accomplish this comprehensive process, Wachovia has developed an assessment, measurement, and evaluation team (referred to as the AME network) for the entire HR function. This decentralized thirty-person team implements the AME in each business unit. Although full-time Wachovia employees, team members are not usually full-time AME professionals. They are HR professionals who, by the nature of their work and interest in measurement, have taken on these additional responsibilities. While the overall strategy is coordinated by the vice president for AME in the corporate headquarters, the work is accomplished in the regions and divisions through these teams. Team members, in concert with other HR staff and various stakeholders, ensure that appropriate standards, templates, tools, and processes are in place to streamline the data collection, analysis, and reporting. Also, AME team members develop impact studies and communicate them to various target audiences. This collective effort provides Wachovia executives with information about the value of human capital. Executives decide on which programs are appropriate for impact and ROI analysis in the future. The total cost of this process is about 5 percent of the total HR budget, which includes the corporate university at Wachovia. All the data are combined to develop a human capital scorecard for executives to monitor.
At Suncor Energy, ROI is being used to make the human capital business case. When implementing a human resource management system (HRMS), the vice president of HR calculated the usual costs of the technology and the savings it would produce. But reducing HR transaction costs through automation—though important—was not the most important reason to purchase the system. The business case wasn’t just about doing HR better but about delivering business value.
Suncor, a mining, natural gas, and refining company with about 3,200 employees, is based in Calgary, Alberta, Canada. It is one of a small but growing number of companies savvy enough to understand that the traditional factors considered in calculating ROI—cutting administrative costs and reducing HR staff-to-employee ratio, for instance—are limited. Improving the entire company’s productivity is the priority. So, the vice president of HR set out to measure the business impact of buying an HRMS. Her conclusion matches a growing consensus among consultants and practitioners that executives have already squeezed all the inefficiencies possible from transactions and have reduced HR staff as much as possible. Now, the measures of success will be increased productivity and added business value.[2]
IBM spent over $30 billion in 2001—around 35 percent of its revenue—on its 341,000 employees, with approximately $1 billion dedicated to learning. Given the sums involved, top management asked HR to determine whether this investment was aligned with the company’s strategic goals and whether it delivered an adequate ROI. In order to answer these questions, HR launched a measurement initiative to prove that learning is delivered in a cost-effective manner, reinforces the importance of human capital as a key differentiator for IBM, and ensures that the learning investment supports IBM’s business priority of attracting, motivating, and retaining the best talent.[3]
The program began with a small team made up of representatives from corporate HR and professionals from the business strategy and finance departments. Each of the members possessed knowledge of the subject matter and a high degree of business expertise. After the team created a measurement framework, they began a scaleable project to leverage the HR and strategic business teams at each business unit.
Although the team began the pilot project in only one unit, as soon as it became clear their framework could become part of the overall strategic management system, they quickly expanded it to include all units. Within just over one year, the HR measurement program became embedded in the company’s strategic-planning process.
First Tennessee National has long believed that its employees are the key to its business strategy and customer focus. When the Nashville-based financial services firm selected a new vice president for its HR function, it was seeking to understand and explain how the focus on employees affects financial results. The CEO wanted to be able to go to Wall Street and discuss the value of this employees-first culture.
Today, the HR vice president works closely with the CFO to improve how the company’s biggest investment—its people—affects future results. She sees investors and analysts increasingly making the connection. Many of the analysts and investors confirm that First Tennessee is on the right path.
The first step in the process was an exhaustive study in 2000 examining how First Tennessee’s reward and recognition system lined up with its business strategy. The study integrated all of the data First Tennessee had available: seven years of employee data collected on the company’s central HR/IS system; all marketing and customer research information, including market share; customer value and loyalty information; profitability data; and employee survey data. The study validated the links First Tennessee already believed existed between high-performing employees, customer loyalty and retention, and higher profitability. Now, First Tennessee is grappling with how to quantify a return on human capital investment beyond looking at the connection between salaries, variable compensation, and financial results.[4]
This strategy is implemented from three different perspectives: defensive, responsive, or proactive.
Defensive. Most organizations address the payoff versus investment issue from a defensive posture. Additional measurement and evaluation data are needed to justify, maintain, or modify the HR budget. Sometimes these types of data are necessary to avoid budget cuts or obtain additional funding for human capital projects. Still, in other situations, top executives request results. Consequently, HR executives use this strategy to respond to those requests.
Responsive. Approximately one-third of the organizations using this strategy are doing so because they perceive measurement and evaluation as a routine responsibility, such as budgeting and project management. Human resources executives understand that they must show a contribution for major expenditures and align HR programs and projects with the business. Also, this effort is necessary to keep the HR staff engaged and motivated so they can see the contribution they are making to the organization.
Proactive. Approximately 20 percent of organizations pursuing this strategy do so from a proactive stance. These HR executives have a desire to be leaders in their profession. They want to be the “best practice,” “benchmarked,” “most admired” organization, and the “best place to work.” They have a desire to keep stakeholders satisfied and build critical relationships with key executives. Also, they want to make human capital management more efficient and effective and build on accountability. The ROI strategy provides a vehicle to transform the human capital function.
Although the trend toward additional accountability has been increasing over a decade, there are several reasons why this strategy is critical at this time. In the last few years, HR professionals have had to demonstrate the value their programs and departments add to the organization. They have also had to develop the skills to communicate with other managers, in the language of business, the HR contribution to the financial bottom line. In a world in which financial results are measured, a failure to measure human capital policy and practice dooms this function to second-class status, oversight, neglect, and potential failure. It has become apparent that HR specialists need to be able to evaluate in financial terms the costs and benefits of different HR strategies and individual HRM practices.[5]
The increasing cost of human capital is another driving force. As discussed throughout this book, investment in human capital is quite large and growing. As HR budgets continue to grow—often outpacing other parts of the organization—the costs alone require some executives to question the value of human capital. Consequently, these executives often request or suggest that the impact of HR be determined or forecasted. In some cases, ROI is required at budget review time. A production manager, for example, may propose investing in new technology and incorporate into the proposal projected increases in productivity and decreases in unit production cost. With this in mind, HR professionals must compete for scarce organizational resources in the same language as their colleagues and present credible information on the relative costs and benefits of HR interventions.[6]
The desire for organizations to be more effective and efficient has brought a host of change strategies such as Six-Sigma transformation, reengineering, and other improvement processes. Many of these processes are focused on measurement issues and, in turn, drive more interest in measurement, including measurements for human capital. In some organizations, a measurement culture is created, driving additional requirements for all types of measures.
A special research report from CFO magazine provided input on ROI from the perspective of the chief financial officer: It made an argument for trying to calculate the ROI. Taken as a whole, the report concluded, human capital is an unavoidable cost of business. When considered as a collection of smaller investments, though, there are clearly choices to be made. Which training programs are worth investing in? What employee segments should receive higher compensation? What components should the employee health care plan include? If managers can gain some sense of the return on these different options, then they can ensure that money is being put to the best use. This may not mean putting a dollar value on the different choices, but perhaps understanding their effect on key nonfinancial indicators, such as customer or employee retention.[7]
More HR executives are managing the human capital function as a business. These executives have operational experience and, in some cases, financial experience. They recognize that human capital should add value to the organization and, consequently, these executives are implementing a variety of measurement tools, even in the hard-to-measure areas. These measurement tools have gradually become more quantitative and less qualitative. ROI is now being applied in human capital just as it is in technology, quality, and product development. A decade ago it was almost unheard of to use ROI in the HR area. Now, business-minded HR executives are attempting to show value in ways that top executives want to see. Top executives who are asking for value—including ROI—are viewing HR differently than they have in the past and are no longer willing to accept HR programs, projects, and initiatives on faith. This is not to suggest that they do not have a commitment to HR, but now they see that measurement is possible—and ROI is feasible—and they want to see more value.
These forces are driving a significant use of the ROI methodology described in this chapter.
What types of organizations are applying human capital measurement, including ROI? Typically, there are common threads among adapters. They are:
Medium to large in size, where the HR budget becomes a critical issue.
Developing a performance-improvement culture and even a measurement culture. This culture is spreading to the HR function.
Experiencing a leadership change in the HR area. A new HR executive is often willing to bring additional accountability to HR, and usually does not have the attachment to, or ownership of, previous HR programs.
Going through constant and significant change; their world is always in a flux and on the move. To keep up with this change, many executives are asking for value from the multitude of HR programs implemented.
Facing demanding top executives (even a CEO) who expect results from all types of HR programs.
Straddled with a relatively low investment in measurement and have a desire to increase that investment.
Attempting to rectify the problems generated in the past; it could be one or more HR programs that were considered failures or, in some cases, disasters.
Suffering from a low approval rating from executives where the HR function is often perceived less than satisfactory in its effectiveness.
Table 5-3 shows a small sample of the over 2,000 organizations using the ROI strategy to help determine the human capital investment level.
Table 5-3. Private-sector organizations using the ROI process.
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To develop a credible approach for calculating the ROI in human capital, several components must be developed and integrated. This strategy comprises five important elements:
An evaluation framework is needed to define the various levels of evaluation and types of data, as well as how data are captured.
A process model must be created to provide a step-by-step procedure for developing the ROI calculation. Part of this process is the isolation of the effects of the HR program from other factors in order to show its monetary payoff.
A set of operating standards with a conservative philosophy is required. These guiding principles keep the process on track to ensure successful replication. The operating standards also build credibility with key stakeholders in the organization.
Resources should be devoted to implementation to ensure that the ROI methodology becomes operational and routine in the organization. Implementation addresses issues such as responsibilities, policies, procedures, guidelines, goals, and internal skill building.
Successful applications are critical to show how ROI works with different types of human capital programs and projects.
Together, these five elements are necessary to develop a comprehensive evaluation system that contains a balanced set of measures, has credibility with the various stakeholders involved, and can be easily replicated. Because of the importance of, and interest in this ROI strategy, the remainder of this chapter is devoted to taking a closer look at these five essential pieces.
Seven types of data used in the ROI strategy were described at the beginning of the chapter. Figure 5-1 shows the types of data arranged as a chain of impact that occurs when a human capital program drives business impact. Also, the connection to the types of data is indicated within the blocks. Although these data types can be considered separately, they are inevitably woven together in this chain of impact and their meanings are integrated.[8] The levels of evaluation help explain the chain of impact. The higher the level, the more valuable the data for driving the business impact.
Usually the first type of data, reaction from HR stakeholders, is measured on almost all HR functions, programs, and projects with generic questionnaires and surveys. Although this level of evaluation is important as a customer-satisfaction measure from program participants and other stakeholders, a favorable reaction does not ensure that the participants know how to implement the HR program. A learning check is helpful to ensure that participants absorb new skills, knowledge, and know-how to make the HR program successful. However, a positive measure at this level is no guarantee that the program will be successfully implemented.
Measuring application and implementation is necessary to determine if participants implement the HR program successfully. The frequency and use of skills may be important measures at this level. In addition, this measure includes all the steps, actions, tasks, and procedures needed to implement the program. Although evaluation is important to gauge the success of the program’s implementation, it still does not guarantee a positive business impact on the organization.
Measuring the business impact tracks the business results achieved directly by the HR program. Typical measures include output, quality, costs, time, employee satisfaction, and customer satisfaction. Although the HR program may produce a measurable business impact, there is still a concern that the costs for the program may be too high. Measuring costs involves monitoring or developing all of the costs related to the HR program. A fully loaded cost profile is recommended in which all direct and indirect costs are tabulated.
ROI is the ultimate level of evaluation, where the HR program’s monetary benefits are compared with its costs. Although ROI can be expressed in several ways, it is usually presented as a percentage or benefit/cost ratio (BCR). In addition to tangible, monetary benefits, most HR programs will have intangible, nonmonetary benefits. Intangible benefits are defined as implementation and business benefits not converted to monetary value.
When the chain of impact occurs through each level, the HR program becomes successful. A positive reaction leads to learning and, as the implementation progresses, business impact and ROI are generated. If measurements are not taken at each level, it is difficult to conclude that the results achieved were actually produced by the program. Because of this, it is recommended that evaluation be conducted at all levels when pursuing an ROI evaluation.
The chain of impact is detailed by the model in figure 5-2, the ROI methodology, which has been refined and modified over many applications.[9] As the figure illustrates, the process is comprehensive as data is developed at different times and gathered from different sources to develop the seven types of measures. Each part of the ROI process is outlined below.
The first two steps of the ROI methodology focus on critical planning issues. The first step is to develop appropriate objectives for the HR programs and initiatives. These are often referred to as the ultimate objectives of the HR program. These range from developing objectives for satisfaction to developing an objective for the ROI. A specific program should have multiple levels of objectives.
With the objectives in hand, the next step is to develop two important planning documents. A data collection plan indicates the type of data that should be collected, the method for data collection, data sources, the timing of collection, and the various responsibilities for collection. The ROI analysis plan details how the HR program is isolated from other influences, how data are converted to monetary values, the appropriate cost categories, the expected intangible measures, and the anticipated target audience for communication.
Data collected during the launch of the HR program (Levels 1 and 2) measures employee reaction, satisfaction, and learning to ensure that adjustments are made to keep the program on track. The reaction, satisfaction, and learning data are critical for providing immediate feedback so that early changes can be made. Post-program data are collected and compared with preprogram data and expectations (Levels 3 and 4). Both hard data and soft data, including work habits, work climate, and attitudes are collected. Data can be collected using a variety of methods, such as:
Follow-up surveys and questionnaires to measure satisfaction and reaction from stakeholders, as well as to uncover specific application issues with HR programs
Tests and assessments to measure the extent of learning
Interviews to measure reaction and determine the extent to which the program has been implemented
Focus groups to determine the degree of application of the HR program in job situations
Action plans to show progress with implementation on the job and the impact obtained
Business-performance monitoring to show improvement in various performance records and operational data
The important challenge in data collection is selecting the method(s) appropriate for the setting and the specific HR program, within time and budget constraints.
An often-overlooked issue in most evaluations is the process of isolating the effects of the HR program or project. This step is essential because many factors will influence performance data after a program is implemented. Specific strategies in this step will pinpoint the amount of improvement directly related to the program. The result is increased accuracy and credibility of the ROI calculation. The following strategies have been used to address this important issue:
A pilot group of participants in the program is compared with another group (control group) not participating in the program in order to isolate program impact.
Trend lines are used to project the values of business impact data, and projections are compared with the actual data after the program.
Participants/stakeholders estimate the amount of improvement related to the program; supervisors and managers estimate the impact of the program on the output measures.
External studies or previous research provides input about the impact of the program; independent experts estimate the impact of the program on the performance variable.
Customers (internal or external) provide input about the extent to which the program has influenced their decisions to use a product or service.
Collectively, these strategies provide a variety of methods to tackle the critical issue of isolating the effects of an HR program.
To calculate the return on investment (Level 5), business impact data must be converted to monetary values and compared with HR program costs. This requires a value to be placed on each unit of data connected with the program. The list below shows most of the key strategies available to convert data to monetary values. The specific strategy selected usually depends on the type of data and the situation:
Output data, such as an additional product or service provided, are converted to profit contribution (or cost savings) and reported as a standard value.
The cost of a quality measure, such as a customer complaint, is calculated and reported as a standard value.
Employee time saved is converted to fully loaded compensation.
Historical costs or value of a measure, such as preventing a lost-time accident, are used when available.
Internal and external experts estimate a value of a measure, such as an employee complaint.
External databases contain an approximate value or cost of a measure, such as employee turnover.
The measure is linked to other measures for which the costs are easily developed (for example, employee satisfaction linked to employee turnover).
Participants estimate the cost or value of the data item, such as work group conflict.
Supervisors or managers estimate costs or values when they are capable of providing an estimate (for example, an unscheduled absence).
The HR staff estimates the value of a data item, such as a sexual harassment complaint.
This step in the ROI methodology is critical and absolutely necessary for determining the monetary benefits from an HR program or solution. The process is challenging, particularly with soft data, but can be methodically accomplished using one or more of the above strategies.
The denominator of the ROI formula is the cost of the program. The following cost components should be included:
Initial analysis and assessment, possibly prorated over the expected life of the program
Purchase/acquisition cost, if applicable
Development/design cost for the program (prorated if necessary)
Participant/stakeholder time for the program using fully loaded compensation costs
Materials and supplies for the program
Application and implementation costs of the program
Routine maintenance and monitoring costs
Administration and overhead costs for the program, allocated in a convenient way
Evaluating and reporting costs
The conservative approach is to include all these costs so that the total is fully loaded. All costs must be taken into account to ensure a stronger position from which to present the final findings.
The return on investment is calculated using benefits and costs. The benefit/cost ratio (BCR) is the monetary benefits of the HR program or intervention divided by the costs. In formula form, it is:
The return on investment uses the net benefits divided by costs. The net benefits are the program benefits minus the costs. In formula form, the ROI becomes:
This is the same basic formula used in evaluating other investments where the ROI is traditionally reported as earnings divided by investment.
The BCR and the ROI present the same general information but with slightly different perspectives. The following example illustrates the use of these formulas. An absenteeism reduction program produced savings of $581,000, with a cost of $229,000. Therefore, the benefit/cost ratio is:
As this calculation shows, for every $1 invested, $2.50 in monetary benefits is returned. In this example, net benefits are $581,000 – $229,000 = $352,000. Thus, the ROI would be:
This means that for every $1 invested in the program, there is a return of $1.54 in net benefits, after the $1 is recovered. The benefits are usually expressed as annual benefits for short-term programs, representing the amount saved or gained for a complete year after the program has been implemented. Although the benefits may continue after the first year, the impact usually diminishes and is omitted from calculations in short-term situations. For long-term projects, the benefits are spread over several years. The timing of the benefits stream should be determined before the impact study begins, as part of the planning process.
During data analysis, every attempt is made to convert all data to monetary values. For example, hard data—such as output, quality, cost, and time—are always converted to monetary values while soft data conversion is attempted. However, if the conversion process is too subjective or inaccurate and the resulting values lose credibility in the process, the data are listed as intangible benefits with the appropriate explanation. For some programs, intangible, nonmonetary benefits have highly perceived value, often commanding as much attention and influence as hard data. Intangible benefits may include items such as improved public image, increased job satisfaction, increased organizational commitment, reduced stress, and improved teamwork.
A final operational step of the ROI methodology is to generate an impact study documenting the results achieved by the HR program and communicating them to various target audiences. The impact study presents the basic process used to generate the seven categories of data. The methodology, assumptions, key concepts, and guiding principles are all outlined before the actual results are presented. Next, the seven categories of data, beginning with reaction and satisfaction and moving through ROI and intangible measures, are presented in a rational, logical process, showing the building blocks to success for the study. Conclusions and recommendations are always a part of the study. This study becomes the historical document that presents the complete assessment of the program.
Since a variety of target audiences need information, different reports and formats are generated. All the stakeholders involved will need some communication about the success of the program, including executives who may not be interested in knowing the full details. A general interest report may be appropriate for stakeholders who are involved but not directly responsible for the project. A variety of reports and formats are used to disseminate the information, ranging from the complete impact study described above to a one-page summary for clients who understand the process. The key issue in this step of the ROI methodology is to analyze the target audiences detailed during the evaluation planning and develop the appropriate report to meet their specific needs.
To ensure that each study is developed in the same way, consistent processes and operating standards for the measurement and evaluation process should be implemented. Table 5-4 presents the guiding principles used as operating standards when implementing the ROI methodology. These guiding principles will ensure that the proper conservative approach is taken and the impact study can be replicated and compared with others. More importantly, the principles build credibility with, and support from, clients and senior managers who review and scrutinize the results.
Table 5-4. Operating standards for this strategy.
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The best tool, technique, or model will not be successful unless it is properly used and it becomes a routine part of the HR function. As with any change, it will be resisted by the HR staff and other stakeholders. Some of the resistance will be based on realistic barriers, while some will be based on misunderstandings that may be mythical. In both cases, specific steps must be taken to overcome the resistance by carefully and methodically implementing the ROI methodology.
Implementation involves many issues, including assigning responsibilities, building the necessary skills, and developing the plans and goals around the process. It also involves preparing the environment, individuals, and support teams for this type of comprehensive analysis. The organizations experiencing the most success with the ROI methodology have devoted adequate resources for implementation and deliberately planned for transition from their current state to where they desire the organization to be in terms of accountability. Additional detail about this methodology is presented in chapter 8.
The methodology described in this chapter is not suitable for every organization and certainly not for every program. It has some very important barriers to success. The ROI methodology will add additional costs and time to the HR budget, but not a significant amount—probably no more than 3 to 5 percent of the total direct HR budget. The additional investment in ROI should be offset by the results achieved from implementation. However, this barrier often stops many ROI implementations early in the process. Many HR staff members may not have the basic skills necessary to apply the ROI methodology within their scope of responsibilities. The typical HR program does not focus on results, but on qualitative feedback data. It is necessary to shift HR policy and practice from an activity-based approach to a results-based approach. Some HR staff members do not pursue ROI because they perceive the ROI methodology as an individual performance-evaluation process instead of a process-improvement tool.
The ROI methodology has several important advantages. With it, the HR staff and the client will know the specific contribution of a program in a language the client understands. Measuring the ROI in an HR program is one of the most convincing ways to earn the respect and support of the senior management team—not only for a particular program but for the human capital function as well. The client who requests and authorizes an HR program or project will have a complete set of data to show the overall success of the process.
Because a variety of feedback data are collected during the program implementation, the comprehensive analysis provides data to drive changes in processes and make adjustments during implementation. Throughout the cycle of program design, development, and implementation, the entire team of stakeholders focuses on results. If a program is not effective, and the results are not materializing, the ROI methodology will prompt changes or modifications. On rare occasions, the program may have to be halted if it is not adding the appropriate value.
This chapter provides an overview of the ROI strategy, underscoring the urgency and the challenge to develop a comprehensive measurement and evaluation process. Various forces create a critical need for increased accountability. An evaluation framework, the ROI process model, operating standards, implementation, and application are all necessary to develop a reliable, credible process that can be replicated from one HR project to another. This process is not without its concerns and barriers, but many of these can be overcome with simplified, economical methods and a disciplined approach.