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HR AS A STRATEGIC PARTNER

The Measurement Challenge

How can we ensure that HR is at the table—
and not on the table?

AS YOU BEGIN TO READ THIS BOOK, take a moment to reflect on your firm’s human resources “architecture”—the sum of the HR function, the broader HR system, and the resulting employee behaviors. Why are these three features important? How does the HR architecture help your company to excel in the marketplace?

If your organization is like most, you’re probably finding it difficult to answer these questions. In our experience, many HR management teams have a well-developed vision of their department’s strategic value (at least from the perspective of HR), but the CEO and senior line managers are at best skeptical of HR’s role in the firm’s success. Worse, in many firms, executives want to believe that “people are our most important asset,” but they just can’t understand how the HR function makes that vision a reality.

What explains this situation? We believe that these problems have the same root cause: HR’s influence on firm performance is difficult to measure. Consider the elements and outcomes of your firm’s human resources architecture that are tracked on a regular basis. You might have included total compensation, employee turnover, cost per hire, the percentage of employees who had a performance appraisal in the last twelve months, and employee attitudes such as job satisfaction. Now consider those HR attributes that you believe are crucial to the implementation of your firm’s competitive strategy. Here you might mention a capable and committed workforce, development of essential employee competencies, or a training system that helps your employees learn faster than your competitors.

How well do your existing HR measures capture the “strategic HR drivers” that you identified in your second list? For most firms there won’t be a very close match. More important, even in firms where HR professionals think there is a close match, frequently the senior executives do not agree that this second list actually describes how HR creates value. In either case, there is a disconnect between what is measured and what is important.

These questions are fundamental, because new economic realities are putting pressure on HR to widen its focus from the administrative role it has traditionally played to a broader, strategic role. As the primary source of production in our economy has shifted from physical to intellectual capital, senior HR managers have come under fire to demonstrate exactly how they create value for their organizations. More important, they have been challenged to serve increasingly as strategic partners in running the business.

But what does it mean to be a strategic asset? The literature defines the term as “the set of difficult to trade and imitate, scarce, appropriable, and specialized resources and capabilities that bestow the firm’s competitive advantage.”¹ Think about the difference between the ability to align every employee’s efforts with the company’s overall vision, and an innovative policy such as 360-degree performance appraisals. The first is a strategic capability whose cause is largely invisible to competitors; the second is a policy that, although initially innovative, is visible to competitors—and thus quickly copied. Simply put, strategic assets keep a firm’s competitive edge sharp for the long haul—but by definition they are difficult to copy.

Thus HR’s problem—that its impact on firm strategy is difficult to see—is the very quality that also makes it a prime source of sustainable competitive potential. But to realize this potential, human resource managers must understand the firm’s strategy; that is, its plan for developing and sustaining an advantage in the marketplace. Then, they must grasp the implications of that strategy for HR. In short, they must move from a “bottom-up” perspective (emphasizing compliance and traditional HR) to a “top-down” perspective (emphasizing the implementation of strategy). Finally, they need innovative assessment systems that will let them demonstrate their influence on measures that matter to CEOs, namely, firm profitability and shareholder value.

THE EVOLVING PICTURE OF HR:
FROM PROFESSIONAL TO STRATEGIC PARTNER

Recent decades have witnessed dramatic shifts in the role of HR. Traditionally, managers saw the human resource function as primarily administrative and professional. HR staff focused on administering benefits and other payroll and operational functions and didn’t think of themselves as playing a part in the firm’s overall strategy.

Efforts to measure HR’s influence on the firm’s performance reflected this mind-set. Specifically, theorists examined methodologies and practices that are focused at the level of the individual employee, the individual job, and the individual practice (such as employee selection, incentive compensation, and so forth). The idea was that improvements in individual employee performance would automatically enhance the organization’s performance.

Although such research attempted to extend the range of HR’s influence, it did little to advance HR as a new source of competitive advantage. It provided scant insight into the complexities of a strategic HR architecture. And simply put, it didn’t encourage HR managers to think differently about their role.

In the 1990s, a new emphasis on strategy and the importance of HR systems emerged. Researchers and practitioners alike began to recognize the impact of aligning those systems with the company’s larger strategy implementation effort—and assessing the quality of that fit. Indeed, although many kinds of HR models are in use today, we can think of them as representing the following evolution of human resources as a strategic asset:

The personnel perspective: The firm hires and pays people but doesn’t focus on hiring the very best or developing exceptional employees.

The compensation perspective: The firm uses bonuses, incentive pay, and meaningful distinctions in pay to reward high and low performers. This is a first step toward relying on people as a source of competitive advantage, but it doesn’t fully exploit the benefits of HR as a strategic asset.

The alignment perspective: Senior managers see employees as strategic assets, but they don’t invest in overhauling HR’s capabilities. Therefore, the HR system can’t leverage management’s perspective.

The high-performance perspective: HR and other executives view HR as a system embedded within the larger system of the firm’s strategy implementation. The firm manages and measures the relationship between these two systems and firm performance.

We’re living in a time when a new economic paradigm—characterized by speed, innovation, short cycle times, quality, and customer satisfaction—is highlighting the importance of intangible assets, such as brand recognition, knowledge, innovation, and particularly human capital. This new paradigm can mark the beginning of a golden age for HR. Yet even when human resource professionals and senior line managers grasp this potential, many of them don’t know how to take the first steps toward realizing it.

In our view, the most potent action HR managers can take to ensure their strategic contribution is to develop a measurement system that convincingly showcases HR’s impact on business performance. To design such a measurement system, HR managers must adopt a dramatically different perspective, one that focuses on how human resources can play a central role in implementing the firm’s strategy. With a properly developed strategic HR architecture, managers throughout the firm can understand exactly how people create value and how to measure the value-creation process.

Learning to serve as strategic partners isn’t just a way for HR practitioners to justify their existence or defend their turf. It has implications for their very survival and for the survival of the firm as a whole. If the HR function can’t show that it adds value, it risks being outsourced. In itself, this isn’t necessarily a bad thing; outsourcing inefficient functions can actually enhance a firm’s overall bottom line. However, it can waste much-needed potential. With the right mind-set and measurement tools, the HR architecture can mean the difference between a company that’s just keeping pace with the competition and one that is surging ahead.

A recent experience of ours graphically illustrates this principle. In a company we visited, we asked the president what most worried him. He quickly responded that the financial market was valuing his firm’s earnings at half that of his competitors’. In simple terms, his firm’s $100 of cash flow had a market value of $2,000, while his largest competitor’s $100 of cash flow had a market value of $4,000. He worried that unless he could change the market’s perception of the long-term value of his organization’s earnings, his firm would remain undervalued and possibly become a takeover target. He also had a large portion of his personal net worth in the firm, and he worried that it was not valued as highly as it could be.

When we asked him how he was involving his HR executive in grappling with this problem, he dismissed the question with a wave of his hand and said, “My head of HR is very talented. But this is business, not HR.” He acknowledged that his HR department had launched innovative recruiting techniques, performance-based pay systems, and extensive employee communications. Nevertheless, he didn’t see those functions’ relevance to his problem of how to change investors’ perceptions of his firm’s market value.

Six months after our meeting, a competitor acquired the firm.

The sad truth is that the HR executive in this story missed a valuable opportunity. If he had understood and known how to measure the connection between investments in HR architecture and shareholder value, things might have turned out differently. Armed with an awareness of how investors value intangibles, he might have helped his president build the economic case for increased shareholder value.

The story of Sears, Roebuck and Co.’s recent transformation stands in stark contrast to this anecdote and shows what companies can achieve when they do align HR with the larger organization’s strategy.² After struggling with lack of focus and losses in the billions in the early 1990s, Sears completely overhauled its strategy implementation process. Led by Arthur Martinez, a senior management team incorporated the full range of performance drivers into the process, from the employee through financial performance. Then, they articulated a new, inspiring vision: For Sears to be a compelling place for investors, they said, the company must first become a compelling place to shop. For it to be a compelling place to shop, it must become a compelling place to work.

But Sears didn’t just leave this strategic vision in the executive suite or type it up on little cards for employees to put in their wallets. It actually validated the vision with hard data. Sears then designed a way to manage this strategy with a measurement system that reflected this vision in all its richness. Specifically, the team developed objective measures for each of the three “compellings.” For example, “support for ideas and innovation” helped establish Sears as a “compelling place to work.” Similarly, by focusing on being a “fun place to shop,” Sears became a more “compelling place to shop.”³ The team extended this approach further by developing an associated series of required employee competencies and identifying behavioral objectives for each of the “3-Cs” at several levels through the organization. These competencies then became the foundation on which the firm built its job design, recruiting, selection, performance management, compensation, and promotion activities. Sears even created Sears University in order to train employees to achieve the newly defined competencies. The result was a significant financial turnaround that reflected not only a “strategic” influence for HR but one that could be measured directly.

Few firms have taken such a comprehensive approach to the measurement of strategy implementation as Sears has. Granted, retail service industries are characterized by a clear “line of sight” between employees and customers. Thus their value-creation story is easier to articulate. But that doesn’t mean that other industries can’t accomplish this feat. The challenges may be greater—but so are the rewards.

WHY HR? WHY NOW?

Consider the following:

In most industries, it is now possible to buy on the international marketplace machinery and equipment that is comparable to that in place by the leading global firms. Access to machinery and equipment is not the differentiating factor. Ability to use it effectively is. A company that lost all of its equipment but kept the skills and knowhow of its workforce could be back in business relatively quickly. A company that lost its workforce, while keeping its equipment, would never recover. ⁴

This excerpt captures the difference between physical and intellectual capital—and reveals the unique advantages of the latter. The Coca-Cola Company’s experience testifies to this reality. According to then-CFO James Chestnut, after transferring the bulk of its tangible assets to its bottlers, Coke’s $150 billion market value derived largely from its brand and management systems.⁵

The evidence is unmistakable: HR’s emerging strategic potential hinges on the increasingly central role of intangible assets and intellectual capital in today’s economy. Sustained, superior business performance requires a firm to continually hone its competitive edge. Traditionally, this effort took the form of industry-level barriers to entry, patent protections, and governmental regulations. But technological change, rapid innovation, and deregulation have largely eliminated those barriers. Because enduring, superior performance now requires flexibility, innovation, and speed to market, competitive advantage today stems primarily from the internal resources and capabilities of individual organizations—including a firm’s ability to develop and retain a capable and committed workforce. As the key enabler of human capital, HR is in a prime position to leverage many other intangibles as well, such as goodwill, research and development, and advertising.

Table 1-1 takes a closer look at the major differences between tangible and intangible assets. It also suggests that managing HR requires vastly different skills from those needed to manage tangible assets. In particular, the benefits of HR as an asset are not always visible—they come to light only when the HR role is skillfully aligned with another intangible asset: the organization’s strategy implementation system.

Table 1-1 Tangible versus Intangible Assets

Tangible Assets	Intangible Assets
Readily visible	Invisible
Rigorously quantified	Difficult to quantify
Part of the balance sheet	Not tracked through accounting
Investment produces known returns	Assessment based on assumptions
Can be easily duplicated	Cannot be bought or imitated
Depreciates with use	Appreciates with purposeful use
Has finite applications	Has multiple applications without value reduction
Best managed with “scarcity” mentality	Best managed with “abundance” mentality
Best leveraged through control	Best leveraged through alignment
Can be accumulated and stored	Dynamic, short shelf life when not in use

Source: Hubert Saint-Onge, Conference Board presentation, Boston, MA, October 17, 1996. Reprinted with permission.

INTANGIBLE ASSETS GENERATE TANGIBLE BENEFITS

The increasing importance of organizational capabilities and intangible assets is much more than academic speculation. Trends in U.S. equity markets also reflect this shift. Specifically, these markets have shown a consistent widening in the ratio of the market value of a firm (i.e., the shareholders’ assessment of the firm’s value) to its book value (the shareholders’ initial investment). This ratio has more than doubled in the last ten years alone (see figure 1-1). This phenomenon is widespread, but it’s particularly noteworthy in companies that rely heavily on intellectual capital as their source of competitive advantage. Some of these firms have invented entirely new business models based largely on intangible assets. For example, Dell and Amazon.com, which essentially deal in commodities, have reaped extraordinary gains in shareholder value through their management systems.

In addition, many financial analysts are now including intangibles in their valuation models. A recent study of financial analysts and portfolio managers reveals that, for the average analyst, 35 percent of his or her investment decision is determined by nonfinancial information (see table 1-2).

Figure 1-1 Market to Book Value of S&P 500

These results are striking for several reasons. First, notice that at least seven of these intangibles are affected by a strategically focused HR system, either directly or indirectly. Second, note that the most important intangible cited by financial analysts is the ability to implement strategy. This finding is consistent with one of the underlying themes in our book, namely, that the ability to execute strategy may be more important than the strategy itself. Indeed, a popular analogy compares the difference between strategic content and implementation to the difference between styles in a poker game. The former emphasizes what game you play; the latter, how you play your hand.

Yet despite the high ranking of strategy implementation in the table, financial analysts are often frustrated in their efforts to collect information on this form of organizational competency. Frequently, they resort to such unconventional sources as personal contacts throughout the firm and industry, contacts with customers, and rumor. Organizations that do link business performance measurement with strategy implementation thus position themselves well to communicate with analysts and thereby influence their perceptions of the market. By aligning the HR architecture with the firm’s overall strategy, HR professionals could play a key role in shaping those perceptions.

Managers, too, are frustrated by the quality of nonfinancial information that they receive. Across a variety of data categories, including financial, operations, customer, and employees, J. Low and T. Siesfield, the authors of the study ranking nonfinancial variables, asked senior managers how much they valued this type of information and whether or not they would be willing to bet their jobs on the quality of this information within their own firms. Predictably, managers placed great value on financial data, and they also expressed a high degree of confidence in their own firm’s financial information. Managers placed great value on information relevant to their firm’s human capital as well. Yet they gave their own firms extremely low marks on the quality of employee-related data. The gap between the desired and actual data quality for people was more than fifty percentage points—substantially more than the gap found in any other category that they studied.

Table 1-2   Top Ten Nonfinancial Variables Considered by

Financial Analysts

Variable	Rank
Execution of corporate strategy	1
Management credibility	2
Quality of corporate strategy	3
Innovation	4
Ability to attract and retain talented people	5
Market share	6
Management expertise	7
Alignment of compensation with shareholders’ interests	8
Research leadership	9
Quality of major business processes	10

Source: J. Low and T. Siesfield, Measures That Matter (Boston: Ernst & Young, 1998).

A CLOSER LOOK AT INTANGIBLES:
THE MEASUREMENT CHALLENGE

GTE (now part of Verizon) has been a leader in efforts to develop measures of intangible assets such as human capital. The firm has recognized both the limitations of traditional accounting measures for intangible assets, and the potential represented by more “balanced” performance measurement systems. According to Lawrence R. Whitman, deputy CFO at GTE:

A direct link between human capital and corporate financial results is not readily apparent in traditional accounting practices. Right now, we are only beginning to understand the potential of this tool, but it’s the measurement process that’s important. … Once we are able to measure intangible assets more accurately, I think investors and finance professionals will begin to look at human capital metrics as another indicator of a company’s value. ⁶

Clearly, businesspeople everywhere recognize the importance of intangibles in today’s marketplace. Yet managing these intangibles is challenging, for a number of reasons. For one thing, the accounting systems in use today evolved during a time when tangible capital, both financial and physical, constituted the principal source of profits. During this time, those organizations that had the most access to money and equipment enjoyed a huge competitive advantage. With the emphasis on knowledge and intangible assets in today’s economy, conventional accounting systems actually create dangerous informational distortions. As just one example, these systems encourage short-term thinking with respect to the management of intangibles. Why? Because expenditures in these areas are treated as expenses rather than investments in assets. By contrast, investments in buildings and machinery are capitalized and depreciated over their useful lives. Consider the senior manager faced with the decision to invest $10 million in hard assets or $10 million in people. In practical terms, when a firm invests $10 million dollars in a building or other physical asset, this investment is depreciated over time, and earnings are reduced gradually over a twenty- or thirty-year period. In contrast, a $10 million dollar investment in people is expensed in its entirety (and therefore earnings are reduced by $10 million dollars) during the current year. For managers whose pay is tied to this year’s earnings (as many are), the choice of investment is obvious.

As a result, companies under financial pressure tend to invest in physical capital at the expense of human capital—even though the latter may well generate more value. This kind of pressure can lead to poor decisions: for instance, to initiate a round of layoffs solely to garner short-term “cost savings.” Research has repeatedly shown that after a layoff, the market may initially respond with a jump in share value. However, investors often eventually lose all of these gains, and sometimes more.⁷ This pattern isn’t surprising, given that people are a crucial source of competitive advantage rather than an expensive luxury that should be minimized.

The bottom line is this: If current accounting methods can’t give HR professionals the measurement tools they need, then they will have to develop their own ways of demonstrating their contribution to firm performance. The first step is to discard the accounting mentality that says that HR is primarily a cost center in which cost minimization is the principal objective and measure of success. At the same time, HR managers must grasp the rare opportunity afforded them by this transitional period. Investors have made it clear that they value intangible assets. It’s up to HR to develop a new measurement system that creates real value for the firm and secures human resources’ legitimate place as a strategic partner.

THE HR ARCHITECTURE AS A STRATEGIC ASSET

If the focus of corporate strategy is to create sustained competitive advantage, the focus of HR strategy is equally straightforward. It is to maximize the contribution of HR toward that same goal, thereby creating value for shareholders. The foundation of a strategic HR role is the three dimensions of the “value chain” represented by the firm’s HR architecture: the function, the system, and employee behaviors. Thinking about HR’s influence on firm performance requires a focus on multiple levels of analysis. We use the term “HR architecture” to broadly describe the continuum from the HR professionals within the HR function, to the system of HR-related policies and practices, through the competencies, motivations, and associated behaviors of the firm’s employees.⁸ (See figure 1-2.)

The HR Function

The foundation of a value-creating HR strategy is a management infrastructure that understands and can implement the firm’s strategy. Normally the professionals in the HR function would be expected to lead this effort. This implies a departure from the traditional functional orientation of many HR managers and a wider understanding of the strategic role that HR might play in the firm. For example, Mark Huselid, Susan Jackson, and Randall Schuler point out that human resources management (HRM) effectiveness has two essential dimensions. The first, technical HRM, includes the delivery of HR basics such as recruiting, compensation, and benefits. The second, strategic HRM, involves delivering those services in a way that directly supports the implementation of the firm’s strategy.

Huselid and his colleagues found that most HR managers were very proficient in the delivery of traditional or technical HRM activities, but much less so in delivering strategic HRM capabilities. In a sample of nearly 300 large firms, the average level of technical proficiency was 35 percent higher than the average level of strategic HRM proficiency. HR managers were particularly limited in their ability to translate the firm’s strategy and operational goals into actionable HR goals, and subsequently to implement those goals. Yet it was this ability to embed HR within the larger system of strategy implementation that turned out to have the most important influence on corporate financial performance. This was true whether firm performance was measured as sales per employee, cash flow per employee, or market value per employee. The authors conclude that most firms are already demonstrating acceptable levels of technical HRM competencies and effectiveness, noting that traditional HR skills have not diminished in value, but simply are no longer adequate to satisfy the wider strategic demands on the HR function.⁹ The competencies that HR managers need to develop—and the ones that have the greatest impact on firm performance—are business and strategic HRM competencies.

Figure 1-2 HR’s Strategic Architecture

The HR System

The HR system is the linchpin of HR’s strategic influence. The model of this system advocated in this book is what we call a High-Performance Work System (HPWS). In an HPWS, each element of the HR system is designed to maximize the overall quality of human capital throughout the organization. To build and maintain a stock of talented human capital, an HPWS does the following:

•  links its selection and promotion decisions to validated competency models;

•  develops strategies that provide timely and effective support for the skills demanded by the firm’s strategy implementation; and

•  enacts compensation and performance management policies that attract, retain, and motivate high-performance employees.

The items on this list may seem obvious. However, they are vital steps in improving the quality of employee decision-making throughout the organization—something that makes good business sense as traditional command-and-control management models increasingly go out of fashion. In short, for HR to create value, a firm needs to structure each element of its HR system in a way that relentlessly emphasizes, supports, and reinforces a high-performance workforce.

But adopting a high-performance focus for individual HR policies and practices is not nearly enough. We use the term system intentionally here. Thinking systemically emphasizes the interrelationships of the HR system’s components and the link between HR and the larger strategy implementation system. It is these linkages between a system’s components—not any individual component itself—that make a system more than just the sum of its parts (see “The Laws of Systems Thinking”).

Our description of the HPWS raises the obvious question: What, exactly, are the specific policies and practices that lead to high performance? Since 1990, two of us have conducted a biannual survey of the HR management systems in U.S. publicly held companies. The foundation of this research effort has been a biannual survey of HR systems that targets a broad cross-section of publicly traded firms: firms with sales greater than $5 million and more than 100 employees. These data on HR systems are then matched with publicly available data on financial performance. This research program is ongoing and now includes more than 2,800 corporations.¹⁰

Each survey enabled us to construct an HPWS index that measures the extent to which a firm’s HR system is consistent with the principles of a high-performance HR strategy. Table 1-3 compares firms in our 1998 sample at the two ends of the high-performance HR continuum. Based on our HPWS index, we calculated each firm’s percentile ranking in our sample and then compared firms ranked in the top decile on the HPWS index with those in the bottom decile on several characteristics. The results in table 1-3 are based on the 429 firms in our 1998 sample. However, the results are very robust and highly similar for our 1992, 1994, and 1996 samples.¹¹

Table 1-3 Comparison of High and Low HR Management Quality

	Bottom 10% HR Index (42 firms)	Top 10% HR Index (43 firms)
HR Practices
Number of qualified applicants per position	8.24	36.55
Percentage hired based on a validated selection test	4.26	29.67
Percentage of jobs filled from within	34.90	61.46
Percentage in a formal HR plan including recruitment, development, and succession	4.79	46.72
Number of hours of training for new employees (less than 1 year)	35.02	116.87
Number of hours of training for experienced employees	13.40	72.00
Percentage of employees receiving a regular performance appraisal	41.31	95.17
Percentage of workforce whose merit increase or incentive pay is tied to performance	23.36	87.27
Percentage of workforce who received performance feedback from multiple sources (360)	3.90	51.67
Target percentile for total compensation (market rate = 50%)	43.03	58.67
Percentage of the workforce eligible for incentive pay	27.83	83.56
Percentage of difference in incentive pay between a low-performing and high-performing employee	3.62	6.21
Percentage of the workforce routinely working in a self-managed, cross-functional, or project team	10.64	42.28
Percentage of HR budget spent on outsourced activities (e.g., recruiting, benefits, payroll)	13.46	26.24
Number of employees per HR professional	253.88	139.51
Percentage of the eligible workforce covered by a union contract	30.00	8.98
HR Outcomes*
Extent to which strategy is clearly articulated and well understood throughout the firm	3.40	4.21
Extent to which the average employee understands how his or her job contributes to the firm’s success	2.80	4.00
Extent to which senior management sees employees as a source of value creation versus a cost to be minimized	3.31	4.21
Extent to which the executive leadership team is visionary	3.02	4.33
Extent to which the firm attempts to provide job security, even if confronted with declining financial performance	2.71	4.11
Extent to which the firm’s decision-making style can be described as participative	3.02	3.81
Extent to which the firm’s HR professionals are generally perceived to be administrative experts	3.76	4.56
Extent to which the firm’s HR professionals are generally perceived to be employee champions	3.69	4.40
Extent to which the firm’s HR professionals are generally perceived to be agents for change	3.31	4.12
Extent to which the firm’s HR professionals are generally perceived to be business partners	3.19	4.30
Extent to which line managers generally believe that effective diversity management is a business imperative	2.45	3.65
Extent to which top management shows commitment to and leadership in knowledge sharing	2.99	4.05
Extent to which the firm has developed and communicated measures of financial performance	3.38	4.63
Extent to which the firm has developed and communicated measures of customer reactions	3.02	4.27
Extent to which the firm has developed and communicated measures of key business processes	3.09	4.13
Extent to which the firm has developed and communicated measures of learning and growth	2.26	3.12
Firm Performance
Employee turnover	34.09	20.87
Sales per employee	$158,101	$617,576
Market value to book value	3.64	11.06

* Each of the variables in the “HR Outcomes” section is scaled from 1 to 6, where 1 = “not at all” and 6 = “to a very great extent.”

The differences between these two groups of firms are very substantial, and these differences are not solely due to firm size, industry, or age. Firms with high-performance work systems adopt HR management practices very different from those adopted by firms with low-performance work systems: They devote considerably more resources to recruiting and selection, they train with much greater vigor, they do a lot more performance management and tie compensation to it, they use teams to a much greater extent, they have roughly double the number of HR professionals per employee, and they are much less likely to be unionized. Indeed, the most striking attribute of these comparisons is not any one HR management practice—it is not recruiting or training or compensation. Rather, the differences are much more comprehensive—and systemic.

The HR outcomes associated with this system are comprehensive as well. Compared with low-performing HR management systems, the very best firms in our sample are much more likely to have developed a clear strategic intent and communicated it effectively to employees. In addition, they are more likely to have their HR professionals rated positively in both their traditional and strategic roles. They are also more likely to have developed a comprehensive measurement system for communicating nonfinancial information to employees.

Finally, firms with the most effective HR management systems exhibited dramatically higher performance: Employee turnover was close to half, sales per employee were four times as great, and the ratio of firm market value to the book value of assets—a key indicator of management quality, as it indicates the extent to which management has increased shareholders’ initial investment—was more than three times as large in high-performing companies.

An HPWS is itself a strategy implementation system, embedded within the firm’s larger strategy implementation system. HR intersects with that larger system at many different points and perhaps with multiple elements of the HR system at the same point. Understanding how to identify those points of intersection in your own firm, and how to align the HR system accordingly, is the key to securing a strategic role for HR and knowing how to measure HR’s impact on value creation. In addition, firms must constantly sharpen their awareness of how well the HR system’s components are aligned, that is, how much they reinforce or conflict with one another. As an example of reinforcement, a firm might combine above-market pay policies with comprehensive performance management systems. This combination lets the firm cultivate a talented applicant and employee pool, and recognize and reward the best employees for superior performance. By contrast, when these components are in conflict, an organization might encourage employees to work together in teams, but then provide raises based on individual contributions.

In short, an HPWS directly generates unique customer value, or it leverages other related sources of such value. In certain service industries, the employee-customer relationship is so visible that its impact on value creation is unmistakable. But for most firms, value derives from operational processes or innovations that affect the customer in less obvious ways. It is these firms that most need to articulate the strategy implementation process and then align the HR system to support that process. And it is in these firms, where such alignments and strategies are not easily observed and thus imitated by competitors, that HR has the greatest potential.

In our view, this alignment process must begin with a clear understanding of the firm’s value chain—a solid comprehension, throughout the firm, of what kind of value the organization generates and exactly how that value is created. For example, every firm should be able to describe how its ultimate financial goals are linked to key success factors at the level of its customers, operations, people, and IT systems. Robert Kaplan and David Norton have coined the term “strategy map” to describe these relationships.¹² With this shared understanding of the value-creation process, the organization can then design a strategy implementation model that specifies needed competencies and employee behaviors throughout the firm. The firm’s system for managing people can then be geared toward the generation of these competencies and behaviors. In fact, a key distinguishing characteristic of a High-Performance Work System is not just the adoption of appropriate HR policies and practices such as employee acquisition, development, compensation, and performance management, but also the way in which these practices are deployed. In an HPWS, the firm’s HR policies and practices show a strong alignment with the firm’s competitive strategy and operational goals. Moreover, each HPWS will be different. No single best example exists; each organization must customize its system to meet its own unique strengths and needs. For example, table 1-3 shows that high-performing firms are characterized by greater use of incentive pay. However, the behaviors and outcomes that are being reinforced will differ substantially across firms and strategies.

Strategic Employee Behaviors

Ultimately any discussion of the strategic role of human resources or human capital will implicitly focus on the productive behaviors of the people in the organization. In one sense this is almost tautological since it is only through behaviors that human beings can influence their environment. We are interested, however, in certain types of employee behaviors and not others. In chapter 2 we describe our own research linking employee strategic focus to firm performance. This work emphasizes the importance of aligning organizational processes and support systems so that they encourage and motivate an understanding of “the big picture.” Similarly, we define strategic behaviors as the subset of productive behaviors that directly serve to implement the firm’s strategy. These strategic behaviors will fall into two general categories. The first would be the core behaviors that flow directly from behavioral core competencies defined by the firm. These are behaviors that are considered fundamental to the success of the firm, across all business units and levels. The second are situation-specific behaviors that are essential at key points in the firm’s or business unit’s value chain. An example of these latter behaviors might be the cross-selling skills required in the branch of a retail bank.

Integrating a focus on behaviors into an overall effort to influence and measure HR’s contribution to firm performance is a challenge. Which ones are important? How should they be “managed”? We need to keep a few points in mind. First, the importance of the behaviors will be defined by their importance to the implementation of the firm’s strategy. Understanding how people and processes within the firm actually create value is the first step. That analysis will reveal both the kinds of behaviors that are generally required throughout the firm and those with specific value at key points in the value chain. Second, it’s essential to remember that we don’t affect strategic behaviors directly. They are the end result of the larger HR architecture. Especially important is the influence of an HR system that is aligned with the firm’s strategy.

ALIGNING PERFORMANCE MEASUREMENT AND
STRATEGY IMPLEMENTATION

You are undoubtedly familiar with the assertion that “what gets measured gets managed—and what gets managed gets accomplished.” But how true is this, really? Can measuring organizational processes provide competitive advantage? We believe that developing measurement competency is important, because it can add value at the level of the firm. But few managers (HR or otherwise) have strong competencies in this area. In recent years, HR managers have been asked to learn about finance and accounting. Now, they must hone their measurement skills as well.

We are not the first to emphasize the importance of measuring business performance from the perspective of strategy implementation, rather than relying simply on financial results. Robert Kaplan and David Norton’s Balanced Scorecard approach pioneered this concept of moving beyond mere financial measurement.¹³ To use this tool, a firm must specify not only the financial elements of its value chain but also the customer, business process, and learning and growth elements. Then, it must develop tangible ways to assess each.

The premise underlying the Balanced Scorecard approach is that senior managers have paid far too much attention to the financial dimensions of performance, and not enough attention to the forces that drive those results. After all, financial measures are inherently backward-looking. Because “performance drivers” are within management’s control now, the entire Balanced Scorecard measurement system encourages managers to actively engage with the strategy implementation process, rather than simply monitor financial results. By specifying the vital process measures, assessing them, and regularly communicating the firm’s performance on these criteria to employees, managers ensure that the entire organization participates in strategy implementation. The Balanced Scorecard approach thus makes strategy everyone’s business.

THE PURPOSE OF THIS BOOK

In this book, we address the crucial question of how HR practitioners can measure their contribution to their firm’s strategy implementation—and thus be at the table and not on the table. We believe that effective measurement systems serve two important purposes: They guide decision making throughout the organization, and they serve as a basis for evaluating performance. The measurement approach we describe addresses these two purposes in three ways. First, it encourages a clear, consistent, and shared view of how the firm can implement its strategy at each level in the organization. It won’t guarantee that every employee can articulate the entire value-creation process, but it should ensure that each employee has a clear understanding of his or her own role in the process. Use of our model also builds consensus around how different elements within the organization contribute to value creation.

Second, our approach forces managers to focus on the “vital few” measures that really make a difference. Anyone could easily generate fifty or more measures of firm performance, across a variety of categories. Yet this exercise would probably be counterproductive because that many measures would be difficult to track. We argue that a truly effective measurement system contains no more than twenty-five measures.

Third, this approach lets practitioners express these vital few measures in terms that line managers and senior executives will understand—and value. In HR, conventional measures of cost control, such as hours of training, time to fill an opening position, and even turnover rates and employee satisfaction, will continue to lack credibility unless they are shown to influence key performance drivers in the business.

We’ve also organized the book around two central tenets. The first is that a firm’s HR architecture—particularly the HR management system—can have a substantial impact on firm performance. This thesis will probably come as no surprise to most HR professionals. They believe that the field has always been important, even if many managers outside the HR function didn’t recognize its true value. But for the first time, HR has the potential to boost the bottom line by a method other than simply by minimizing costs. To paraphrase C. K. Prahalad and Gary Hamel, HR professionals are now in a position to become numerator managers (contributing to top-line growth) rather than just denominator managers (cutting costs and reducing overhead).¹⁴ However, to exert this influence on firm performance, the HR system has to be embedded in the organization’s strategy implementation, that larger management system that is the key to sustained competitive advantage and financial success.

This strategic role also requires new competencies on the part of HR professionals. To be sure, the HR field has made huge technical strides in the last twenty years. Nevertheless, it has essentially been doing the same things, though better and more efficiently. The new economic paradigm requires that HR professionals do different things, in an entirely different role. This means more than just understanding the firm’s articulated strategy. Being a strategic partner requires that HR professionals comprehend exactly what capabilities drive successful strategy implementation in their firms—and how HR affects those capabilities. This is a challenging task, for HR’s traditional roles as administrative experts, employee champions, and agents of change are no less important in this new environment.

The second key tenet of this book follows directly from the first. It reflects the two most common questions we hear from HR practitioners:

•  How can we measure the value of what we do in HR in terms that line and general managers will understand and respect? For example, how can we determine the return on investment (ROI) of a new training and development program?

•  How can HR metrics be incorporated in my organization’s measures of business performance?

To demonstrate its strategic contribution to senior line managers, HR needs a measurement system that focuses on two dimensions:

•  cost control (driving out costs in the HR function and enhancing operational efficiency outside of HR), and

•  value creation (ensuring that the HR architecture intersects with the strategy implementation process)

As we’ve seen, Kaplan and Norton’s Balanced Scorecard framework has received enormous attention, in part because it incorporates measures that describe the actual value-creation process rather than focusing on just the financial results that traditional accounting methods assess. It is a framework that we will draw on heavily in this book. In addition, we seek to strengthen an aspect of the Balanced Scorecard approach that Norton and Kaplan themselves acknowledge to be its weakest feature—the question of how best to integrate HR’s role into a firm’s measurement of business performance. They note the following:

[W]hen it comes to specific measures concerning [HR and people-related issues] companies have devoted virtually no effort for measuring either outcomes or the drivers of these capabilities. This gap is disappointing, since one of the most important goals for adopting the scorecard measurement and management framework is to promote the growth of individual and organizational capabilities. … [This] reflects the limited progress that most organizations have made linking employees … and organizational alignment with their strategic objectives. ¹⁵

Our book is designed to close the gap that Kaplan and Norton have identified. The framework that we present here will help HR practitioners develop the conceptual and operational tools they need to structure their role in a way that adds unmistakable value. Moreover, it will show them how to demonstrate those gains in terms that senior HR managers and other leaders will find compelling.

OUR FOCUS ON HR MANAGERS

The reader will see that we have organized our work around the role of the HR professional rather than the general manager. By adopting such a focus, we do not mean to give the impression that line managers play an unimportant role in making HR a strategic asset. In fact, the appropriate values and behaviors of an organization’s leadership team are key prerequisites for HR to realize the potential role we describe in this book. In addition, there are many general managers whose traditional view of HR’s role would benefit from an introduction to these ideas. Nevertheless, HR managers have the greatest professional stake in the future role of HR in their organizations, and therefore we have chosen to orient the book to their particular challenge.

USING THIS BOOK

The next five chapters in this book show you how to actually create a measurement system for assessing HR’s contribution to value creation in your firm. Chapter 2 describes a seven-step process that will lay the foundation for HR’s strategic influence. We specifically highlight the importance of a strategically focused HR architecture as a prerequisite for a measurement system that can link HR with firm performance.

Chapter 3 then lays out a process for developing the HR Scorecard based on the concepts discussed in chapter 2. We specifically discuss how to incorporate concepts such as efficiency, value creation, and alignment in the HR measurement system.

HR measurement also means being able to evaluate HR programs and initiatives with the same rigor as decisions elsewhere in the organization. In chapter 4 we describe a process for cost-benefit analysis that will allow HR professionals to determine the return on investment for these decisions.

Chapter 5 offers a process for validating the quality of the measurement system you develop and the data it generates. Here we explore ways to determine when “enough is enough,” define accountabilities for the measurement process, and present guidelines for developing measurement champions in your organization.

Chapter 6 focuses on one of the most difficult measurement challenges for a firm attempting to manage HR as a strategic asset—the problem of alignment. In this chapter we describe several ways to think about alignment and offer several alternative measurement approaches.

Chapter 7 discusses the prevailing competency models for HR professionals and how our view of what constitutes an appropriate set of HR competencies is influenced by the demands of a strategic measurement initiative.

In chapter 8 we conclude with a discussion of the challenges involved in implementing a strategically focused HR architecture and HR Scorecard. We develop a seven-step model for planning and evaluating the change management activities associated with the implementation efforts.

For those readers interested in the full extent of the theoretical underpinnings of our approach, we have also provided an appendix at the back of this book describing our research in more detail.

A FINAL NOTE OF ADVICE AND ENCOURAGEMENT

Clearly, designing any new measurement system for intangible assets isn’t easy—if it were, most companies would have already done it. Embracing this challenge takes time and a lot of careful thought. We encourage you to progress through each chapter in this book in sequence and to actively engage with the concepts as much as possible. This means thinking about how your own HR architecture operates and identifying ways in which you can customize our approach to meet the unique needs and characteristics of your firm. We also fully expect you to involve your entire HR staff in mastering the tools described in this book. After all, real innovation comes only when people work together on the most pressing challenges of the workplace.