Macro, Meso, Micro: Human Capital
Matt Barney
Motorola
New techniques that value intangible assets are becoming increasingly
prominent in finance, HR and government regulator circles (Lev, 2001). Employee
contributions are a key missing asset in traditional financial valuation
information. Historically, I-O psychologists have used utility analysis to
retrospectively determine the financial value of interventions (e.g. Raju,
Burke, & Normand, 1990). However, these approaches have had limited success
(Latham & Whyte, 1994). Utility analysis-based valuations have had both
technical and social problems. Technically, it has been difficult to validly
estimate the standard deviation of performance in dollars. Socially, executives
dont always believe the results, and sometimes even feel less convinced about
intervention efficacy after reviewing utility estimates (Latham & Whyte,
1994). Together this has stopped utility techniques from being adopted widely in
organizations.
It might be surprising to those of us with a psychological education that a
solution could be emerging from outside our discipline. Finance is starting to
acknowledge the gaps between traditional accounting practices, market
capitalization, and asset values (Lev, 2001). Investors for a long time have
been valuing stock shares beyond the book value (i.e., physical and financial
assets) of the companies (Lev, 2001). Take a look at your favorite securities
portfolio, and youll note that in spite of the recent stock market deflation,
many stocks are still trading significantly above what their tangible assets are
worth. This is because markets realize that intangibles help predict what the
future cash flows will be worth (Lev, 2001). Empirical evidence and theory
increasingly suggest that stock-market wealth creation involves optimally mixing
people, technology, and physical assets as they perform together in combination
to produce strategic goals (Becker & Huselid, 1998; Boudreau & Ramstad,
1997; DiFrancesco & Berman, 2000; Huselid 1995; Lev, 2001; Provo, 2000; ).
Commonalities between the approaches proposed to manage human intangibles
seem to be emerging. Im happy to say that it appears that they may be
fruitful in overcoming both technical and social problems with traditional
utility analysis approaches.
For example, the HC BRidgeTM (Boudreau & Ramstad, 1997; Boudreau,
Dunford, & Ramstad 2001) and Human Capital Asset Management (HCAMTM) (DiFrancesco
& Berman, 2000) models consider the strategic alignment of employees in the
value chain. The value chain is the sequence of work activities that produces
products and services at a meso-organizational level of analysis. Combinations
of people, technology, and physical assets perform this chain of work
activities. Both the HC BRidgeTM and HCAMTM models suggest that the key to
measuring and maximizing the value of the intangible assets (e.g., employees,
brand, technology) is in their joint contributions to the overall throughput.
Releasing constraints in the value chain are the places most fruitful for I-O
interventions to produce economic value (Boudreau & Ramstad, 1997;
DiFrancesco & Berman, 2000).
The HC BRidgeTM and HCAMTM models provide causal explanatory mechanisms to
describe how revenues are created by employee performance. In contrast, utility
analysis struggles with estimating SDy, and sometimes substitutes employee
salary as a crude proxy. Newer macro-level approaches (e.g., Huselid, 1995) use
correlational associations between HR practices and economic outcomes without
explicitly describing the mechanism by which employees create value in tandem
with other resources. The Boudreau/Ramstad and DiFrancesco/Berman approaches
explicitly describe how human labor (and supporting HR systems) creates value by
partitioning costs and investments and returns. By using a model of logic about
how employees create value along with traditional balance sheet financials, I
believe these approaches have promise to persuade CFOs and CEOs beyond what our
previous techniques have been able to achieve.
These methods can provide a meaningful way to consider, prospectively in HR
planning, where investments in I-O interventions will pay off, and how much to
invest. These are the sorts of tools I-O psychologists need to become cocreators
and managers of businesses.
Interview
Im thankful that Jeanne DiFrancesco, one of the thinkers and practitioners
in the area, has agreed to introduce the topic to our readers. DiFrancesco is
the Principal of ProOrbisTM, LLC, a consulting firm specializing in the
development and application of advanced management concepts. She holds an MBA
from the University of Pennsylvanias Wharton School of Business and an
interdisciplinary undergraduate degree from the College of William and Mary. Her
previous experience includes 15 years of executive and strategic-level positions
in human resources for firms ranging from small start-ups to multi-billion
dollar global concerns. She is the author of the general theory of Human Capital
Asset Management (HCAMTM ) which includes the economic methods for the valuation
of intangible assets (DiFrancesco & Berman, 2000).
How did you get involved with the topic of human capital? I got
involved with the topic while at Wharton where, after years as an HR executive,
I was awakened to the cold hard reality that human capital was not a business
asset (at least not to the finance profession). My keen interest was in how to
handle human capital as a business asset and how you would actually calculate
return on investments in that assetfrom training to incentive pay to the
company picnic.
How would you characterize Human Capital Asset Management (HCAMTM)?
Its the way to understand human capital as a business asset by connecting all
the various arenas of HR into a system that helps the firm create revenues. We
do this in a way that makes it clear where the investments are and where returns
will be achieved. The key difference between this technique and academic work is
that we incorporate systems theory (operations research) more than appealing to
inferential statistics. This is because we understand how HR participates in the
creation of human capital, so we dont have to infer anything. Because the
theories academics appeal to currently do not articulate the causal
relationship, they have to rely on inferential approaches. In our projects,
were not constrained in the way academics are constrained. In our model, we
know what to make happen to create returns. Even though this approach is
conceptually elegant, and meets very high standards for theoretical integrity,
it was really developed with a deep understanding of the way things work in real
companies.
Macro, Meso, Micros readers are I-O psychologists, and have
familiarity with traditional utility analysis. How does the Human Capital Asset
Management approach overcome some of the challenges of the past? Im
not an expert at Utility AnalysisI understand it from a rewards mix strategy
point of view. What makes this approach different from most academic work in
this arena at this time is that it uses many different business disciplines
(such as economics, finance, HR, OD, social psychology, and business management)
in a way that is consistent with their core principles but very differently than
the current state of the practice.
For example, if you look at a cost in finance versus a cost in economics,
they are two very different ideas. Ive found that as disciplines specialize,
they move farther away from their core principles. After they get very
specialized, its hard for them to speak the language of the other
disciplines. We try to live comfortably at the core of those key disciplines,
and we borrow techniques and use them in unexpected ways. This gives our
techniques a lot of analytical power and understandability across a host of
disciplines.
Human Capital Asset Management (HCAMTM) uses these core principles to create
a very different view of the firm and affords us the great luxury of using
analytical techniques that were developed for one purpose and use them for
another. In this way, analyses that may have seemed impossible in the past, all
of a sudden look relatively straightforward. The calculation itself is not
always easy, but what the number means when you are done with the calculation is
a lot more clear.
Any view of the firm must consider business science. You have to be
able to speak to and relate to what it is that youre suggesting. I think that
any sort of one-dimensional approach to human capital is unlikely to be accepted
across the firm, or implementable. In principle these disciplines dont
disagree; they just disagree in practice.
HCAMTM is more of a strategic framework that views human capital as an asset
of the firmthis isnt a view of the individualwhich is how I view
utility analysis. One of the critical paradigm shifts required to understand
human capital as an asset is to understand that the human capital of a business
is not people. People are the owners of their own human capital and invest some
of it in their work. Therefore, the human capital of a business is the sum of
what all its people have invested in their work. We consider individual behavior
and the limits of individual performance in developing our solutions, but it is
not the focus of our work. We are more interested in how individuals perform
together and in combination with other assets such as technology and physical
capital to create economic value.
Some have argued that the reason utility analysis and human resource
accounting hasnt taken hold is because its not credible to managers (Johanson,
Eklov, Holmgren & Martensson, 1998; Latham & Whyte, 1994). What
reactions have you had with your approach from general managers and finance
leaders? It is always difficult to generalize, but my experience says in
general, the closer you are to a P&L (Profit & Loss statement) the more
receptive you are to this concept. The people with the biggest problems with our
ideas are the single disciplinary people. If youre a finance person three
layers down in the organization, you may have a hard time wrapping your brain
around this. If youre a plant manager, you get this intuitively, and it makes
a lot of sense to youand you cant understand why people dont do this
already. In finance, the people who get it the best are the very most
sophisticated professionals. Thats a very small population, but fortunately,
its an important, influential group. CEOs and GMs get it way faster than
finance professionals in general. HR is somewhere in the middle.
One of the new ideas you introduce into HR systems is the concept of
tolerance and employee performance. Would you explain this idea? Basically,
any business process is designed to tolerate certain kinds of performance from
the assets that execute the process. This is well understood for physical
capitalthe same is true of human capital. Understanding the system tolerance
and variability in performance of human capital is one of the most important
ideas in understanding human capital as an assethow human capital can make a
difference to the business outcome. If you know how human capital creates value,
then you know how you can cause it to create more value. The value of human
capital is derived from the value it helps to create.
Business assets (as opposed to financial assets) are assets because they have
certain productive capabilities. This is an important concept. This is not a
concept of liquidated value, more a concept of value in use. Business
assets have value as part of a production function. When the liquidated value is
greater than the value in use, companies get broken up. We deal with human
capitals value in a going concernnot its liquidated value.
One of the HCAMTM analytic approaches involves understanding input
costs, throughput value and capitals (physical, human, and technology) role
in producing this value. How does this work at a micro or meso level of
analysisfor example in a department, work group, or division?
Basically, to do the analysis in a segment of a business, its very important
to understand the role of that segments process in the overall value chain.
The same analytic techniques apply as those we would use for the entire
business. In this way, you can decompose any part of the organization, as long
as you understand the costs of whats coming in and the value of whats
coming out. Where its an internal operation, often the cost coming in is a
true accounting concept of cost. To the extent the cost is coming on a value
basis (transfer price), then you have inputs that are more market valued. The
transfer price might represent the cost to the segment. This is the attempt of
firms to place the value where the value gets created.
There is some controversy over whether HR metrics and intangibles in
general should be regularly disclosed in corporate financial reports (e.g.,
annual report, balance sheet). What is your thinking on this? For the
most part, people dont understand what the assets of a firm aretangible or
intangibleso disclosure would have to educate consumers of financial
information about what the assets, in fact, are. Then, public disclosure could
be focused usefully on providing the core information to make various
assessments about what is happening to the intangible assets.
What concerns me the most about the clamoring to report intangibles, is that
most people dont know how to think about intangibles, so making disclosures
would be potentially confusing, just like any information that has no reasonable
standard or context. But I do think public disclosure of certain variables would
be extremely helpful to investors and other consumers of financial information,
like employees. I just think a lot of education would be required to make the
information useable.
Some experts on intangibles, like Baruch Lev (2001) have suggested that
if the financial community is educated and companies report intangibles, that
stock market volatility could be reduced. Do you agree? I absolutely
agreetoday markets are speculating on intangibles, and market volatility
would be reduced if people really understood intangibles. Otherwise, market
volatility could be increased if people misunderstand them. I think thats the
fear of the people on the other side. Im a very big supporter of standards in
this regard, because people should know what theyre looking at. By
understanding value, theyll make better decisions.
You have a nice overview of your approach in the National Productivity
Review. Are there any additional references you can recommend for readers
interested in more details? You can look at CFO Magazine in the April
2001 issue or go to www.proorbis.com. We
havent published as much yet; weve got a lot of behind-the-scenes stuff
going on.
Any final comments? Its exciting to see the HR disciplines
starting to grab on to HC as an asset. I would encourage specialists to broaden
their perspective to get a strategic understanding, so they can create more
value for their organizations.
In many ways, HR is my first loveits the discipline with the most hope
of leading this new disciplinary arena. Many observers write off HR as the last
bastion of administration, but I dont believe that. I think to do HR well, it
takes a lot of knowledge of many disciplines, and that it is the breadth of
knowledge that is the best foundation for building the tools and techniques to
treat human capital as an asset.
Closing Thoughts
Im heartened that these ideas about valuing intangibles are getting
increasing attention from many prominent sources, including the Financial
Accounting Standards Board and the Securities and Exchange Commission (Lev,
2001). Given I-O psychologists quantitative training, we should be some of
the first to lead organizations down this path. To do that, as DiFrancesco
suggests, it may require us to borrow ideas outside of our traditional academic
tradition and from other areas of organizational science (e.g., industrial
engineering, strategy, marketing, and finance).
I always appreciate your feedback and ideas; please write to me at matt.barney@motorola.com.
References
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DiFrancesco, J. M. & Berman, S. J.
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Lev, B. (2001). Intangibles: Management,
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Provo, J.M. (2000). Utilizing a human
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Unpublished doctoral dissertation, University of Minnesota.
Raju, N. S., Burke, M. J., & Normand, J.
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