Human Capital, made simple

Everything should be made as simple as possible, but not simpler - Albert Einstein

Suddenly, Human Capital is in vogue. Hot on the heels from a major report on the subject issued by a collaboration between Schroders and Oxford Said Business School, another Human Capital ETF has recently been launched and the topic grabbed the front cover of last week's Investor’s Chronicle magazine.

What’s all the fuss about?

Human Capital – why it’s so important

Economists have known for a long time that factors closely related to Human Capital (defined by Schroders as people’s capabilities, individual and collective attributes, including skills, experiences, and relationships, available to the organisation to create economic value)[1] make a large and significant difference to a company’s financial success.

For example, landmark and impressive multi-decade studies by a collaboration @jon between Harvard, Stanford and London School of Economics economists found that the quality of a firm’s management accounts for a whopping 40% of a firm’s Total Factor Productivity (greater even than contributions made by a firm’s R&D or Technology investments)[2], while a major study into firm competitiveness late last year by the OECD found that employee skills (including manager skills) have a huge impact into a company’s ability to win in any field or market.[3]

We can break these numbers down further to get a sense of the scale of the opportunity.

In the first example, a 10% increase in manager skill has been found to equate to 0.7% of a firm’s revenue in terms of value add (this is large on an annualised basis – in a previous company this deceptively small percentage was worth hundreds of millions of dollars).

In the second example, the gap simply between ‘Leaders’ and ‘Median’ companies in any field was over 31% in terms of productivity – and it was almost entirely down to skills and capabilities.

Put simply, on the top of any CEO’s To Do List of where they should spend their time, Human Capital should be right at the top. There is simply no other factor of value that even comes close.

But there’s a problem: complexity.

Human Capital, made complicated

One of the challenges involved in Human Capital is the complexity of measuring and, perhaps more importantly, moving it in the direction we would like it to go. So we can split this into two considerations: measuring Human Capital (with robust numbers that relate to a company’s financial performance), and moving Human Capital (with robust numbers that relate to changes in culture and underlying behaviours).

However, taking this approach quickly leads us into a minefield of complexity. For one thing, each of these lie within the domain expertise of different practitioners.

First, measuring typically falls within the province of economists. In their efforts to boil measures down to numbers, It’s not long before you see papers laden with sigmas and complex formulae, and these are usually complex enough to discourage the lay reader from going any further. Straight into the too difficult box, then.

Moving Human Capital, meanwhile, falls within the province of change management practitioners, HR and leadership development professionals. Within this domain which can be quite subjective, evidence-based practice quickly loses its grip and numbers are few and far between.

It doesn’t help that these professionals operate within silos of their own, and there are often silos within these silos. In the absence of robust evidence-based measures and practices any can agree on, ego approaches quickly prevail.

But it’s not much use measuring Human Capital if you can’t move it; and it’s pretty pointless moving (or trying to move it) without any robust measures. All that emerges is a talking shop without any clear sense of gain or loss.

Simplifying Human Capital using basic accounting principles

What’s needed instead is a way of conceptualising Human Capital that allows for easy (or easy enough) operationalisation at the move level, while preserving the integrity of the numbers at the measure level.

This can be done (in my view) in a way accessible to all: via the concepts of a P&L account and Balance Sheet already standard in global accounting practices.

Here’s how it works. Imagine you walk into a company – any company – and you see a hive of activity, with goods and services being created and delivered to customers. Put simply, how well a company is able to do this within its overall cost structure is found in the P&L. If more goes out than comes in, the company will make losses.

Human Capital works in exactly the same way. If more of a company’s headcount goes out than comes in, then a company will eventually find itself drained of its Human Capital (this is not the only way a company can lose Human Capital, more on this in a moment).

In both cases above, a company is not usually run into Chapter 11 Bankruptcy. This is because of the second factor – the company’s Balance Sheet. (Have a look at the illustration of this concept below).

If a small company loses $10,000 in a year, it may well still be OK, because of its Balance Sheet. Likewise with Human Capital. If a large company loses 10,000 employees in a year it may still be OK if it is able to redistribute work among its remaining capital. We can see the concept illustrated below.

The P&L

Of course, the above explanation is an oversimplification. This is firstly because there are other ways a company can lose Human Capital. The first of these is if the employees (or a large section of them) simply down tools by striking. Then there are a myriad of other ways the company can lose short-term Human Capital value, including a range of behaviours we can group under the term ‘disengagement’ including quiet quitting, taking sick leave, abusive or incompetent management, useless meetings, burnout, toxic environments and so on. These, as have been found, significantly impact the ‘P&L’ side of our accounting model, as noted earlier. Central to this is the effectiveness of managers, and the effectiveness of managers worldwide has been found to be really average (more on this in a future post).

Bottom line: here we measure the P&L side through Engagement indicators, which are not only a survey, but include:

-????????? Attrition rates, especially regrettable attrition

-????????? Exit interview data

-????????? Productivity measures

The Balance Sheet

Recall earlier the simplification of employees leaving a company directly impacts its Human Capital ‘Balance Sheet’.

We all know this is not what usually happens. If one employee leaves, they are usually replaced by a new candidate. Or, the work is redistributed among remaining employees.

But what happens if the level of the hire in a company gradually declines over time? If, say, a manager hires a star performer, the star performer finds themselves in a crappy culture, then leaves… how likely is it that the manager will hire at this level again? It’s not a good optic, hiring people who then leave. Plus, it’s a load of extra work.

Better to hire a mediocrity! Someone who will ‘suck it up’ even if their contribution will be lacking.

This is another way companies gradually erode their Balance Sheet. Promoting incompetents also helps, given that it has been reliably found that an employee will only ever operate at or below the level of their manager (Zenger Folkman).

Normally, the countermeasure to this happening is by implementing robust Talent Management. But organisations mostly fail in this (more in a future post) and pretty much all use the same systems anyway. This is why we see all companies having pretty much similar problems the world over.

Measuring and Moving, together

The key point here is that measures and their movement need to be robustly linked. Unfortunately, in spite of the large and reliable link found between Human Capital measures and company outcomes, most finance professionals continue to account for employees as a cost (on the P&L side of the accounts) and not as an asset or liability (on the Balance Sheet side). Unless this simple step is done (and it can be done internally as an extra line) it is hard to see how the overall effectiveness and health in companies will change.

As a starting point for implementing a Human Capital-led approach, companies need to do the following:

1.?????? Measure the cost of attrition, consistently

2.?????? Consistently measure productivity measures, such as Profit Per Employee and Operating Margin %

3.?????? Hold HR to account with financial KPIs on the above, to get past language-based window-dressing.

4 Develop individuals using Engagement (and Engagement only) and Talent Management measures

These are the crucial first steps to achieving the nexus between the moving and measuring of Human Capital in a company.

In coming posts we will see how companies can make capital of the sizeable opportunities in this field by operationalising the Human Capital model shared.

Stay tuned!

[1] Schroders July 2023, HUMAN CAPITAL MANAGEMENT Research summary: people are our greatest asset

[2] Bloom et al 2016, Management as a Technology?; the HBR article here is an easier read Why Do We Undervalue Competent Management? (hbr.org)

[3] OECD Dec 2021, The human side of productivity Uncovering the role of skills and diversity for firm productivity