The term human capital can be used to describe the asset value of your people and is certainly not a new concept for today’s businesses. But what’s surprising is that many medium to large companies are still not fully realizing a return on investment (ROI) on their human capital. People are often spoken of as assets but are generally treated as costs, because there is no standardized system of valuing them.
However, if you view people as value-creating entities—if you can quantify the knowledge they bring to the organization and apply that knowledge within the organization, it becomes a key competitive advantage. Weigh it against the associated costs of hiring, retaining, and training and you can better appreciate the foundational role people play in the success of your business.
Basic Accounting Principles
Generally Accepted Accounting Principles (GAAP)—the standard framework of guidelines for financial accounting that most businesses within North America operate under—list physical assets (such as property, machinery, buildings, and inventory) as the assets that generate revenue for an organization.
In financial accounting, in order to qualify as an “asset,” three general rules are followed:
- The asset must be owned by the business—the business must have total control of the asset.
- The asset must have future benefit—the asset must benefit the future profit of business.
- The asset must be valued in monetary units—the accounts related to the asset can be observed objectively.
Clearly human assets satisfy the criteria of future benefit and monetary value, but human capital does not appear on the financial statements of most organizations. The reason for this is clear: unlike all other factors of operations and production within an organization, human capital cannot be owned.
So, if a person cannot be owned, how does human capital qualify as an asset? The basic accounting equation is where assets equal the sum of liabilities (costs) plus capital. Viewed with a human perspective (figure 1), we can begin to see how the term “asset” can be used to describe our employees.
While the value of human assets (which are often considered to be intangible) and material assets such as property, equipment, etc. (which are considered tangible) are calculated differently, the bottom line results are the same—they both add value to the organization over time.
The Cost of Human Capital
There are three major points within the employee lifecycle at which costs are incurred. Interestingly, these are also points at which the company is acquiring very important capital (often referred to as knowledge capital):
- Capital acquisition: costs incurred during the recruitment process (e.g., for advertising, interviewing, and employee relocation). The costs of recruiting an employee can be assessed and then depreciated over the expected future service of the person hired. Alternatively the person’s gross remuneration can be used as a base.
- Education and learning: costs incurred to train and develop the employee’s skill set (e.g., for training materials, facilities, and instructors).
- Position replacement (succession): costs for replacing employees who are exiting the company (e.g., due to retirement or new employment).
Many of the costs mentioned above are recognized as expenses on the income statement in financial accounting. The balance sheet of a successful business generally has assets that exceed costs. Many businesses, in an effort to improve their bottom line, often cut back on costs.
These days, many larger corporations are “trimming the fat”—conducting mass layoffs in hopes of reducing expenditures and thereby increasing stock market value. This may seem like a logical way to cut costs. But when people costs are cut, so too are the assets that generate future revenue and profitability for the company.
This could be an effective solution if the employees being cut were poor performers, had the wrong skills sets for the jobs that were in, were high flight risks, or did not blend well within the culture of the organization. But effectively developing these employees (through career development training) throughout the course of employment, in my opinion, might be a much better solution. Here’s why.
When employees are laid off, in some cases, they take with them very valuable knowledge and expertise. If the company doesn’t take the time to understand and measure the value the employee brings through these “knowledge assets,” then it is potentially losing an individual that could be an asset to the company in the future. By retaining, training, and further developing this individual, however, the company may discover that the employee has skills and expertise that can be used in other areas of the business where employee know-how may be lacking.
This tactic helps companies to place people in the right jobs, reduce employee turnover, better align employee training goals with the overall business strategy, and streamline the succession planning process.
Defining Employee Value
Traditionally, an employee who adds value to the organization is someone who:
- makes his or her workplace better by taking initiative (has a good work ethic)
- uses good judgment to improve his or her personal productivity
- increases revenues for the company (for example, by winning repeat business)
But, in a less traditional sense, the employee who offers suggestions that help solve issues or who motivates others and brings optimism to the environment—creating a more positive attitude in the workplace—is also adding value. From a human resources (HR) perspective, it is very easy to appreciate how behaviors can add value to an organization, but from a financial perspective, placing a value on something as intangible as attitude, or even skills and knowledge, proves a little more difficult.
Two of the main asset components that help determine an employee’s value are:
- Behavior—which includes elements such as having a positive attitude (optimistic, motivated, etc.), the ability to build interpersonal relationships both inside and outside the organization (with coworkers and customers), or the ability to attract new customers
- Knowledge—which includes elements such as personal performance (productivity), skill or know-how, expertise in a given field, the ability to create new and more efficient processes, and suggesting or making recommendations regarding inefficiencies
If we put these factors (both liabilities and assets) onto a balance sheet, it would look something like what you see in Figure 2. When all the employee liabilities (employer expenses or costs) are subtracted from the employee’s assets, the result is the employee’s net value.
“Valuing an employee” from a financial perspective is both a science and an art. The science aspect of accounting represents everything quantifiable or tangible (such as salaries, benefits, and productivity). The artful aspect of accounting includes being able to assign value to elements (such as employee behavior, skill, and similar intangibles), which can’t ordinarily be measured in dollars and cents.
A common way to calculate an employee’s worth to a company is to divide the company’s net income by the number of active employees. The problem with this method, however, is that it provides an average number for the value of all employees in the company—not an individual employee’s worth or value. A more accurate calculation would involve looking at the specific employee’s productivity. This is an easy task if the employee actually produces something concrete (such as a product that can be sold, increasing company revenues), because the employee’s productivity can be quantified. All expenses attributed to this employee can then be deducted to arrive at the net value.
For employees that are not directly involved in the development of a product (e.g., accountants, data entry clerks, and maintenance workers), the calculation is a little more difficult because the productivity of these employees cannot be given a dollar amount. Arbitrary productivity values must then be assigned to each of these employees. Only your organization can uniquely define what those values may be. In any case, these types of values must be documented for future use.
There are also various other systematic measures that have been applied in the attempt to value people financially as assets. They include:
- developing an index of HR best practices that can be related to business results
- measuring the efficiency of HR functions and processes and the ROI for people initiatives and programs
- integrating people-related measures through a performance management framework
The above examples represent some various approaches to quantifying employee value; however, there is no one standardized approach that has become widely accepted as yet. Use the method that best fits with your company’s processes and culture.
The Bottom Line: The Value of Human Capital
The way in which organizations currently view their balance sheets must change. The human capital assets of the company must be considered alongside its financial statements so that the ROI can be properly calculated. In addition, good accountability, integrity, and administrative practices (e.g., performance evaluation and analysis) will help optimize human capital. Like any other asset, it must be carefully managed, monitored, and measured.
There are two very different schools of thought among companies: those that view employees as a liability and those that view employees as an asset. For those companies that view employees as an asset, activities such as training, learning, developing, and transforming the workforce have become a top priority for the HR department.
But in an attempt to hold down expenses, many companies (those that view employees as a liability) are cutting into the muscle of their firms, instead of investing in their people. In the short term, their financial statements may reflect positively, but in the long term they will be sorry for the decisions they make today.
Over time, the investment in your employees can produce tangible substantial benefits—as well as profits—for your organization. That investment allows you to:
- acquire a pool of qualified people through effective recruitment processes
- acquire a pool of skilled employees ready to move through your organization, through effective training programs
- acquire more productive and more engaged employees
- acquire employees that bring knowledge and information to your organization through previous experience (which can help with product development, customers, suppliers, etc.)
In an upcoming article I’ll take a look at a related issue—human capital analytics and how organizations can leverage data intelligence using today’s new and innovative HR technologies to make better workforce decisions.