One of the great frustrations for those who work in human resource management is an inability to make an economic case for an investment in HR tools and processes.
Yet the basic methodology for making effective return-on-investment (ROI) calculations to value the impact of HR initiatives has been around for some time.
Why have HR practitioners — seemingly themselves convinced of the business justification for investing in HR programs — shied away from using the same kind of analysis that other functions habitually use?
One possible explanation is HR practitioners’ fear of even challenging the continuing skepticism of the many line managers that continue to doubt HR’s ability to contribute appreciably to the financial success of the organization.
Another likely cause is that the HR profession is not interested in getting involved in such prosaic pounds-and-pence debates; they are content to leave such grubby financial matters to others while they involve themselves in the loftier questions of human development, ethics and diversity. Or is the reason, dare one suggest, that HR is populated with the innumerate, and the thought of analysing costs and benefits and coming to a mathematical conclusion just beyond the ken of most HR practitioners?
We suggest the answer lies in a more basic realm, though in a way it is a conclusion that is no less unkind to the profession. It is simply that few HR managers are aware of the research and the processes that permit rational ROI assessments to be made in the world of HR. And, because so few are aware, the method does not get used. Whatever the explanation, it is a serious and missed opportunity. If there is a credibility gap affecting the HR function, this is one way to bridge it.
It is also an issue that has a huge impact on human performance at work. If the implementation of best-practice HR processes in development, training, performance management, compensation, recruitment and selection and the rest are critical to the performance of organizations, then their absence is a serious restriction on individuals who want to develop and perform at work.
Clearly, the ability of the HR profession to make the case and to win resources in competition with other worthy causes is critical to the perception of the function, and to the credibility of its claims to make a demonstrable difference to human and organizational performance.
The business scenario
The following case study is drawn from a real proposal offered to the New York-based executive committee of an international financial services organization.
The task was to persuade financially sophisticated HR skeptics that making a significant investment in a major program of competency analysis and applications in recruitment, development and performance management was worth it to an organization in a shrinking-market sector and facing tough times well into the foreseeable future. This was just the sort of challenge the average HR practitioner would relish.
The business scenario was not atypical of those that HR has to face in many market sectors. The company had grown over a number of years from a standing start into a major player in its sector. It had a strong customer base, and enjoyed effective relationships built on a strong technical foundation for its products.
But, as with many such organizations, it faced an uncertain future as its main market had matured and was probably already beyond saturation point. Technical developments in other arenas were now threatening the very rationale on which the company’s original product range was built.
The executive committee — prompted by a recent board-level recruit to the corporate services portfolio — was realizing that it was ill-equipped to manage through a period of ever-quickening change, and was in danger of failing to match the technical skills, agility, creativity and drive for achievement that some of its own corporate customers were able to demonstrate. For some members, including the chief executive, the need for a drive towards improving the capability of their people was becoming clear. Many, however, remained unconvinced — beyond allowing a modest increase in the technical training budget. The money could be spent on many other things. So how to make the case, and in terms that would win over the skeptics?
The proposition
The organization had ambition; it was not content to be the biggest player in a shrinking market, moving to an inevitable point of oblivion somewhere on a not-too-distant horizon. Clearly, more of the same would not provide a springboard for change.
The proposition was to build and implement competency models — initially for the senior level itself, and later at a broader level — across the sales and marketing function.
The focus for implementation would be on recruitment and selection, as well as development and succession planning. Developing and using competencies that reflected the strategic needs of the organization and the development needs of individuals was seen as an effective way to kick-start the change process.
The basic information on which the board presentation was constructed was as follows:
The sales and marketing team
•The function was globally dispersed, with major concentrations in three regional locations. It totalled some 100 staff.
•Salaries varied across regions, but a reasonable average was US$90,000 (all figures in US) plus 50 per cent variable bonus payable for “on-target” performance, generating typical total compensation of around $135,000.
•Staff turnover for the group was around the 20 per cent mark, although actual levels varied between regions.
The senior management team
•Included the chief executive officer and the team reporting directly to this level, plus selected members of their direct-report teams. In all, the target group numbered 20 individuals.
•All of the senior team was located in either the United Kingdom or the United States, although many of the group had international responsibilities.
•Succession to the senior group, and development of the senior group itself, were the key management issues identified by the CEO and board members.
The challenge was to show, in financial terms, how an investment in competency analysis and applications could be justified. The organization was familiar with cost-benefit analysis as a process for assessing prospective and competing technical projects; why should this potential investment be treated any differently?
It was a good question, and the answer was that there was no reason why it should be treated differently, other than the traditional reticence of HR towards using such a methodology.
Cost-benefit analysis: Sales and marketing recruitment
Elementary laws of statistics predict that the output of a group of workers forms a bell-shaped distribution.
It was a reasonable assumption that this “rule of thumb” applied to the organization concerned. So, in the case of the people working within the sales and marketing teams — the vast majority of whom have been recruited, selected and trained using “traditional” methods — there would most likely be a normal distribution of performance.
That is, a small proportion of staff would be performing at superior levels, most would be performing around the middle at an acceptable level of performance, and another small group would be at or below the margins of acceptability.
From this, the next reasonable assumption was that the continued use of existing methods of recruitment, training and development would ensure the maintenance of the normal performance distribution curve. With a reported 20 per cent labour turnover rate within the sales and marketing group, there was a high cost associated with maintaining average performance, but the target was to raise performance towards superior levels.
“Superior” performance is defined statistically by researchers as one “standard deviation” above average performance — roughly the level achieved by the top 10 per cent of staff in a given work situation.
By identifying the competencies that differentiate superior performance from average performance — that is, those used by the top 10 per cent — the selection and training processes could be refocused to recruit people who possess these competencies or who are capable of developing them quickly.
Again, the conclusion of extensive research is that for sales jobs, one “standard deviation” above the mean is worth 48 per cent to 120 per cent of output (see “Individual differences in output variability as a function of job complexity,” J. Hunter, F. Schmidt and M. Judiesch, Journal of Applied Psychology, 75, 1990.)
So for this organization, (readers can substitute their own salary and turnover rates to get a sense of the potential ROI in their organizations) calculation of the cost or benefit for the competencies project for sales and marketing was as follows:
a) Given an existing labour turnover rate of 20 per cent, there will be 20 new recruits within one year (current staff level of 100).
b) Two of these new recruits are likely to be “superior” performers, based on using existing processes of recruitment (top 10 per cent).
c) The opportunity is to use competency-based behavioural interviewing to recruit the remaining 18 people at a superior level, rather than at average or below.
d) Using current actual salary and bonus levels (typically $135,000) as the basis of the calculation, and using the lowest of the projected improvements to output (48 per cent), the following benefit in terms of improved performance would be derived, if the selection process worked perfectly:
18 x ($135,000 x 0.48) = $1,166,000.
e) But it will not work perfectly. So the number has to be discounted by a “degree of imperfection.” In other words, we need to account for how successful behavioural interviewing is at selecting “good” candidates and rejecting “bad” ones. The average rate for this is 0.545, which we shall use as the “discount” factor. So the calculation continues:
18 x ($135,000 x 0.48) = $1,166,000 x 0.545 = $635,000.
f) So, by using competency-based behavioural interviewing techniques as the basis for selection in sales and marketing, at least as effectively as most other organizations that use it, the company could expect to derive $635,000 in additional value within one year of implementation — given current levels of labour turnover and total compensation, and the opportunity in the market to achieve it.
g) The basic cost of the competency project for sales and marketing was $130,000; but $635,000 in expected additional value translates into a one-year gross ROI of 488 per cent.
This calculation is based on a turnover rate of 20 per cent. More effective recruitment, it is reasonable to assume, would have a positive impact on this relatively high rate, although there may be a range of factors producing the high attrition rate.
While lower turnover would have a negative impact on the net value of the competency intervention in subsequent years, there would be positive financial impact through reduced recruitment and other costs. These savings are not included here.
Another factor not taken into account in the calculation is the learning curve that the new recruits will go through to get up to speed in their new jobs.
Again, while this may be a factor that “discounts” the net value derived from the competency-based recruitment, it is reasonable to assume that more competent recruits will learn and contribute more quickly than the average performers likely to have been recruited through existing methods. Either case is very difficult to quantify; the working assumption is that these two effects cancel each other out.
It can also be reasonably argued that not all the benefits will be achieved in the first year, and that at least a two-year realization is more likely. If performance is ramped up over a two-year period, 25 per cent of the benefits would be generated in the first year, 75 per cent in the second and the full 100 per cent in the third, all other things remaining equal. But all these benefits would in theory be cumulative since there would be the opportunity to replace average and poor performers with top performers — to the point where everyone is a top performer.
Again, it is very difficult to make plausible assumptions about these effects over time. And in the final analysis, even if the numbers in the original calculation exaggerate the impact by a factor of 100 per cent (that is, the calculated value is twice the actual value), it still makes a compelling case.
Cost-benefit analysis: Sales and marketing training
For the other 80 staff in the sales and marketing team who were not new recruits in year one, the issue became one of identifying the impact that competency-based training and development would have on performance. (Other applications, such as performance management and compensation would also have a positive impact, but are not included in this analysis.)
As with the earlier example, the value of moving the whole sales population to “superior performance” is research based. A general and reliable rule of thumb has developed from extensive analysis that values “one standard deviation” as equivalent to 40 per cent of the compensation paid to that group (Selection and Assessment — a new appraisal, M. Smith and D. Andrews, 1989). And as with recruitment, the implementation of competency-based training would not be perfect.
Creditable research indicates that the average effect of competency-based technical and sales training results in a positive shift of the performance curve by 0.67 of one standard deviation.
Using the same basic process as earlier, the potential impact of implementing competency-based technical and sales training across the whole group (excluding new recruits) was calculated as follows:
80 staff at an average total compensation of $135,000 = $10.8 million.
Value of one standard deviation: $10.8 million x 0.4 = $4.32 million.
“Imperfect discount” factor: $4.32 million x 0.67 = $2.89 million.
Therefore, by successfully applying competency-based technical and sales training and development to the whole group, the company could reasonably expect a positive financial impact to the value of $2.89 million within one year of implementation.
Even by allowing for a relatively large budget of say $750,000 to cover the additional costs of training needs analysis, planning and delivery across the group, this still represented a healthy 385 per-cent ROI (the actual cost of the project had been accounted for in the earlier calculation).
Of course, some of the same time-scale and negative-discount arguments referred to above could also be made here, counterbalanced by other factors that may produce a positive impact but are also not taken into account.
Given that, in many organizations, the minimum required one-year ROI for capital projects is typically in the range of 20 per cent to 40 per cent, such arguments become somewhat academic.
Cost-benefit analysis: The senior management group
Research in the field indicates that there is generally wider variance in performance in senior jobs due to greater spans of control and discretion, the longer time-scales over which they operate, and the greater degree of complexity involved. This is consistent with the much higher variable compensation usually offered at the senior levels in organizations.
It follows that the potential impact of improved performance at this level on the overall performance of the organization is much greater than at middle and junior levels. However, to avoid the danger of exaggeration, it is prudent to continue to use the “40 per-cent rule” for the cost/benefit calculation in respect to the senior group.
Making some assumptions about total compensation at the senior level, the calculation for the company was as follows:
20 staff at average estimated total compensation of $150,000 x 20 = $3 million.
Value of one standard deviation: $3 million x 0.4 = $1.2 million.
“Imperfection discount” factor: $1.2 million x 0.67 = $804,000.
Against the project cost of $80,000, and adding an estimated training and development cost of $250,000 generates a gross ROI of 243 per cent on successful implementation.
Conclusion
For this organization, which was making difficult and expensive investment decisions, evaluating competing proposals and allocating scarce resources in the real world, with real money, this methodology proved helpful and, ultimately, convincing. While the procedure outlined here may not be perfect — and, indeed, we have highlighted some of the inadequacies of the calculations — it represents a major step forward in terms of making the case for investment in HR-related programs.
We do of course accept, and indeed habitually make, the case for serious consideration of non-financial benefits derived from such projects. But it is difficult to deny that the ability to make a rational case in financial terms represents a powerful “new” weapon in the armoury of any ambitious HR function.
Stephen Martin is managing director of Kimball Consulting and president of ITAP Europe; he can be contacted at 01923 241402, or by e-mail at [email protected] www.itapintl.com/kcl.htm.
Lionel Laroche, a regular contributor to Canadian HR Reporter, is president of ITAP Canada. He can be reached at (416) 248-4064 or by e-mail at [email protected]. This article originally ran in Competency and Emotional Intelligence.
Yet the basic methodology for making effective return-on-investment (ROI) calculations to value the impact of HR initiatives has been around for some time.
Why have HR practitioners — seemingly themselves convinced of the business justification for investing in HR programs — shied away from using the same kind of analysis that other functions habitually use?
One possible explanation is HR practitioners’ fear of even challenging the continuing skepticism of the many line managers that continue to doubt HR’s ability to contribute appreciably to the financial success of the organization.
Another likely cause is that the HR profession is not interested in getting involved in such prosaic pounds-and-pence debates; they are content to leave such grubby financial matters to others while they involve themselves in the loftier questions of human development, ethics and diversity. Or is the reason, dare one suggest, that HR is populated with the innumerate, and the thought of analysing costs and benefits and coming to a mathematical conclusion just beyond the ken of most HR practitioners?
We suggest the answer lies in a more basic realm, though in a way it is a conclusion that is no less unkind to the profession. It is simply that few HR managers are aware of the research and the processes that permit rational ROI assessments to be made in the world of HR. And, because so few are aware, the method does not get used. Whatever the explanation, it is a serious and missed opportunity. If there is a credibility gap affecting the HR function, this is one way to bridge it.
It is also an issue that has a huge impact on human performance at work. If the implementation of best-practice HR processes in development, training, performance management, compensation, recruitment and selection and the rest are critical to the performance of organizations, then their absence is a serious restriction on individuals who want to develop and perform at work.
Clearly, the ability of the HR profession to make the case and to win resources in competition with other worthy causes is critical to the perception of the function, and to the credibility of its claims to make a demonstrable difference to human and organizational performance.
The business scenario
The following case study is drawn from a real proposal offered to the New York-based executive committee of an international financial services organization.
The task was to persuade financially sophisticated HR skeptics that making a significant investment in a major program of competency analysis and applications in recruitment, development and performance management was worth it to an organization in a shrinking-market sector and facing tough times well into the foreseeable future. This was just the sort of challenge the average HR practitioner would relish.
The business scenario was not atypical of those that HR has to face in many market sectors. The company had grown over a number of years from a standing start into a major player in its sector. It had a strong customer base, and enjoyed effective relationships built on a strong technical foundation for its products.
But, as with many such organizations, it faced an uncertain future as its main market had matured and was probably already beyond saturation point. Technical developments in other arenas were now threatening the very rationale on which the company’s original product range was built.
The executive committee — prompted by a recent board-level recruit to the corporate services portfolio — was realizing that it was ill-equipped to manage through a period of ever-quickening change, and was in danger of failing to match the technical skills, agility, creativity and drive for achievement that some of its own corporate customers were able to demonstrate. For some members, including the chief executive, the need for a drive towards improving the capability of their people was becoming clear. Many, however, remained unconvinced — beyond allowing a modest increase in the technical training budget. The money could be spent on many other things. So how to make the case, and in terms that would win over the skeptics?
The proposition
The organization had ambition; it was not content to be the biggest player in a shrinking market, moving to an inevitable point of oblivion somewhere on a not-too-distant horizon. Clearly, more of the same would not provide a springboard for change.
The proposition was to build and implement competency models — initially for the senior level itself, and later at a broader level — across the sales and marketing function.
The focus for implementation would be on recruitment and selection, as well as development and succession planning. Developing and using competencies that reflected the strategic needs of the organization and the development needs of individuals was seen as an effective way to kick-start the change process.
The basic information on which the board presentation was constructed was as follows:
The sales and marketing team
•The function was globally dispersed, with major concentrations in three regional locations. It totalled some 100 staff.
•Salaries varied across regions, but a reasonable average was US$90,000 (all figures in US) plus 50 per cent variable bonus payable for “on-target” performance, generating typical total compensation of around $135,000.
•Staff turnover for the group was around the 20 per cent mark, although actual levels varied between regions.
The senior management team
•Included the chief executive officer and the team reporting directly to this level, plus selected members of their direct-report teams. In all, the target group numbered 20 individuals.
•All of the senior team was located in either the United Kingdom or the United States, although many of the group had international responsibilities.
•Succession to the senior group, and development of the senior group itself, were the key management issues identified by the CEO and board members.
The challenge was to show, in financial terms, how an investment in competency analysis and applications could be justified. The organization was familiar with cost-benefit analysis as a process for assessing prospective and competing technical projects; why should this potential investment be treated any differently?
It was a good question, and the answer was that there was no reason why it should be treated differently, other than the traditional reticence of HR towards using such a methodology.
Cost-benefit analysis: Sales and marketing recruitment
Elementary laws of statistics predict that the output of a group of workers forms a bell-shaped distribution.
It was a reasonable assumption that this “rule of thumb” applied to the organization concerned. So, in the case of the people working within the sales and marketing teams — the vast majority of whom have been recruited, selected and trained using “traditional” methods — there would most likely be a normal distribution of performance.
That is, a small proportion of staff would be performing at superior levels, most would be performing around the middle at an acceptable level of performance, and another small group would be at or below the margins of acceptability.
From this, the next reasonable assumption was that the continued use of existing methods of recruitment, training and development would ensure the maintenance of the normal performance distribution curve. With a reported 20 per cent labour turnover rate within the sales and marketing group, there was a high cost associated with maintaining average performance, but the target was to raise performance towards superior levels.
“Superior” performance is defined statistically by researchers as one “standard deviation” above average performance — roughly the level achieved by the top 10 per cent of staff in a given work situation.
By identifying the competencies that differentiate superior performance from average performance — that is, those used by the top 10 per cent — the selection and training processes could be refocused to recruit people who possess these competencies or who are capable of developing them quickly.
Again, the conclusion of extensive research is that for sales jobs, one “standard deviation” above the mean is worth 48 per cent to 120 per cent of output (see “Individual differences in output variability as a function of job complexity,” J. Hunter, F. Schmidt and M. Judiesch, Journal of Applied Psychology, 75, 1990.)
So for this organization, (readers can substitute their own salary and turnover rates to get a sense of the potential ROI in their organizations) calculation of the cost or benefit for the competencies project for sales and marketing was as follows:
a) Given an existing labour turnover rate of 20 per cent, there will be 20 new recruits within one year (current staff level of 100).
b) Two of these new recruits are likely to be “superior” performers, based on using existing processes of recruitment (top 10 per cent).
c) The opportunity is to use competency-based behavioural interviewing to recruit the remaining 18 people at a superior level, rather than at average or below.
d) Using current actual salary and bonus levels (typically $135,000) as the basis of the calculation, and using the lowest of the projected improvements to output (48 per cent), the following benefit in terms of improved performance would be derived, if the selection process worked perfectly:
18 x ($135,000 x 0.48) = $1,166,000.
e) But it will not work perfectly. So the number has to be discounted by a “degree of imperfection.” In other words, we need to account for how successful behavioural interviewing is at selecting “good” candidates and rejecting “bad” ones. The average rate for this is 0.545, which we shall use as the “discount” factor. So the calculation continues:
18 x ($135,000 x 0.48) = $1,166,000 x 0.545 = $635,000.
f) So, by using competency-based behavioural interviewing techniques as the basis for selection in sales and marketing, at least as effectively as most other organizations that use it, the company could expect to derive $635,000 in additional value within one year of implementation — given current levels of labour turnover and total compensation, and the opportunity in the market to achieve it.
g) The basic cost of the competency project for sales and marketing was $130,000; but $635,000 in expected additional value translates into a one-year gross ROI of 488 per cent.
This calculation is based on a turnover rate of 20 per cent. More effective recruitment, it is reasonable to assume, would have a positive impact on this relatively high rate, although there may be a range of factors producing the high attrition rate.
While lower turnover would have a negative impact on the net value of the competency intervention in subsequent years, there would be positive financial impact through reduced recruitment and other costs. These savings are not included here.
Another factor not taken into account in the calculation is the learning curve that the new recruits will go through to get up to speed in their new jobs.
Again, while this may be a factor that “discounts” the net value derived from the competency-based recruitment, it is reasonable to assume that more competent recruits will learn and contribute more quickly than the average performers likely to have been recruited through existing methods. Either case is very difficult to quantify; the working assumption is that these two effects cancel each other out.
It can also be reasonably argued that not all the benefits will be achieved in the first year, and that at least a two-year realization is more likely. If performance is ramped up over a two-year period, 25 per cent of the benefits would be generated in the first year, 75 per cent in the second and the full 100 per cent in the third, all other things remaining equal. But all these benefits would in theory be cumulative since there would be the opportunity to replace average and poor performers with top performers — to the point where everyone is a top performer.
Again, it is very difficult to make plausible assumptions about these effects over time. And in the final analysis, even if the numbers in the original calculation exaggerate the impact by a factor of 100 per cent (that is, the calculated value is twice the actual value), it still makes a compelling case.
Cost-benefit analysis: Sales and marketing training
For the other 80 staff in the sales and marketing team who were not new recruits in year one, the issue became one of identifying the impact that competency-based training and development would have on performance. (Other applications, such as performance management and compensation would also have a positive impact, but are not included in this analysis.)
As with the earlier example, the value of moving the whole sales population to “superior performance” is research based. A general and reliable rule of thumb has developed from extensive analysis that values “one standard deviation” as equivalent to 40 per cent of the compensation paid to that group (Selection and Assessment — a new appraisal, M. Smith and D. Andrews, 1989). And as with recruitment, the implementation of competency-based training would not be perfect.
Creditable research indicates that the average effect of competency-based technical and sales training results in a positive shift of the performance curve by 0.67 of one standard deviation.
Using the same basic process as earlier, the potential impact of implementing competency-based technical and sales training across the whole group (excluding new recruits) was calculated as follows:
80 staff at an average total compensation of $135,000 = $10.8 million.
Value of one standard deviation: $10.8 million x 0.4 = $4.32 million.
“Imperfect discount” factor: $4.32 million x 0.67 = $2.89 million.
Therefore, by successfully applying competency-based technical and sales training and development to the whole group, the company could reasonably expect a positive financial impact to the value of $2.89 million within one year of implementation.
Even by allowing for a relatively large budget of say $750,000 to cover the additional costs of training needs analysis, planning and delivery across the group, this still represented a healthy 385 per-cent ROI (the actual cost of the project had been accounted for in the earlier calculation).
Of course, some of the same time-scale and negative-discount arguments referred to above could also be made here, counterbalanced by other factors that may produce a positive impact but are also not taken into account.
Given that, in many organizations, the minimum required one-year ROI for capital projects is typically in the range of 20 per cent to 40 per cent, such arguments become somewhat academic.
Cost-benefit analysis: The senior management group
Research in the field indicates that there is generally wider variance in performance in senior jobs due to greater spans of control and discretion, the longer time-scales over which they operate, and the greater degree of complexity involved. This is consistent with the much higher variable compensation usually offered at the senior levels in organizations.
It follows that the potential impact of improved performance at this level on the overall performance of the organization is much greater than at middle and junior levels. However, to avoid the danger of exaggeration, it is prudent to continue to use the “40 per-cent rule” for the cost/benefit calculation in respect to the senior group.
Making some assumptions about total compensation at the senior level, the calculation for the company was as follows:
20 staff at average estimated total compensation of $150,000 x 20 = $3 million.
Value of one standard deviation: $3 million x 0.4 = $1.2 million.
“Imperfection discount” factor: $1.2 million x 0.67 = $804,000.
Against the project cost of $80,000, and adding an estimated training and development cost of $250,000 generates a gross ROI of 243 per cent on successful implementation.
Conclusion
For this organization, which was making difficult and expensive investment decisions, evaluating competing proposals and allocating scarce resources in the real world, with real money, this methodology proved helpful and, ultimately, convincing. While the procedure outlined here may not be perfect — and, indeed, we have highlighted some of the inadequacies of the calculations — it represents a major step forward in terms of making the case for investment in HR-related programs.
We do of course accept, and indeed habitually make, the case for serious consideration of non-financial benefits derived from such projects. But it is difficult to deny that the ability to make a rational case in financial terms represents a powerful “new” weapon in the armoury of any ambitious HR function.
Stephen Martin is managing director of Kimball Consulting and president of ITAP Europe; he can be contacted at 01923 241402, or by e-mail at [email protected] www.itapintl.com/kcl.htm.
Lionel Laroche, a regular contributor to Canadian HR Reporter, is president of ITAP Canada. He can be reached at (416) 248-4064 or by e-mail at [email protected]. This article originally ran in Competency and Emotional Intelligence.
