2 word docs.

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By Mark L. Frigo and Mark C. Ubelhart

Human Capital Management: The Central Element of All Risk

T here are myriad risks that every company must contend with each day. HR helps recognize, manage, and respond to such risks. As you look across the different types of exposure facing your firm, how well can you identify and measure the potential strategic impact if these risks are not attended to?

HR can ensure a resilient enterprise by using human resource data and tech- niques characteristic of business strategy, finance, and enterprise risk manage- ment. We’ll examine the issue of employee retention, specifically talent critical to achieving strategic priorities, and then illustrate how traditional strategy maps can be enhanced with a human capital perspective and explain how this enables us to recognize and measure a variety of people-related risks to strategic priorities and enterprise viability.

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The Strategic Impact of Pivotal Employees It is reasonable to ask, “When does underperfor- mance of not engaging and retaining employees become a risk to the enterprise?” It happens when you lose sight of who your pivotal employees are and can no longer see the consequences of their disengagement or potential exit.

HR has many tools at its disposal, including those used for the attraction and retention of key employees—we refer to them as “pivotal employ- ees.” HR also has command of data and informa- tion needed to identify such employees and plays a significant role in training and compensation to enhance alignment.

Research on high-performing companies high- lights the importance of employee engagement and human capital as a key driver for superior business performance. It also shows the value of

Case Studies Using human capital analytics to predict business financial results gives organizations the ability to use them in internal strategic decision-making and for connecting finance and HR. Here are some brief illustrations.

Lowes Home Improvement Lowes discovered that a IBPET measure predicted store profit- ability, just as it does for overall corporate results. This led to the adoption of a new regional manager-training program designed to retain Pivotal Employees and to use of IBPET internal report- ing at the regional level in addition to the usual financial results.

Campbell Soup Company At Campbell Soup, Pivotal Employees were defined as those who received top quartile percentage pay increases; this form of Investment Based Pivotal Employee Turnover (IBPET) was utilized to evaluate their Performance Management Program. Research demonstrating the link between IBPET and business financial performance provided quantitative justification that had been previously lacking for this HR practice. The result was a worldwide meeting of performance management staff and a change in the level of differentiation across employees.

Eli Lilly and Company At Eli Lilly, a completely different result revealed that to do better in retaining Pivotal Employees, and get the financial benefit of a higher IBPET for their sales force, surprisingly more emphasis was needed on base pay rather than incentive com- pensation. The change was made as this counterintuitive result was supported by the financial proof.

Kellogg Company Lack of long-term retention of key R&D staff can cripple any company depending on innovation. At Kellogg, a unique long- term incentive plan was designed including all employees in their R&D group. It featured a compensation fund created by 5% (all percentages are illustrated but consistent with actuals) of Revenue for the first 3 years, 10 percent of profits for the next three years, and 15 percent of the economic profit (profit in ex- cess of a minimum return on investment) for the next four years. This is a 10-year long interest in the business, patterned after the natural economics of a startup that must first position itself to compete in the market, then migrate to generate profit and then return on investment. The business thrived and became a precedent for HR innovation.

Common to these illustrations is the explicit connection to financial results, reinforced by accountability reporting and compensation. Evidence-based research underlying IBPET is the crucial performance metric that HR can implement and has the data control to do so. If you believe that loss of pivotal talent could pose an unacceptable threat to your business strategies, you now have a metric to demonstrate your point of view; and it is one that will gain the support of your CFO.

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disciplined performance measures that link with long-term shareholder value creation and the stewardship of capital (for more information see Driven: Business Strategy, Human

Action and the Creation of Wealth, Frigo & Litman, 2008). So how can companies develop human capital metrics that can link with business financial results?

The “Moneyball” of Human Capital Marketing and sales functions have long demonstrated the power of using big data for decision making. The book- turned-movie Moneyball revealed how a general manager of a baseball team could use data on individual and collective performance to predict outcomes and guide decisions in Major League Baseball for optimal player acquisition and utilization.

HR already makes use of its wealth of data in employee engagement assessments and more than 600 HR metrics

now featured in the Human Capital Management Institute’s (HCMI) Human Capital Management Handbook. Using internal financial information, some companies connect their own HR metrics to business results. Yet they stop short of linking human capital metrics to comparative financial results—that is, winning the ball game against other compa- nies. This is attributable to the lack of commonly accepted and reported HR metrics.

There is evidence-based research that this hurdle can and, to some extent, has already been overcome. An April 2015 study, “The Materiality of Human Capital to Corpo- rate Financial Performance,” by Aaron Bernstein and Larry Befferman of Harvard Law School found “the evidence for human capital sufficiently compelling to warrant investor re- quests for companies to report systematically” and “one way to start thinking about desired reporting [at least internally to the board] is to draw upon policies found to be linked to financial results.”

HR already does benchmarking for executive compen- sation and benefit programs. In 2009, AON Hewitt (then Hewitt Associates) demonstrated that the disproportionate loss of pivotal employees could be quantified in subsequent poorer financial results (“An Economic View of the Impact of Human Capital on Firm Performance and Valuation” in The Valuation Handbook, Valuation Techniques from Today’s Top Practitioners). The study found a 10 percent loss predicted a 0.7 percent to 1.6 percent of investment ($70 million to $160 million for a $10 billion corporation)—a Moneyball result. This was after adjusting for reverse causality, that is, poor performance leading to the departure of more key em- ployees. In other words, the enterprise risk is a subtle but powerful lowering of the capacity of the enterprise to carry out its mission and objectives. While not as immediately visi- ble as a cyberattack or safety incident, it is no less impactful across the business.

1. Develop an action plan for a Strategic Human Capital Analytics Initiative. This can be a joint initiative of the CEO, CFO, and CHRO.

2. Develop a strategy map that incorporates existing and new human capital analytics and strategic objectives for developing human capital metrics that link with business and financial out- comes.

3. Review the metrics described in sources such as the HCMI Human Capital Metrics Handbook, and highlight those that have emerged internally as most useful and relevant.

4. Review the status and direction of internal report- ing, emphasizing the places where predictive HR analytics are or could be applied to link human capital metrics to business results.

5. Identify what is needed to better enable board of directors’ oversight of the management of human capital with the same degree of rigor that charac- terizes other investment decisions.

6. Identify and prioritize HR metrics that can be used to instill accountability and that can be inte- grated with reports to the board of directors and for internal reporting.

Strategic Human Capital Analytics Initiative Checklist Here’s a checklist that can be used in developing human capital metrics and analytics.

Research on high-performing companies highlights the importance

of employee engagement and human capital as a key driver for superior

business performance. It also shows the value of disciplined performance

measures that link with long-term shareholder value creation and the

stewardship of capital

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A Metric That Matters: Investment- Based Pivotal Employee Turnover Metrics command attention, especially when they predict important company outcomes. One metric we designed for summarizing the loss of key employees is Investment-Based Pivotal Employee Turnover (IBPET, see Exhibit 2 below). This metrics is similar to the Talent Quotient developed by Hewitt Associates but provides for flexibility in defining piv- otal employees. Pivotal employees were identified in previous studies and applications as those with top quartile percent- age pay progression (adjusted for age, pay, and tenure) to standardize for companies and over time. Investment-Based Pivotal Employee Turnover is the ratio of the compensation investment lost when pivotal people depart divided by that of all employees (see Exhibit 1 above). While this may seem to be just another employee turnover metric, it can predict financial results, and so can be employed as an outcome metric to evaluate any HR program.

Certainly many readers are familiar with FICO credit scores, the predominant metric and technique used to predict loan defaults. The very same methodology has been applied to determine retention risk scores (RRS) for all employees of a company. Higher scores mean greater risk. All available data is used within a company and from other economic and demographic data sources. The principals of Global Analytics who developed FICO also created RRS. In specific client situations the predictive accuracy actually exceeded that of loan default assessments. Combining the identification of pivotal employees with their risk of leaving adds another dimension to what HR can provide. Obvi-

ously, great care must be taken to manage such sensitive information and prevent misuse. In this case protecting the individual is a paramount consideration, more like health care than baseball.

A Strategy Map with Human Capital Analytics Strateg y Maps describe the “what” and “how” of the business strateg y. It also leads to some key questions management teams should ask, such as, “W ho is doing

what to execute this strateg y?” and “W hat is our human capital at risk?” Companies that have developed Strateg y Maps know that human capital risk is a critical element, but don’t regularly embed this within their maps, or if they do, they give it limited attention since it is diff icult to measure and predict.

The excerpt of a Strategy Map in Exhibit 3 shows how management can describe and prioritize its strategic activi- ties, while also incorporating the human capital perspective. This example shows four strategic themes that should be

relevant to most compa- nies. Each strategic theme, however, translates into a different set of internal process objectives, and each has a unique form of strategic risk manage- ment to be addressed. The pool of employees who are considered pivotal under each strategic theme may also be different,

Savvy executives ... intuitively know that the inability to retain their most pivotal employees can jeopardize even well planned strategic objectives

Exhibit 1

Exhibit 2

and inability to retain those pivotal employees places that strategy at greater risk. This approach also leads to a tailored set of objectives for organizational learning, innovation and growth as it impacts the pivotal talent pool. The human capital analytics, such as a Retention Risk Score, attaches a measure to the potential behavior of pivotal employees and the consequence for that particular strategy.

Savvy executives know that people are critical to achiev- ing strategy, but often struggle to put a number on it. They intuitively know that the inability to retain their most piv- otal employees can jeopardize even well planned strategic objectives. As HR departments learn to develop metrics of employee risk, and demonstrate how these predict financial performance, they earn more credibility across the C-suite and board of directors, and become seen as even more critical partners in strategy fulfillment.

References Bernstein, A. and Befferman, L. (April 2015) “The Materiality of

Human Capital to Corporate Financial Performance.” Harvard Law School

Frigo, M. L. and Ubelhart, M.C. (November 2015) “CFO + CHRO = Power Pair” Strategic Finance.

Frigo, M. L. The Balanced Scorecard: Applications in Internal Auditing and Risk Management, 2014, Institute of Internal Auditors Research Foundation.

Frigo, M.L. and Litman, J., “Driven: Business Strategy, Human Action and the Creation of Wealth,” 2008. Strategy & Execution Press.

Human Capital Management Institute’s (HCMI) Human Capital Man- agement Handbook, 2nd edition, 2012.

Ubelhart, M. C,., (2009). “An Economic View of the Impact of Hu- man Capital on Firm Performance and Valuation” in The Valuation Handbook, Valuation Techniques from Today’s Top Practitioners 2009, pp. 508–524.

Ublehart, M. C. “The Convergence of HR and Finance.” presentation at the 2014 HRPS Strategic HR Forum, Practices that Drive Orga- nizational Results, Oct 19–21, 2014.

Mark L. Frigo, Ph.D., C.P.A., C.M.A., is director of the Center for Strategy, Execution and Valuation and the Strategic Risk Manage- ment Lab in the Kellstadt Graduate School of Business, and the Ledger & Quill Foundation Distinguished Professor of Strategy and Leadership in the Driehaus College of Business, DePaul University. He is the author of seven books and more than 100 articles, He can be reached at [email protected].

Mark Ubelhart, M.B.A., is clinical professor of strategic finance and human resource management in the Center for Strategy, Execution and Valuation in the Kellstadt Graduate School of Business, DePaul University. Mark was also the Hewitt Associates practice leader, first for corporate finance/executive compensation and then for human capi- tal foresight. He can be reached at [email protected].

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Exhibit 3: Human Capital Analytics in Strategy Maps

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