Cost-Benefit Analysis

To sit at the table, you have to know the language: important financial metrics for HR directors

Chad Albrecht, Tim Gardner, Scott Allred, Brad Winn and Adam Condie

Chad Albrecht is Associate Professor at the Huntsman School of Business, Utah State University, Logan, Utah, USA. Tim Gardner, Scott Allred, Brad Winn and Adam Condie are all based at Utah State University, Logan, Utah, USA.

Abstract Purpose – The main thrust behind strategic human resources (HR) includes strengthening the impact of HR on the organization. In other words, strategic HR attempts to place the HR department on equal footing with other functional areas of business. HR professionals who understand both operational indicators and their decisions on various financial metrics have greater focus and clarity when making decisions. HR professionals with such knowledge are also more likely to be viewed favorably by their counterparts in other departments and have a greater voice in the executive suite and boardroom. Design/methodology/approach – Interviews with board of director(s). Findings – There has been a significant shift in the role of HR over the past several decades. The HR department has evolved from a role focused primarily on dealing with administrative issues, litigation and unions, to a department that drives strategy and adds value throughout the company. To continue this transition, HR professionals should have a solid knowledge of critical financial information, including financial and operational metrics and ratios. By combining this information with a strategic mindset, HR professionals are better prepared to add value to the firm, and they participate more fully with other members of management in determining the strategic direction of a firm. Originality/value – A competent, strategically minded HR professional who understands not only people-related issues but also financial issues can “elevate strategic discussions” in the executive suite and boardroom. Just as financial statements serve to direct attention to operational issues and to spur responsive management decisions among line managers, so too can financial statements direct the attention of HR professionals to line items specifically impacted by HR policies and processes. When HR professionals consider the impact of their decisions on the financial statements and financial metrics, they become key players in helping the firm achieve organizational goals.

Keywords Balance sheet, HR Department%2C Strategic Human Resource Management, Income statement

Paper type Technical paper

Introduction

Over the past 100 years, professionals responsible for managing a firm’s human capital have been called employment managers, corporate welfare managers, personnel managers, human resource managers, talent managers and even human capital managers. Often, the contribution of human resources (HR) professionals to firm value has ebbed and flowed depending on the strength of unions and the roll-out of new laws affecting the employment relationship. When unions have been weak and the government less involved in the employment relationship, HR professionals have had fewer contributions, less to do and less status. At times when unions have strengthened or new government regulations dramatically changed the employment relationship, the pay, status and the value of HR managers has increased.

In today’s fast-paced, global and chaotic work environment, the director of HR should provide an insight and value to the management group and even to the board of directors who make decisions for the firm. The HR director and those who work within the HR department should help management understand the people, cost, morale and other

DOI 10.1108/SHR-02-2016-0021 VOL. 15 NO. 3 2016, pp. 123-128, © Emerald Group Publishing Limited, ISSN 1475-4398 STRATEGIC HR REVIEW PAGE 123

implications of decisions before they are made, rather than just implement policies after they are made.

Transitioning to a strategic HR perspective involves understanding the flow of money, tangibles and intangibles across the balance sheets. In other words, to be strategic, HR managers need to understand financial statements and ratios and have a solid understanding of the ways in which HR and people impact financial statement line items. In the process, HR professionals must utilize financial statements to direct attention toward necessary functional improvements in policies and procedures.

Elevating the discussion in the executive suite

The main thrust behind strategic HR includes strengthening the impact of HR on the organization. In other words, strategic HR attempts to place the HR department on equal footing with other functional areas of business. HR professionals who understand both operational indicators and their decisions on various financial metrics have greater focus and clarity when making decisions. HR professionals with such knowledge are also more likely to be viewed favorably by their counterparts in other departments and have a greater voice in the executive suite and boardroom.

Creating a target for the income statement

When looking at the income statement, most people immediately go straight to net income. Although net income is an extremely important number, it is equally important for HR professionals to understand the revenues and costs that contribute to net income because there are various people and other related costs within each subsection that influence the income statement. These costs can only be managed by specifically examining each costs and direct relationship to net income. Furthermore, nearly every company has targets for each subsection of the income statement, and without understanding the various targets and how they are influenced, an HR manager can add little, if any, value. There are several key calculations to determining net income, which are as follows:

� Gross margin and gross margin percentage: Gross margin percentage is calculated by dividing cost of goods sold by net income. The gross margin percentage is a number that every member of the management must know and understand. To increase efficiency, nearly every company has a target gross margin percentage that they are continually trying to reach. For a software company, for example, it might be above 90 per cent. For a manufacturing company, it could be 40-60 per cent. For a retail company, it is may be even less. However, understanding gross margin percentages and how it can be managed and reduced is a frequent discussion in most boardrooms. And, although the gross margin percentage does not directly impact the HR department, unless the HR manager understands the financial elements of the gross margin percentage, the HR manager’s contribution will be limited.

� Operating income and operating income percentage: Operating income percentage is calculated by deducting selling (sales and marketing) expenses, research and development costs and general and administrative costs from the gross margin. Again, most organizations have target numbers for each of these categories. As such, executives and board members will typically focus on the percentage of revenues

‘‘HR professionals who understand both operational indicators and their decisions on various financial metrics have greater focus and clarity when making decisions.’’

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within each of these groupings. For example, a company might have a model of 50 per cent gross margin, 15 per cent research and development, 10 per cent selling costs and 4 per cent general and administrative costs, leaving an operating income percentage of 21 per cent. This target income statement is also conveyed to analysts and institutional investors and managed and discussed in every operations and board meeting of the company.

� Pre-tax income: Pre-tax income is calculated by taking operating income minus non-recurring charges, such as discontinuance of an operating unit or factory and other unusual costs. In calculating pre-tax income, it is important to understand each of the costs included and all non-recurring charges. Often, firms will use non-GAAP (GAAP: generally accepted accounting principles) and exclude items such as stock option costs, amortization of intangible assets and non-recurring costs. As such, it is extremely important that HR professionals understand not only pre-tax income but also the metrics used to determine pre-tax income.

� Net income: Net income is calculated by subtracting income taxes from pre-tax income. Because of the importance of net income to investors, analysts and executives, HR professionals must understand how income tax expense is calculated and how cash is paid to taxing agencies, including the different amounts that are reported on the income statement. Because HR professionals are often involved in outsourcing and insourcing decisions, it becomes increasingly important that HR professionals consider the tax implications and other employee cost when making key strategic decisions. Finally, from a strategic viewpoint, HR professionals should consistently monitor and evaluate the target numbers of the income statement. By understanding the constructs of income statement, executives will have the insight to know if something needs to be changed and if the current strategy is working.

For many organizations, human capital costs are the single largest item on the income statement. As a result, it becomes increasingly important for the HR professionals to ensure that the right number of people, the right span of control, the right type of management, the right kinds of benefits, appropriate retention incentives and other people-related costs and issues are handled efficiently. Having an HR director that understands the financial implications of his or her span of control is a key ingredient to controlling costs on the income statement. Similarly, having a proactive HR department that thinks ahead and helps develop people for future roles within the company is extremely important.

Along this same line of reasoning, having an HR department that has contacts with the right search firm experts, compensation consultants, professional coaches, development consultants and other professionals is extremely important. For example, knowing what type of development activities are best for key employees, including whether or not to retain personal coaches and what kinds of experiences are needed, can make a huge difference in the success of a company. Understanding the cost implications of various business strategies and the impact that people costs have on these strategies catapults an HR professional from being a mere staff member to being an indispensable member of a company’s leadership team.

Even when the HR department is strategic, there will always be an administrative responsibility to the HR department. HR costs are included as part of the general and

‘‘Having an HR director that understands the financial implications of his or her span of control is a key ingredient to controlling costs on the income statement.’’

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administrative costs (G&A) of the organization. As such, it is very important that the HR director knows how much administrative burden his or her department is contributing to the overall general and administrative costs of the organization. Appropriately managing G&A costs can make the difference between a company that is highly profitable and a company that is only marginally profitable. In fact, outside analysts will often compare the G&A percentages of different companies when deciding which companies are efficient (or lean) and which organizations have inefficient (or bloated) G&A costs.

Too often, HR professionals do not consider or even understand the costs that are associated with human capital within the organization. With a good knowledge of the income statement, as well as the various income statement accounts, HR professionals will be more aware of their spending and they will ensure that people-related spending is efficient. A knowledgeable HR professional can be critical in helping reduce wasteful spending and making the company more profitable.

The balance sheet

In addition to the income statement, HR professionals must also understand the balance sheet. While the income statement is a flow statement, the balance sheet represents a snapshot of what the business owns (assets), what the business owes (liabilities) and the value of the business to the stockholders (stockholders equity). Liabilities and stockholder’s equity show the sources of how a company is funded – whether by debt, by earnings or by selling stock. Just as the balance sheet helps operational managers and other users of financial information to identify areas of strength and potential problems, the balance sheet can also direct the attention of HR professionals to line items that are directly impacted by the HR function. Such direction can provide focus to areas that need improvement and can lead to changes in HR policies and processes that support the overall strategy of the firm.

Understanding financial data reported within the financial statements, including the income statement and balance sheet, is often facilitated through the use of various financial ratios. We have identified several financial ratios that have the capacity to strengthen the position and operations of a firm and provide further direction for HR professionals.

One key ratio, for example, is the number of days in accounts receivable or the days-sales-outstanding ratio. Simply put, this ratio describes how long it takes a company to collect payment after a sale has been made. The number of days in accounts receivable will often vary greatly depending on industry and revenue cycle. However, the number of days in accounts receivable is an important indicator that is calculated from various balance sheet line items of which all HR managers must be aware.

Another key ratio that HR professionals must understand is days in inventory or the inventory turnover ratio. Simply speaking, this ratio reflects the time it takes to sell an item, from the time it was initially built or placed in inventory to when it is shipped to the customer. As with other financial ratios, an acceptable value for the inventory turnover ratio depends on the industry. A high inventory turnover might indicate strong sales, but it may also indicate inadequate purchasing quantities and, therefore, employees in need of training. A

‘‘An HR professional that understand revenues, costs, key ratios and cash balances and needs can be a key advisor to a CEO and board of directors.’’

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low inventory turnover ratio might indicate slowing sales and thus the potential of being overstaffed.

Another reason why the inventory turnover ratio might be low is because of ineffective sales personnel. An HR professional viewing the inventory turnover ratio might realize the need for improved hiring and training practices for the sales force. The HR manager might realize weaknesses in current training protocols and materials and may make adjustments to train employees to become more effective. Using the specialties that HR professionals possess can help save the company time and money by strengthening the performance of existing employees. As with uncollectable receivables, there have been many companies that have gone bankrupt because they did not manage the receivables and inventory turnover ratios effectively. HR professionals can use these ratios to alert them to all kinds of personnel issues including hiring, training, retention, benefits, etc.

At the end of the day, the most important asset for any business is money, i.e. cash. Similar to the common phrase, “cash is king”. Even if a business has a worthy priority such as a social mission or other initiative if cash is insufficient, the company is at risk. Obviously, without sufficient cash, every business ultimately fails and is not able to accomplish its goals and objectives. As a result, cash must always be managed and everyone within the company, especially top managers and HR professionals, need to be aware of the company’s cash situation.

Nearly every company has cash balance targets. The cash balance must be adequate to deal with operating issues such as seasonality, bad quarters, operating hiccups, economic slowdowns and disruptive technologies of other companies. It must also be adequate to pay dividends, buy back company stock, make strategic acquisitions and pay vendors and taxes. In international organizations, the importance of monitoring cash balances becomes even more important as repatriating cash can be extremely expensive in terms of taxes. Knowing when to use debt and what kinds of debt is also critical.

In reality, there are two cash situations that businesses must manage – having excess cash and having too little cash. When a company has excess cash, activist and institutional investors will want companies to share that cash with shareholders in terms of dividends or stock buybacks. Having cash amounts that investors think is too high is one of the indicators that activist investors use to assess the performance of management. Managements that are not using cash wisely – either to expand current operations, make acquisitions or distribute to shareholders – are often criticized. Having large balances of cash in foreign countries is also problematic because it makes the company look like it is cash rich when, in fact, usable cash may be low.

Similarly, having too little cash is also problematic and can lead to dysfunctional management decisions and even bankruptcy and/or takeover by other companies.

An HR professional that understands revenues, costs, key ratios and cash balances and needs can be a key advisor to a CEO and board of directors.

Conclusion

We have seen a significant shift in the role of HR over the past several decades. The HR department has evolved from a role focused primarily on dealing with administrative issues, litigation and unions, to a department that drives strategy and adds value throughout the company. To continue this transition, HR professionals should have a solid knowledge of critical financial information, including financial and operational metrics and ratios. By combining this information, with a strategic mindset, HR professionals are better prepared to add value to the firm, and they participate more fully with other members of management in determining the strategic direction of a firm.

A competent, strategically minded HR professional who understands not only people-related issues but also financial issues can “elevate strategic discussions” in the

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executive suite and boardroom. Just as financial statements serve to direct attention to operational issues and to spur responsive management decisions among line managers, so too can financial statements direct the attention of HR professionals to line items specifically impacted by HR policies and processes. When HR professionals consider the impact of their decisions on the financial statements and financial metrics, they become key players in helping the firm achieve organizational goals.

Corresponding author

Chad Albrecht can be contacted at: [email protected]

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