Chapter 3: Focus on Value

Overview

The third principle of human capital management concerns value. Value is generated when revenue exceeds costs (including the cost of capital). When one focuses on value and the many activities and decisions that create it, one is focusing on the right things.

Like any asset, human capital is an investment with a stream of economic returns. When those returns are positive—that is, when the benefits produced exceed their costs—that asset has produced real value. It produces a current return and some level of future return. Every alteration in the asset has an effect on those returns. Therefore, rotating people through positions, investing in training, reconfiguring pay and incentives, and so forth, change this asset’s potential to produce value.

The type of human capital that is developed through managerial decisions also affects value. The global manufacturing company case described in Chapter 1 showed how decisions about career development produced a cadre of managers with skills that were too general for the company’s good. In another organization those general skills might have produced greater value, but this company needed more specialized talent along with its generalists, especially managers who knew in detail how to move new product concepts from the design stage through manufacturing to on-schedule product launches.

The personal choices of employees—to stay or leave, to increase their skills or allow those skills to become obsolete—also shape the value-producing power of a company’s human capital. Company policies and practices can influence those decisions but in the end cannot control them. Thus, the human capital asset of an organization is always in the process of becoming something else, with greater or lesser power to create value for shareholders and customers.

Regrettably, most executives are inclined to view human capital as a cost rather than a value-producing asset. They manage it accordingly, as something to be minimized, reduced, reined in. This view of human capital is supported by traditional accounting practices which expense rather than capitalize workforce investments that build capability and motivation such as training and financial incentives. Unlike fixed costs that do not vary with the volume of production (e.g., leases, interest expenses), variable costs are charges that increase and decrease with the level of production. Thus, when sales slacken and production decreases, fewer overtime hours are worked, employees are furloughed or laid off, and wages may be frozen or even cut. It is a short step from regarding a workforce as a variable cost to regarding it as something that can be increased or decreased with the ebb and flow of customer demand.

One also can speculate that executives manage human capital as a cost because they manage what they can measure and know how to measure people as costs. Indeed, most companies know to the penny the costs of their human assets in terms of base pay, variable pay, benefits, and support services. What they haven’t been able to measure until now has been the value of those assets, and managing anything one cannot measure is bound to be problematic.

Managing human capital as a cost is often unavoidable during periods of business distress, but it is a strategy with clear limits: There is a point below which there are no costs left to cut. Gordon Bethune acknowledged this in reflecting on his struggle to pull Continental Airlines out of its death spiral in the mid-1990s.^[1] The company, he noted, had managed costs so aggressively that it had very little left to offer its customers. Gertz and Baptista made the same observation when they wrote that a company “cannot shrink to greatness.” Further, they noted that cost reduction is “a game that anyone can play,” not a viable strategy to achieve a sustainable competitive advantage.^[2]

Cost reduction has a natural floor. However, there is no ceiling on the potential value of human capital. For example, a company might save a grand total of $55,000 by canning the lethargic-looking drone in the research and development (R&D) lab who never appears to be doing anything useful, but that quiet individual might be the unrecognized genius who is halfway to creating the company’s next great hit: a product family worth hundreds of millions of dollars in revenue every year. This example may stretch the point, but it underscores the fact that a focus on cost management eventually leads to a dead end, whereas managing human capital for value has no theoretical limit. This point is recognized by investors who pay attention to the intangible worth of employees when pricing company shares.

Ironically, the executives who manage the people side of a business as a cost problem do not approach the costs of other assets in that way. When they get out the checkbook for other assets, they don’t talk about cost as much as about expected future returns net of costs. In the best cases they balance costs against returns over time, producing a single number—net present value—that encapsulates the cost of the investment, the cost of capital, and all the anticipated cash flows from the investment. When the net present value is sufficiently high relative to alternatives with similar risks, concerns about costs take a very different and more positive form: “Where can we find the cash?”

^[1]Gordon Bethune and Scott Huler, From Worst to First: Behind the Scenes of Continental’s Remarkable Comeback. New York: John Wiley & Sons, Inc., 1998.

^[2]Dwight L. Gertz and Joao Baptista, Grow To Be Great. New York: Free Press, 1995, 7–12.