September 2004 - The links between human capital and profit

The Chartered Institute of Personnel and Development, an organisation that represents more than 100,000 personnel and human resources managers in the UK, is not known for the strength of its opinions.

So when it delivers a robustly-worded response to government proposals covering company law, we ought to sit up and take notice. The CIPD is dismayed at the way the Department of Trade and Industry has interpreted recommendations of the Accounting for People taskforce on human capital reporting in Operating and Financial Reviews (OFRs).

These reviews will need to be included as a legal requirement in the annual reports of publicly listed companies for financial years from January 1 2005. In its response to the DTI's draft regulations on OFRs, the institute says that the Accounting for People recommendations have been "severely weakened and undervalued".

The comment is disturbing because the Accounting for People report anticipated OFRs that would contain important information on employment polices and practices useful for investors to assess the future direction of the companies they were considering as an investment prospect.

Industry bodies have lobbied hard to ensure that future legislation will not create new bureaucratic burdens that could harm the competitiveness of business. But has the lobbying been too successful? If we take the view that OFRs are designed solely to improve the transparency of business policies, there may be an argument against greater disclosure. Why should a well-run company spend time and effort developing policies in areas where it sees little of relevance to the business and to which the directors will be accountable?

This would explain why the DTI has avoided using the strict accounting concept of materiality. Instead it has chosen to give directors much greater discretion over the way they review and identify relevant factors. Does this mean that some OFRs could get away with including little more than figures on the total number of employees in a company? The question needs to be asked since the DTI has declared nothing stronger in its consultation document than "the Government hopes that companies will use the (Accounting for People) guidance when preparing their OFR".

"While we agree that the ultimate right to not include human capital information should be available as a last resort, and so long as it can be adequately explained and justified, the requirement to provide it should be more strongly expressed and supported by the DTI," says the CIPD. This goes to the nub of these requirements. If the OFRs are to mean anything, they must contain solid information, not bland statements and platitudes about the importance of the workforce. They should also deal directly with the concept of "human capital", a term which is used repeatedly in Accounting for People, but which has been replaced in the DTI document with "information about employees".

There is a big difference between employee information and human capital. Human capital is a well-defined economic idea based on studies that have linked investment in the skills and education of people with their prospective economic worth. It is not a piece of management jargon or a faddish term for human resources. It is a measurement-based discipline that is going to be as important for business in the 21st century as cost-accounting was in the 20th century.

This is why the reporting of human capital should not be seen as a burden for companies.

Mastery and understanding of human capital measurement and the way this relates to other measures of business performance is transforming the way many companies do business.

You need only look at businesses such as Sears and Enterprise Rent-a-Car, both of which link their reward and management systems closely to customer satisfaction feedback.

Research at Sears in the US has shown how increases in employee satisfaction feed through to improved customer satisfaction and revenues. The key to these systems has been the introduction of effective measuring systems. Some companies shy away from measuring employee attitudes in the belief they are dealing with "soft" issues. But well-designed attitude surveys can identify the areas in which employees and managers need to concentrate their efforts. Detailed research at Enterprise Rent-A-Car, the largest car rental business in North America, has enabled the company to create its own customer satisfaction index which rates the service performance of individual branches.

Managers are unable to achieve promotion unless they achieve better than average customer satisfaction scores, even if their branches may be achieving higher than average growth in sales and profits. Neither of these companies would have difficulty reporting on these human capital measures although Enterprise Rent-A-Car, as a privately-owned company, does not need to worry about shareholders. Instead, it ensures that its employment policies are in line with its attitudes to service. It promotes from within, allows a high degree of autonomy in the way that local branches are run and links a significant proportion of managers' pay to branch profits. These companies do not need a piece of legislation to convince them of the need for effective human capital management.

They have refined their measuring systems to avoid creating stodgy processes that get in the way of day-to-day operations.

Companies and investors in the UK need to realise that effective human capital management can make a strong impact on profits.

Unfortunately too many companies fail to investigate the link between policies on, for example, training, pay and recruitment and the bottom line. But measuring areas of employment alone is not enough.

HR managers must begin to use specific measures to demonstrate cause and effect. The best way to do this is to canvass the opinions of employees. What kind of training do they value? How would they like to be paid? Would they care to risk some of their salary as a variable profit and loss-related figure? If so, how much? The answers to some of these questions might be just as enlightening as tables of figures in a set of accounts. This is why the disciplines behind human capital reporting are so important to businesses. Even if the government allows plenty of room for directors' discretion on employment reporting in the OFRs, companies should not take the view that they have won some kind of reprieve.

The market is a far sterner judge of performance than any reporting requirement and it is the companies that best understand the relationship between work and profit that will win in the long run.

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