Making Sense of Human Capital Economics

For years HR professionals have struggled to bring economic rigor to measurement and decisions about people development and management. One familiar measure has been return on investment (ROI), for example, ROI of training. But like many such metrics, ROI

No, this is not just another buzzword. Measuring and quantifying human sources of value (knowledge, skills, practices, etc.) and making informed management judgments based on that is real—and probably lies ahead for every organization. Unlike ROI, which tends to be rear-mirror-looking, new human capital economic approaches are evolving as predictive methodologies. Jonathan Low, co-author with Pam Kalafut of “Invisible Advantage: How Intangibles Are Driving Business Performance,” said, “Face it, we are not returning to the Industrial Age. Decisions about people are getting more strategic, thus more rigorous, and ergo require more quantitative approaches.”

Background and History

Human capital economics is really not new, but it continues to evolve. Decades ago, labor economists began analyzing measures like wage levels, movements and specialization of skills. When HR was called “Personnel” there were also ongoing efforts to measure the economics of people-related processes, and in the 1950s and 1960s academics like University of Chicago’s Gary Becker were working on foundational theory, in Becker’s case even winning the Nobel Prize.

Starting in the 1980s, momentum in the practical sphere grew, complementing the advances in theory. European companies—especially Scandinavian—focused attention on non-financial dimensions of business, including environmental impact and workforce welfare. As such issues rose in political importance in those societies, many enterprises developed metrics for driving “intangible objectives,” incorporating them in annual reports. A related political theme added to the fray—the rise of labor-rich third-world economies and the belief that established countries would have to compete more systematically on intangibles.

Organizational intangibles also began to interest investors and capital market analysts. As equity market numbers increasingly diverged from hard-asset values and accounting leaders began to argue that traditional measures were not accurately reflecting underlying values, new research and practice emerged to quantify work, human contributions and different kinds of “capital.”

Rising Need on the Shop Floor

Meanwhile, managers were addressing the practical implications of other related trends. Amid accelerating global competition, executives pushed for improved effectiveness and costs related to the “all-important asset.” As the 1990s economy heated up and the demographic crunch of baby-boomer retirement loomed, HR practice shifted to a war for talent, emphasizing more strategic hiring, development, leadership and yes, tools for quantifying the value of human capital. As Wharton Professor Peter Cappelli reflected, “The topic has had two basic issues: First, regarding individual performers—can we identify the best talent and quantify the value of specific high performers? The second is organizational—what are the human capital and learning processes that drive overall company performance?” Add the explosion of management techniques, tools and performance-improvement approaches of the past decade—competency-based strategy, knowledge management, job-specific improvement programs, outsourcing and new technologies to analyze human capital data—and you have a virtual jungle of theory and practice that has grown around managing people via measurement and economic principles.

Indeed, this jungle can be very confusing. Beyond often-inconsistent terminology (e.g., differences among human, organizational, intellectual and structural capital), practitioners must wrestle with issues of scope and scale. Are you focusing only on the HR group or on the broader enterprise? Are you taking statistical samples or analyzing every employee in every unit? Are you looking for basic correlations or causal relationships? Are you trying to quantify the past or predict the future? Are you even limiting yourself to employees per se? As IQNavigator’s John Martin noted, “leading companies now use tools to measure the economics of not just their employees, but also contractors and contingent workers—the entire value chain of labor.”

Finding a Way Through the Jungle

So how to make sense of it all? To simplify things, let’s sketch a map of what’s been done and what’s being done across this new landscape and, at the risk of oversimplifying, identify a few major domains and key questions of research and practice.

The first part of the map might be the general theory of human capital—what it is, why it matters and the economic and behavioral modeling of such things as investment and outcomes in training, knowledge and skills. In addition to Becker’s and others’ foundational work, there is now expanding business school research about accounting theory—the kind of reporting measures needed to value human intangibles. Leading researchers here include Ulf Johanson of Uppsala University in Sweden, Baruch Lev of NYU’s Stern School of Business and David Larcker of Wharton.

A related domain is work that links measurable human capital processes and overall economic value. At best, it is well-argued consciousness-raising—“see, this stuff really matters” (e.g., Tom Stewart’s “Intellectual Capital: The New Wealth of Organizations” or Jeffrey Pfeffer’s “The Human Equation: Building Profits by Putting People First”). Other researchers and consultants have explicitly correlated human capital economics with returns to shareholders. For example, Bruce Pfau and Ira Kay of Watson Wyatt demonstrated a positive effect of 21 human capital practices upon stock market performance in their Human Capital Index of 750 large public companies (documented in “The Human Capital Edge” published by McGraw-Hill).

From Measurement to Causality

More aggressive approaches are what we might call “strategic linkage and causality.” These efforts, which have also been around for some time (e.g., Kirkpatrick Level IV), have recently taken a quantum leap in sophistication. Their goal is to identify specific algorithms that determine predictable and replicable business and financial outcomes, based on quantifiable measures of human processes, practices and knowledge application. The fundamental quest, notes Cornell and USC professor John Boudreau, is “to transform HR from program and practice-based activities to a decision-science with the same rigor as financial analysis.”

In “Strategic HRM Measurement in the 21st Century: From Justifying HR to Strategic Talent Leadership,” Boudreau and Pete Ramstad articulate a simple hierarchy that can help guide our map of the human capital economics landscape. At the lowest levels of aspiration are basic economic analyses to improve the efficiency of the HR function, for example, quantifying efficiencies of core processes, such as recruiting (cost to hire), learning (cost of training, time to competence, etc.) and retention (losses due to turnover). More advanced analyses benchmark against other organizations, identifying best practices and how to foster better business outcomes.

More ambitious approaches establish HR dashboards or scorecards. These formulate human-capital-related measures (e.g., retention ratios, educational achievements of workforce, etc.) as complements to key measures in the financial arena. At a corporate level these often become part of an overall “balanced scorecard” that helps companies broaden their definition of success and provide a richer set of indicators of organizational health. Though aiming at human capital effectiveness and not just efficiency, HR dashboards and balanced-scorecard approaches, like many other human-capital-measurement frameworks, for the most part still don’t reach the ideal espoused by the newest generation of economic thinking—more quantitatively demonstrated and causal linkage between specific factors and business results.

That highest level in the quest for the ideal represents the golden ring: applications of human capital economics that establish a causal chain—“If I invest in this kind of skill or improve retention of this talent pool, I can expect this degree of improved profitability.” As organizations master basic measurement and benchmarking programs, they position themselves for more strategic levels of economic analysis. And there is a growing cadre of experts and consultants who are developing and applying such methodologies.

New Methodologies

One example is the HC BRidge, developed by Boudreau and Ramstad, which builds a “decision science” framework they call “talentship.” Talentship is based on three linked anchor points. At the highest level are questions of organizational impact—how a particular talent pool affects financial and other business outcomes. Below that is effectiveness—how specific practices improve the quality of the talent pool that has the most impact. At the lowest level is efficiency, the benchmarkable costs and efforts needed to acquire and manage the pool. The methodology focuses on so-called “pivotal roles”—specific jobs or pools of talent whose quality and actions can distinctively (and sometimes surprisingly) affect business outcomes. Boudreau notes, for example, how the street cleaners in Disney parks significantly contribute to the overall customer experience and thus are selected and trained for skills beyond simply sweeping.

Another approach is taken by Laurie Bassi and Karen McGraw of Human Capital Capability Inc. Theirs, another three-part framework, guides companies to causal relationships between a first level of human-capital-foundational inputs such as “enablers,” “resources,” “operations” and “systems,” a second level of “summative indices” and the resulting impact on the highest level of business results. Current work at a major commercial appliance manufacturer has demonstrated critical linkages between summative measures such as talent retention, learning effectiveness and optimization of knowledge on the one hand, and on the other, safety in manufacturing plants (measured by incidents and days of work lost). Since these measures directly drive productivity and profitability, the project promises a road map of “key economic levers to pull” among human capital practices.

If linking human capital economics to actionable business results is the new imperative, that strategy itself is expanding to an even larger “decision science” related to intangibles and the organization more broadly. The economics of human capital is but a subset of the still more complex structural system of any business, and consultants and researchers are working on methodologies that are accordingly more inclusive. Many performance improvement methodologies (e.g., Peak Performance Systems) include human capital measures among the many variables to examine for enhancing business results. Similary, Low and Kalafut’s work on intangibles includes algorithms for linking financial outcomes not only to human capital, but also to a range of other measurable determinants of success, such as leadership, brand, alliances, etc. And Robert Kaplan and David Norton, who pioneered the concept and development of the “balanced scorecard”—an important landmark in the evolution of human capital economics—have built on their success with that practice and have evolved it to a new and powerful methodology that includes a broad constellation of factors in driving business success. In their forthcoming book, “Strategy Maps: Converting Intangible Assets Into Tangible Outcomes” (Harvard Business School Publishing, 2004), they lay out an approach of “mapping strategy” and aligning it with results founded upon four clusters of key processes (operations, customer management, innovation and social/regulatory). These in turn depend on various sub-processes—one of which is based on human capital. As Kaplan notes, “The original Balanced Scorecard was important work, but we really didn’t drive the causality among variables and outcomes very hard. We soon learned, however, that linking objectives in the four perspectives provided the missing link to connect improvements in human capital to long-term value creation. Now, managers are using Balanced Scorecard strategy maps to measure and manage their intangible assets, such as human and information capital, for customer and shareholder value creation.”

Optimism and Skepticism

Indeed, “the causality question” is the search for the ultimate prize: knowing with some certainty how a change or investment or innovation—whether in the economics of human capital or any other intangible measure—will lead to business value. Certainly more researchers feel that prize is achievable, even if not fully grasped by most organizations today. But like the arguments about weather forecasting—either an imperfect science slowly getting better or a black art whose certainty can never be known—human capital economics still has plenty of skeptics. Wharton’s Larcker has worked on several intangibles projects and laments that “our ability to document true quantifiable causality is not yet at a standard of evidence I’d like to see.” His colleague Cappelli similarly cautions, “A big problem is ‘contextualization’; we don’t understand enough about what kind of human capital process carries over from one organization to another—so comprehensive economic analysis is difficult.”

At the end of the day, how far and how quickly should you embrace the new economics of human capital? As usual, there’s no “one-size-fits all” answer, and the answer for your organization will really depend on some other key questions. Surely establishing and tracking basic measures and putting in place the systems to collect the information are useful steps for any organization. The harder questions are which measures to track and with what purpose and intent. Similarly, you need to be clear about your level of aspiration: Are you trying to drive a new strategy based on well-calculated economics, or are you simply trying to get more disciplined about the efficiency of some HR processes? And how ready is your organization to follow what may be a very new approach to people development and management? Is it being driven only by HR (less desirable), or by line managers and the top team (better)? Even the most enthusiastic practitioners and researchers will advise clients to adapt the new methodologies to the situations and cultures of their individual companies.

But whether your organization proceeds gently or aggressively, bringing more economic discipline to the creation of human-based value in organizations is certainly here to stay. Call it the next chapter of Tom Peter’s famous imperative for the winning organization: “making the soft hard.”

Brook Manville is chief learning officer of Saba, the Redwood Shores, Calif.-based provider of human capital development and management solutions. He consults and writes frequently on organizational learning and development, technology and strategy. For more information, e-mail Brook at

November 2003 Table of Contents