Human Capital ROI: Definition, Formula, and Calculation

Posted by Erik van Vulpen

Whether you’re at a dinner table or at a board meeting, the big “V’ word is inevitably brought up when it comes to the topic of Human Capital. In other words, what value does human capital create? After decades of research and debate, there is finally a way to substantially show the value that human capital adds through measuring human capital return on investment (human capital ROI). Advances in good data practices, measurements, and metrics have been able to demonstrate the value of human capital efforts. 

Human capital as a function exists to recruit, develop and retain the very best talent. By this logic, human capital ROI is a fundamental measurement of employee contribution. But what exactly is the definition of Human capital ROI? How do you calculate it, and why should you use this metric? Let’s dive in.

What is human capital?

Human capital (HC) is an intangible asset that is a sum of the economic value of employees’ experience and skills. The ‘capital,’ in this instance, refers to assets such as knowledge, skills, health, education, etc. There is a distinct difference between human resources and human capital. 

Resources often imply that it is a finite source or that it can be exploited (the term has also been associated with materials, manufacturing, etc.). This is obviously not the way ‘human resources’ is seen. However, the association tends to strongly imply the above meaning. On the other hand, human capital implies, for example, wealth that can be invested in. Talentalign created this diagram which shows the various aspects of HR and HC. It illustrates how they are similar but also differ:

What is human capital ROI?

Human capital ROI (HCROI) is a strategic HR metric that reflects the financial value added by the workforce as a result of the money spent on employees (in terms of recruiting, employee compensation, talent management, training, etc.). It shows the value that employees contribute individually or collectively. The metric is a true reflection of the value of the human capital in an organization.

GrowthForce shows an example of HCROI:

The human capital ROI formula

Calculating the return on investment for human capital is complex. It requires you to allocate a financial benefit to a human capital initiative. This is not always as straightforward because how do you actually know that, for example, a learning intervention directly contributed towards an increase in revenue? There are so many variables that could affect the outcome, including market volatility, change in conditions, and even luck. The ROI Institute, however, developed a model that is able to accurately calculate HCROI. Let’s break it down:

Let’s break down each of the main steps: 

• Evaluation planning – This is the part to clearly define the objectives of your human capital initiative. For example: “Hire three IT network developers” or “Implement a talent exchange program in the marketing department” or “Achieve an Employee Net Promoter Score of +20”. 
• Data collection – This is the collection of data pre, during, and after implementing an HC program or action. During this period, you may collect human capital metrics: hard data (which you can do via HC systems) and soft data (which you can gather in employee satisfaction surveys, on-the-job observation, etc.).
• Data analysis – To calculate the ROI of human capital, this is one of the most important steps. You need to analyze data on two fronts:
  • Isolate the effects of the HC initiative or program – This is important because many factors can influence performance, and you want to specifically measure the impact of human capital. There are many ways to do this, including launching a pilot program, using trend lines to show differences, customer input, external stakeholder feedback, and using subject matter experts to analyze effects. 
  • Convert HC data to financial output – This requires the cost of every human capital program to be accounted for and given a value. This is situation-dependent. As an example, due to a training program, an employee might develop an additional product. That additional product is thus converted to a profit or cost-saving, depending on the initiative’s outcome.

Once you have followed the above steps, you will have enough information to calculate the financial return with this formula:

Human capital ROI calculation examples

Let’s use this formula in a few examples of human capital ROI calculation.

Suppose you roll out a health and wellness initiative in the workplace, costing approximately $250,000. Those are your human capital expenses. The savings (reduction in stress, absenteeism, burnout, etc.) you made from this initiative amounts to $750,000. Therefore:

HCROI = ($750,000 – $250,000)/$250,000

             = 2 (represented as a ratio 2:1)

This means that for every $1 you spent on the wellness program, there was a benefit of $2. There are variables you need to consider, of course, when analyzing things in this way (for example, the measurement period of the cost-saving). As long as the data and time frame are consistent, this is a highly effective way to calculate HCROI. 

Now, let’s say the team decides to invest an additional $10,000 in the program, but it results in an additional saving of $150,000. Your formula would look like this:

HCROI = $900,000 – $260,000/$260,000

= 2.46 or represented as a ratio (2.46:1)

So, for only investing an additional $10,000, that’s an additional benefit of 0.46. Over a long period of time, the value saved is almost insurmountable. Using these formulas is a great way of planning and reflecting. You’re able to see the long-term effects that investing a little bit more into your human capital can have on the financial performance of the organization.

Benefits of using the human capital ROI as a metric and KPI

• Understanding the impact of your human capital initiatives. You can see what results your initiatives bring. That way, all your decisions are data-based, and every dollar spent can be accounted for.
• Showing tangible results of HC initiatives to the leadership. Essentially, you’re able to quantify the business impact of your efforts and show it to the leadership. For example, you’re able to directly translate the results of HC initiatives such as a “talent exchange program” to the financial impact on the business. 
• Identifying and filling the gaps in human capital. The data helps you understand where your organization is excelling and where it lacks in terms of human capital. You’re able to clearly see through data what adding or subtracting human capital will have on the business outcome. 
• Improve your HC processes. Through a variety of feedback mechanisms received as a result of calculating ROI, you’re able to improve your human capital management practices and processes. Along the way, you’re able to make adjustments (in real-time as well) and understand specifically which part of the HC process needs improvements.
• Eliminate ineffective HC processes. You’re also able to close or remove any human capital initiatives that are not effective. If, for example, a talent exchange program is yielding no financial benefits after five years, you’re able to close the program or make adjustments along the way. Either way, you’re able to cut down on costs.

A final word

If you want to measure the tangible impact of your HC efforts, regularly calculating the human capital ROI will be very beneficial. Based on the results, you’ll be able to gain new insights, see opportunities for improvement and bring your HC initiatives to the next level.

https://www.aihr.com/blog/human-capital-roi/

Measuring the return on human capital

Smita Anand, TNN 

The goal for a business is simple: Invest capital so that it maximises shareholder value. But, not so simple are the actions that are needed for a business to achieve this goal.

Successful strategy execution depends on access to intellectual and operational knowhow, customer and supplier relationships, a committed workforce, and other such intangibles. At the heart of making these intangibles come-alive is the firm's investment in human capital.

Capital budgeting and financial planning frameworks offer very little to guide human capital investment decisions; yet manpower costs typically constitute a significant component of operating expenses. However, it is possible to calculate return on human capital with factual analysis, which, in turn, can help develop insights into human capital management and generate sustainable economic returns.

The critical thing is to track critical employees. Our research demonstrates that the flow of pivotal employees in and out of an organisation is a strong predictor of change in CFROI® (Cash Flow Return on Investment).

Talent Quotient (TQ™) is a measure of a company's ability to attract and retain critical employees — those who may be thought of as pivotal to business success. TQ measures two key components, (i) the proportion of pivotal employees joining an organisation as a ratio of all new hires in a given period (TQ-Attract) and, (ii) the proportion of pivotal employees leaving the organisation as a ratio of all employees leaving over a given period (TQ-Retain).

Few organisations understand their employee investments beyond the cost of salary and benefits and fewer still understand the return on their investment in employees. The fact remains that most firms lack a basis for structuring or prioritising human capital investments, and a concrete notion of what return on investment is generated over time.

There are many ways to do it. Let us take a look at a potential area of application, i.e. measuring ROI on talent retention strategies implemented by an organisation.

Measuring ROI on these strategies (e.g. long term incentives, compensation increases, etc.) could appear to be complex, but it actually is a simple task if one de-constructs the key elements that need to be tracked and correlated.

Let us assume that for our purposes 'critical talent' is those employees who are in the top 25% on performance. This would likely translate into these employees also being the top 25% on compensation increases for the time period (this is the investment made by an organisation). The objective should be to ensure that the organisation is able to retain this group of employees better than the rest of the employee population within the organisation (because it has invested more in this segment).

Thus, a way to measure this in a quantifiable manner could be: ROI on talent retention = 1 – (attrition rate of critical talent/attrition rate of all employees). In a market that is constantly witnessing an upsurge in salaries and shortage of skilled workforce, such measurement would enable organisations to invest in human capital in a focused manner. There are other similar simple constructs that explore the viability of talent attraction and other retention investments. The next logical step would be to establish benchmarks and develop predictive tools to help guide organisations make the right investment decisions.

If one were to look beyond the technicalities of any one particular approach, the basic need is for organisations to apply rigor in calculating the returns on the multi-million dollar investments they make each year in their employees and the ways in which they can do so.

Companies need to measure the value that employees bring to the organisation, evaluate their impact on business performance and then align them with the business results. Companies have always measured their investments in more tangible assets such as buildings, equipment and even new products. Why should talent be far behind?

https://tinyurl.com/3decmkej