Human capital refers to the stock of competences, knowledge and personality attributes embodied in the ability to perform labour so as to produce economic value.
It is the attributes gained by a worker through education and experience. Many early economic theories refer to it simply as workforce, one of three factors of production, and consider it to be a fungible resource – homogeneous and easily interchangeable.
1. Introduction to Human Capital 2. Meaning and Definitions of Human Capital 3. Categories of Human Capital Risk 4. Human Capital Development
5. Valuation Approaches and Models 6. Measures to Value Human Capital 7. Practices 8. Requirements for Maximizing the Value of Human Capital.
Human Capital: Meaning, Definitions, Risks, Valuation, Measures, Practice and Other Details
- Introduction to Human Capital
- Meaning and Definitions of Human Capital
- Categories of Risk of Human Capital
- Human Capital Development
- Valuation of Human Capital
- Measures to Value Human Capital
- Practices of Human Capital
- Requirements for Maximizing the Value of Human Capital
Human Capital – Introduction
Liberalisation, privatisation and globalisation all over the world, has created the need for quality products and quality service. It in turn necessitated organisations to compete with one another to improve the quality and devise cost reduction measures to exist in the industry. That could be done only with the development of human capital which is evidenced by the rapid economic growth of Japan and other East Asian countries.
The investment in human capital cannot be easily measured as it differs from one person to another. Basically, when we talk of human capital it refers to the human knowledge, their inner capabilities and creativity. The development of technology cannot be fully utilised without knowledge and skill. The capabilities of the human capital in relation to the needs of the organisation should be improved by creating a climate in which the human knowledge, skill, capabilities and creativity can be developed.
How do we develop our human capital and put it to optimum use is the challenge faced by the present day corporate sector. Technological improvements, business strategies, quality concerns etc., will have no meaning without people (human capital). So it is people who make all the difference. People and their development only can meet the needs of globalisation and liberalisation. The human capital available in the organisation should be rightly assessed and developed through motivation, training and direction.
Only then, the organisational goals can be achieved. The computer technology offers greater precision but demands different skills. The owners (personnel) of these new skills are both technically educated and trained on the job. It is the human capital which should rightly be invented for the qualitative improvement of human beings who are considered the most valuable asset of an organisation. Thus, the Human capital refers to the basic skill, capabilities, the perception, know-how and expertise.
Every individual has certain skills and understanding. The education one has undergone should help him to develop knowledge in general. Till one gets basic employment he is not keen on planning his future and there is uncertainty. This is normal in most of the cases except a few. As one is placed in an organisation in some position, he starts to look for elevation. The organisation too would tap his basic skills and capabilities and divert them to achieve the goals of the organisation and in the process it attempts to develop his basic skill through proper training, motivation and direction.
The human capital is rightly put through for effective functioning, right decision making and career development. In all these, it creates value for the organisation and makes it more stable in the competitive environment. At last, the cliche ‘people are our most important resource’ has actually come to mean something. Today, more than ever, the management realises that the most effective asset in an organisation is its people. In fact it is obsolete to say people are the most important asset, rather they are the only dynamic asset.
Nothing happens without people money, equipment, technology. Nothing means anything without a human to act. Hence, the management has slowly realised the importance which in turn has edged Human Resource (HR) from the background into mainstream organisational strategies. Having moved to the center stage is not the end. It has to sustain its stand and move even further and for that to happen HR must learn the language of organisations and management, i.e. it has to talk in quantitative and objective terms.
Time and again, every manager has always stated ‘You can’t manage what you can’t measure’. Organisations are managed with quantitative data. Today, HR has also got into the game. It has learned the terminology of the organisation’s financial statements and has begun to contribute in this area. Universally, HR is emerging as a front line strategic player. Every organisation has its eye on the bottom line and all the units work to demonstrate their contribution to service, quality and performance.
It is to be remembered that every unit affects business results and every function is a value-adding operation. Hence, it is imperative to be able to measure this contribution objectively. An organisation uses HRA Asset models when it focuses on assessing its investment in the human capital. In contrast, organisations that intend to measure the economic effects of employee’s behaviour tend to utilize the HRA Expense models. This has led HR to finally attempt to account for an organisation’s intellectual capital.
Tangible assets can be easily valued. How does one evaluate intangible assets such as creativity, service standards etc., Intellectual capital such as knowledge, skill, information, experience etc., helps create wealth that can’t be easily assigned a price? To date, there is no clear agreement in the accounting profession about how to account for them.
Yet the role of intangible assets such as brand names, intellectual capital, patents etc., in their contribution to increase the amount of wealth in firms, can’t be ignored. The shift to a knowledge-based economy has created entirely different categories of assets, popularly known as “soft assets”, that are not recognised in financial statements.
Human Capital, Structural Capital and Customer Capital comprise of a company’s Intellectual Capital. Even though all the three are intangible, they can be measured and targeted for investment. Human capital represents knowledge, skills and capability to provide solutions to problems that customers think are important. Enabling human capital requires other structures such as software manuals, customer files etc. Customer capital is the value of an organisation’s relationship with whom it does business including suppliers.
Human Capital – Meaning, Background, Origin of the Term and Definitions
Human capital refers to the stock of competences, knowledge and personality attributes embodied in the ability to perform labour so as to produce economic value. It is the attributes gained by a worker through education and experience. Many early economic theories refer to it simply as workforce, one of three factors of production, and consider it to be a fungible resource – homogeneous and easily interchangeable.
Adam Smith defined four types of fixed capital (which is characterized as that which affords a revenue or profit without circulating or changing masters).
The four types were:
1. Useful machines, instruments of the trade;
2. Buildings as the means of procuring revenue;
3. Improvements of land;
4. The acquired and useful abilities of all the inhabitants or members of the society.
Smith defined human capital as follows:
“Fourthly, of the acquired and useful abilities of all the inhabitants or members of the society. The acquisition of such talents, by the maintenance of the acquirer during his education, study, or apprenticeship, always cost a real expense, which is a capital fixed and realized, as it were, in his person. Those talents, as they make a part of his fortune, so do they likewise that of the society to which he belongs. The improved dexterity of a workman may be considered in the same light as a machine or instrument of trade which facilitates and abridges labour, and which, though it costs a certain expense, repays that expense with a profit.”
Therefore, Smith argued that the productive power of labour are both dependent on the division of labour –
“The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgment with which it is anywhere directed, or applied, seem to have been the effects of the division of labour”.
There is a complex relationship between the division of labour and human capital.
A.W. Lewis is said to have begun the field of Economic Development and consequently the idea of human capital when he wrote in 1954 the “Economic Development with Unlimited Supplies of Labour”. The term ‘Human Capital’ was not used due to its negative undertones until it was first discussed by Arthur Cecil Pigou – There is such a thing as investment in human capital as well as investment in material capital. So soon as this is recognised, the distinction between economy in consumption and economy in investment becomes blurred.
For, up to a point, consumption is investment in personal productive capacity. This is especially important in connection with children – to reduce unduly expenditure on their consumption may greatly lower their efficiency in after-life. Even for adults, after we have descended a certain distance along the scale of wealth, so that we are beyond the region of luxuries and “unnecessary” comforts, a check to personal consumption is also a check to investment.
The use of the term in the modern neoclassical economic literature dates back to Jacob Mincer’s article “Investment in Human Capital and Personal Income Distribution” in The Journal of Political Economy in 1958. Then T.W. Schultz who is also contributed to the development of the subject matter. The best-known application of the idea of “human capital” in economics is that of Mincer and Gary Becker of the “Chicago School” of economics.
Becker’s book entitled Human Capital, published in 1964, became a standard reference for many years. In this view, human capital is similar to “physical means of production”, e.g., factories and machines – one can invest in human capital (via education, training, medical treatment) and one’s outputs depend partly on the rate of return on the human capital one owns. Thus, human capital is a mean of production, into which additional investment yields additional output. Human capital is substitutable, but not transferable like land, labour, or fixed capital.
Modern growth theory sees human capital as an important growth factor. Further research shows its relevance for democracy or AIDS.
Human Capital – 4 Primary Categories of Human Capital Risk
When Human Capital is assessed by activity based costing via time allocations it becomes possible to assess Human Capital Risk. Human capital risk occurs when the organization operates below attainable operational excellence levels. For example, if a firm could reasonably reduce errors and rework (the Process component of Human Capital) from 10,000 hours per annum to 2,000 hours with attainable technology, the difference of 8,000 hours in Human Capital Risk. When wage costs are applied to this difference (the 8,000 hours) it becomes possible to financially value Human Capital Risk within an organizational perspective.
1. Absence activities (activities related to employees not showing up for work such as sick leave, industrial action, etc.). Unavoidable absence is referred to as Statutory Absence. All other categories of absence are termed “Controllable Absence”;
2. Collaborative activities are related to the expenditure of time between more than one employees within an organizational context. Examples include – meetings, phone calls, instructor led training, etc.;
3. Knowledge Activities are related to time expenditures by a single person and include finding/retrieving information, research, email, messaging, blogging, information analysis, etc.; and
4. Process activities are knowledge and collaborative activities that result due to organizational context such as – errors/rework, manual data transformation, stress, politics, etc.
Human Capital – Development
Human capital may be defined as the knowledge, skills, competence and other attributes embodied in individuals that are relevant to economic activity. Human capital is therefore a notion that captures the valuation of the attributes people invest in, including the know-how, capabilities, skills and expertise of the human members of the organization. It is therefore the single most important asset a company has access to.
By definition it cannot be duplicated by other companies and can therefore be a source of sustainable competitive advantage. However, there is a downside that companies have to cope with. When employees leave an organization, it essentially implies that there has been a loss in the human capital of the company. Today, companies do not hire a person; they hire a person’s knowledge.
It is essential to invest in a company’s human capital, not by simply taking on more people but by investing more in the existing community, through training and by providing the workforce with the necessary means to perform in a pleasant working environment. Skills can be added to the workforce by allowing them to explore new areas of interest and thereby adding to their own knowledge. The most valuable employees will be those who have a broad knowledge base including the ability to put that knowledge to practical use through experience.
Human capital valuation is not an end in itself. It is only a tool that can be used for developing the people resource of an organization, and for enabling a constant monitoring of the success of policies of recruitment, selection, motivation and retention of the best people. Ergo, a drop in the value-so long as methodology is constant will indicate a dip in the quality of its people even if the decline is not visible in the quality of the products and services.
Yet, in this context, it should seem natural that one of the indicators of the human capital of a company would be the availability of man power within the company to take over posts of responsibility when the need arises. Although companies that are currently valuing their human capital are merely using the valuation in the context of accounting implications, human capital valuation has a lot of potential sues. Properly sued, with adequate measures to address emotional issues of employees, human capital valuation can be a very effective tool for motivating employees.
It can acknowledge the roles played by an employee in the organizations, indicate his/her worth and suggest how it can be enhanced by acquiring more knowledge and skills. The potential of employees can be assessed and used, as a flow variable to determine the growth of internal resources the figures can also be an indicator of the future performance of companies.
It also helps companies design future strategy including the future growth of employee strength, designing remuneration, packages for the employees, estimating the replacement costs for employee etc. human capital valuation can also be used for evaluating the price of a firm participating in mergers and acquisitions deal, particularly when the company’s stocks are not traded in the market and internal valuation is the only way to fix the reference price.
Human Capital – Valuation Approaches and Models
Globalization, competition, technology and wide access to financial capital are narrowing opportunities for competitive environment. Companies are being forced to look at long term, sustainable sources of strategic advantage, and many are turning to their real assets-their people. In the shifting industry paradigm, companies are aligning their human capital with their strategic objectives.
Human capital is one of the buzzwords of the knowledge society. The concept laid dormant for two centuries after Adam Smith first introduced it, but it was revived in the 1960s by American economists, such as Gary Becker and Jacob Mincer, who then exported it triumphantly around the world. Human capital is a beautifully unifying idea facilitating quantitative analyses. It is an excellent vehicle for framing policy discussions too, whether on schooling, training or labour market performance.
With companies realizing that people give them the winning edge, valuing the human capital becomes significant. However, the subjective elements of human capital create difficulties in arriving at objective measures. Other issues like ethical and emotional aspects also need to be clarified before one starts valuing an individual. But companies differ in the models they use to value human capital.
An attempt has been made here to develop a model that can be used to value the human resources of organizations. Many models have been created to value human capital, some are based on input measures like salary paid and training expenses, and others are on output measures like productivity and efficiency. Each has its own limitations.
The detailed description is as follows:
i. Cost Based Approaches – This model is based on historical cost, cost of acquisition, training and development of individuals and organization. Replacement cost method – Based on cost of replacing individuals and rebuilding cost of human organization to reflect the human resource asset value.
ii. Economic Models – Goodwill Method – Based on the assumptions that HCV is the extra profit earned by an organization compared to the industry average rate. Adjusted discounted future wages method – Based on the assumptions that present value of future wages payable for next 5 years discounted at the adjusted rate of return is the human resource value.
iii. Jaggi and Lau Model – The human resource value is dependent on rank and performance rating. Assuming the past trend to continue in future estimation on retirement, death and service movements need to be arrived at present value of likely services from employees relevant to different service states considered is human resource value.
iv. Behavioral Models – Likert Model aims to establish through psychological test results, how a set of causal variables reflecting an organization’s management systems determining the depreciating or appreciating of human assets.
Indian Scenario – Indian companies have started treating their human resources assets. BHEL and HMT were pioneers in this field. They valued their human capital around 1980. In the late 90s, with the growth of the knowledge industry, the valuation issue took center stage. Infosys brought the issue back into focus by valuing its human capital in 1996-97.
Since then many companies have followed suit, viz., BPL, Reliance, TCS, Satyam computers, Pentafour, and Balrampur Chini Mills to name a few. To augment the literature in this field. Indian Management institutes have started offering courses in Human Capital Valuation.
Human Capital – 5 Main Measures to Value Human Capital
HR professionals have always been trying to develop measures to value human capital.
Some of the measures utilised are:
Genuine innovation always commands a premium. All companies are always striving to be different from the others and to stand out from the rest. In this endeavor, new products, ideas,(and strategies are the order of the day and now companies are learning to assess this aspect of creativity in the language they well understand, that is the language of finance.
Above all it is only employees’ attitude about the job and the company, which gets reflected in their behaviour towards the customers. That behaviour in turn translates into customer’s retention, recommendations and loyalty, which in turn get reflected in financial performance. Hence, behaviours and attitudes that affect performance are being measured. Some of the attitudes measured are satisfaction, locus of control, organisational involvement and commitment, and motivation, and the behaviours often measured are performance, adjustment, absence or illness and voluntary turnover.
These indices that comprise of a company’s inventory of knowledge workers need to be quantified. Quantifying tenure, turnover, absenteeism and experience is quite simple when compared to learning. Turnover normally represents a substantial cost to business. In measuring turnover, an organisation has to consider three major, separate cost categories – separation costs, replacement costs and training costs.
In addition, the difference in currency valued performance between those leaving and their replacements should also be considered. Similarly, the rate of absenteeism is first calculated and then the cost of absenteeism can be estimated using set formulae and procedures. This cost would include employee-hours lost, supervisory hours lost and all other costs incidental to absenteeism, compensation, benefits, etc.
Sharing, transporting and enabling human capital require other structures or organisational capabilities. Structural capital consists of everything that remains when the employees go home namely, databases, customer files, software manuals, trademarks and organisational structures. In order to find out if a company’s systems are helping or hindering its employees to perform to their optimal level measures such as production- to-market time, suggestions versus implementation, databases at estimated costs, etc., are accounted.
There are many objective ways to measure customer satisfaction. Some of the common measures are customer retention rate, brand equity and customer satisfaction. When customer satisfaction is linked to performance management for individual employees, it can generate helpful data for the 360 degree feedback of employees.
Earlier, for HR programmes, it was sufficient just to collect data and calculate the cause and effect of those programmes. Today, the ultimate aim is to evaluate not only the return on investment and business impact but also to be able to convert these data into monetary values and compare them with the HR’s fully loaded costs.
Human Capital – Practices of Human Capital Management
The main practices of human capital management can be shown below:
Development of people in an organization is very important. Previously talks were about People Capital in an organization, which became Human Capital Value (HCV) in latter stage. Both of these were good starts at recognizing the value of its people to any business. However, we need to do more than recognize that people have a value to the business.
We need to understand and acknowledge that people are the most important asset of any business that hopes to be successful for the long term. People are capital focuses attention on the preeminence of people as an asset to the business. We look at what businesses can do to take advantage of the skill and knowledge of their people, whether employees, contractors, or other suppliers.
i. We document how businesses succeed by carefully managing these people-related assets.
ii. We offer ideas and training for managers and executives who want to improve their utilization of their people in order to improve their businesses.
The following components may help to manage the people in an organization:
Self-directed, or self-managed, teams are not new. Their utility in business situations is well documented. One aspect of the value of such teams that is often overlooked, however, is their ability to effectively manage the competency levels of the team members.
Self-directed teams are frequently created within traditional business organizations either to address cross-functional issues or to promote employee empowerment. They also are found in non-profit companies and in non-business organizations, such as social clubs. One of the more recent appearances of self-directed teams is in “virtual” corporations.
“Virtual” corporations are formed when several individuals, or small companies, band together to pursue a business opportunity. Usually it is an opportunity for which that the individual or small company could not successfully compete on their own. This can be due to lack of specialized expertise or simply lack of size. By teaming with others, they can overcome their handicap. These virtual corporations are a prime example of how self-directed teams manage incompetence.
The timings are usually short-term, like the business opportunities they pursue, but are often repeated frequently. A group of 10 individuals may have a long term understanding, which allows them all to work together smoothly. On any given team, a smaller number of group members may participate based on the opportunity. Which members participate changes frequently, depending on the needs of the group? In cases like this, an individual or small company simply will not be included in those opportunities for which they are not qualified.
The group self-selects the best members for the opportunity. Incompetents just are not selected. If the team continues to select an incompetent, perhaps because he is the only one in the group with a specific area of knowledge, the group will not be able to compete as effectively. In time, they will either cease to exist or they will replace the incompetent with another individual with the level of expertise needed. Self-directed teams can function in this same manner within a company.
There are many requirements for a self-directed team to be successful. In terms of managing the competence levels of their members, however, the key requirement is flexibility. The team has to be given authority to add or remove team members. This does not have to be total authority. The company can, and should, place guidelines around the process.
However, the team must be given sufficient latitude to adjust the composition of the team that they can achieve their objective. If they have this latitude, and if they are committed to achieving their objective, they will either exclude incompetent members or they will move them to a position where they can contribute.
Self-directed teams are one way to flatten the pyramid. Others should be explored. The more we can remove the hierarchy from the organization structure, the less pressure there is on an individual to continue to seek promotion to “higher” levels, even to levels for which they doubt they are qualified.
We also provide an opportunity for individuals to move laterally in their search for challenging, fulfilling work rather than always having to move “up”. Finally, there is less resistance on the part of the individual to moving back down, and there are a greater number of options for the company that needs to move someone to a different position.
The flatter the pyramid, the greater the flexibility you have to manage. Don’t create organizational levels that are not required. Take full advantage of self-directed and matrix teams in your efforts to flatten the pyramid. Not only will you get a more responsive organization, you will be able to limit the number of individuals who rise to their level of incompetence, only to get stuck there.
The Five P’s of Leadership – leading to effective people management
There are whole libraries full of things that tell you what to do about leadership and how to remember what’s important. Here’s another short edition to that library – the 5 P’s of leadership.
i. Pay Attention to What’s Important
ii. Praise What You Want to Continue
iii. Punish What You Want to Stop
iv. Pay for the Results You Want
v. Promote the People Who Deliver Those Results.
Human Capital – Requirements for Maximizing the Value of Human Capital
Human Capital Development (HCD) is the term increasingly used to describe the process of managing how valuable people are acquired, developed, deployed, motivated and retained. Among the traditional business functions that need to be incorporated and coordinated within HCM are recruiting, hiring, worker contracting, training, development, succession planning, project assignments, benefits and compensation. The primary objective of Human Capital Management (HCM) is to maximize the value of an organization’s human capital.
The Human Capital Development (HCD) philosophy is based upon three major principles:
i. The value of an individual represents to an organization is derived from their unique combination of job-related knowledge, skills, attitudes and motivations which determine their on-the- job behavior and achievements.
ii. Relevant human assets do not just include full-time permanent employees – they may include individuals who are part-time employees, temporary employees or independent contractors. In a collaborative commerce environment, relevant human assets may include certain individuals who are employees of suppliers, employees of sales channel partners, and even employees of customers.
iii. A person’s relationship with an organization has a life-cycle that needs to be nurtured and managed for maximum lifetime value.
Human Capital Management might also be thought of as “Employee Relationship Management” and has many parallels with Customer Relationship Management (CRM). Like CRM, HCM seeks to maximize the lifetime value of an asset by managing all stages of an integrated life cycle process that consists of acquiring, developing, deploying, motivating, and retaining it. It is widely held that it is 5 to 10 times more profitable to nurture and expand an existing customer relationship rather than have to create a new one to replace a lost customer. A similar dynamic exists in employee relationships.
There are two major requirements for maximizing the value of Human Capital:
(a) Job-related knowledge, skills, attitudes, motivations and behaviors must be specifically targeted at (i.e., aligned with) executing the business strategy and achieving strategic objectives at all levels of the organization, beginning with each individual and rolling up through each workgroup, department, and business unit.
(b) HCD must be viewed and actively managed and optimized (in terms of total organizational costs and benefits) as a single integrated end-to-end process that is of strategic importance. For example, there is no value in doing a great job recruiting top people if you can’t retain them. There is no value in training people unless you know the learning actually changes behavior that supports executing the business strategy. It’s unreasonable to expect appropriate behavior and achievement if it’s not being measured and rewarded.
The top management consists of such valuable capital that plans and makes strategies, is visionary and capable to lead and motivate the rest of the people. Middle level is the valuable capital of the organisation, which is very competent, is performer and achiever. Empowered to take decisions and Delegate authorities these personnel form an important link between the top and lower levels of management in any organisation.
Then there is an individual, who is the committed, talented, performs and carries out the strategies and achieves the targets set through his skill. Once which was just a resource to an organisation is now an asset – capital of the organisation.