Human capital management: its history, background and evolution

Section one of the Personnel Today Management Resources one stop guide on human capital management (HCM), providing an introduction to the background, history and evolution of HCM and a summary of the different agendas in the HCM debate. Other sections .

Who is this report aimed at? This report is written by an HR professional, from an HR perspective, for HR professionals. It is aimed not only at those who just have a professional interest in human capital management (HCM), but also those who need to be able to provide practical guidance and advice to their own organisations about the latest developments. This will range from giving basic guidance on human capital reporting, right up to starting a discussion about what an HCM strategy might look like and how it will provide a significant competitive advantage. However, HCM is most definitely not just a subject for the HR department. CEOs, board directors and even line managers will all have to understand HCM at some stage, and this report can be used to introduce them to the subject in a very simple, jargon-free way. It should also be useful to financial analysts wanting to have a better understanding of what really constitutes HCM in practice. Also, while most of the current interest in HCM is emanating from the publicly-quoted commercial sector, the principles and practice of HCM are equally applicable to those who work in the public and not-for-profit sectors.

Why you should be looking into HCM

It might seem like the latest jargon but human capital management (HCM) really does regard human beings as potentially very valuable capital.

City analysts and business academics have finally started to convince CEOs and finance directors that there is a golden nugget of truth, after all, in that tired old cliché that people are indeed their greatest asset. The evidence is plain. It is now fully acknowledged that there is a wide discrepancy between market valuations of businesses (based on share price) and their actual book value (tangible assets like offices, stock and money in the bank). In other words, the price that a business will fetch can often be much higher than the sum of its parts.

One possible reason for this is that conventional accounting practices fail to measure the things that really matter - the intangibles. Moreover, the intangibles are mostly related to the human facets of organisations such as talent, capability, creativity, innovation, knowledge and levels of service. Now they are all wrapped up in this catch-all phrase: 'human capital'. This could have significant implications for al of us. So what should the concept of human capital really mean for you and your organisation?

In certain cases, it is obvious just how much value an individual can bring. David Beckham was worth about £25m to Manchester United football club when he was sold to Real Madrid. While banking group HSBC suffered the loss of five of their top fund managers when they defected to their competitor Cazenove in 2002. It also lost much of the business that went with them, and this could easily be counted in millions of pounds.

As they say in the small print: 'investments can go down as well as up'. The first lesson from a human capital perspective, therefore, is people are worth nothing if you cannot hang onto them. So it might not be that long before we see attempts to create a transfer market in the corporate job market. HCM could really mark a significant change in the world of management.

But human capital is not meant to be just about the naturally talented, high-fliers or star employees. They, by their very nature, tend to stand out from the crowd. A focus on human capital will be a focus on every single employee. It is turning the accountants' obsession with the wage bill on its head and getting them to constantly ask the questions 'what value is being realised?' and 'what are the accrual rates?'.

As with any new development, there will always be a temptation to write it off as just another fad, but anyone who is thinking about adopting such an attitude to HCM needs to think long and hard and tread carefully before they write this one off. HCM is about gaining a serious competitive advantage. If you don't take it seriously and your competitors do, you may find you have to start explaining to your shareholders (or stakeholders) why their results and annual reports are starting to look so much more impressive than yours.

In addition to the commercial impact, there could also be a specific requirement by law to report on your human capital. We could then have the basis for a league table of progressive employers, where a healthy profit and loss on its own will not be enough to ensure you stay in the premier league.

Companies that currently make the most of their profits through market domination (Microsoft) or possibly fortuitous circumstances (was Body Shop just the right sort of products at the right time) will not score enough points if they are seen to be squandering the loyalty, commitment and intrinsic value of their most important asset - their people. Of course, city analysts like to see sparkling results but they take a dim view of any organisation failing to realise its full potential. Under-utilisation of human capital will be a sure sign of dropping into the relegation zone.

Can HCM be applied to the public sector as well as PLCs?

With all this focus on real value in pounds and market value, those who work in the public or not-for-profit sectors might conclude that HCM has no relevance for them. This would be a complete misunderstanding of what HCM is really about. Certainly, from a Company Law Review (CLR) perspective, it is unlikely that public sector organisations will have an imminent HCM reporting requirement simply because they do not fall within the remit of this review. However, it is unlikely that the Government will impose HCM reporting requirements on the commercial sector without wanting something similar from what is, after all, one of the largest employment sectors in the economy and funded out of taxpayers' (and voters') funds.

Regardless of any future public sector reporting requirements on HCM, there is also the huge potential benefits to be gained from adopting an HCM strategy. Imagine the NHS, police, education, local government, civil service and central government departments achieving the sort of levels of efficiency that Toyota has managed over the past 40 years? (see Section 2). This could save taxpayers billions of pounds while maintaining or even improving existing quality standards. This is much too attractive a proposition for any government to ignore.

There is one major difference though when applying HCM to the public sector - value can be interpreted more in terms of quality of service than monetary efficiency. For example, take a library service run by a local authority. Cutting the number of libraries to save money cannot be regarded as adding value because the service to the community has also been reduced. Added value is about getting more with less, not cutting corners.

However, introducing HCM should make libraries more efficient and save money but the authority could take a decision to use the savings to provide a much better library service. This is how value should be interpreted by public sector organisations: the level of service provided per pound spent. That is what public sector employers should aim to maximise through HCM, just as a commercial bookshop could reinvest profits to provide a coffee bar for customers to provide an additional revenue stream.

Why your finance director is interested in HCM

One person you will not have to convince about HCM is your finance director. Accountants are only too painfully aware of the shortcomings of their traditional accounting practices and financial reporting conventions and mechanisms. Their 'technology', such as double-entry bookkeeping, profit and loss accounts and balance sheets has been around, virtually unchanged, for hundreds of years. They were designed for 'bean counting' not valuing people potential. They also tend to rely on historical data, which is not very useful for predicting future success. Consequently, they should be eager to re-visit some of their conventional beliefs about how to manage an organisation's finances, as long as you can convince them this human capital idea will generate real value and attractive returns.

HCM is really starting to challenge some of the basic building blocks of accountancy such as 'overheads'. While the concept of overheads makes sense in terms of buildings and fixed assets, it has always seemed wanting as a means for assessing people. Many of the costs associated with employing people are shown as overheads simply because accountants do not have anywhere else in their accounts to put them. Likewise, with the company's investment in training and development, this is shown under overheads, not because they are a genuine overhead by a strict accountant's definition (training and development expenditure is infinitely variable), but because there is no specific item in the accounts for 'people' expenditure that generates a return.

But the problem is not just one of terminology or accounting convention. One of the biggest problems associated with viewing people as an 'overhead' is that it has negative connotations: no one will ever argue for an increase in overheads. Yet, if human capital is to mean anything at all then it should be seen as an under-utilised investment, not an overhead. If it is treated as an overhead, it will always be constrained for no good reason.

Progressive leaders genuinely want to believe that the way in which they acquire, develop and maximise human capital really does produces value, but they currently have no way of demonstrating this. HCM therefore holds out the promise of a methodology to do just that.

The HCM revolution?

HCM is probably the biggest subject to hit the world of management and organisational theory since the advent of total quality management (TQM) in the 1980s. However, if HCM is ever to realise its full potential, it will require nothing short of a complete revolution in the way organisations are managed. In particular, a revolution in the way people are managed.

Anyone who has ever worked in a large organisation and asked questions about its performance, effectiveness and value will already, intuitively, have come to the conclusion that the way employees are selected, recruited, managed, motivated, developed and rewarded is bound to have some impact on the bottom line. However, understanding that there must be a connection is one thing, actually putting a monetary value on the size of that impact is something else entirely. That prospect is now so tantalising that it has become the Holy Grail for many business commentators, observers and management academics.

These questions have been asked for some years now, and so HCM is the culmination of a very long journey. The full story probably dates back as far as the Industrial Revolution, but we will pick it up in the 1960s and 1970s, when academics researching conventional accounting practices (see Section 2) tried to develop methods to put a measurable value on what they referred to as human 'assets'.

The general approach they adopted though was still to apply conventional accounting principles to a subject for which they were never designed, and 'human asset accounting' had a very short shelf life. There was never really any attempt to take a completely fresh perspective on the value that people might bring to an organisation. It was still 'bean counting' by any other name.

From a historical perspective, we could be forgiven for viewing these early attempts at measuring human capital as ill-conceived and rather clumsy. One reason they never really gained a serious foothold in management thinking though was because they failed to answer the simplest but most important question - 'what are your people worth to you?' - with any clarity or conviction. They also failed to produce anything of any practical use. Nevertheless, the questions did not go away because it was obvious that whoever provided the best answers to this question would have found the source of a potentially enormous competitive advantage.

More than three decades later, measuring people is once again becoming a big issue. The same questions are still being asked but with even greater urgency; especially as the markets in countries such as India and China start to develop on such a huge scale and at a breakneck pace.

Jobs are now being transferred across a global economy, and the older, more developed markets in the West have some serious thinking to do about where they will be placed in this new world order. If a nation's people are its greatest asset, the need to get the best out of them assumes an even greater importance. But HCM is not high on the agenda just because of potential threats to labour markets. It also provides some fantastic opportunities.

Some of the greatest business success stories of the last two decades (Microsoft, Cisco Systems, Oracle) have been founded on intellectual property and sheer brainpower rather than financial strength, physical assets, machinery, equipment or even technology. This has not gone unnoticed in Wall Street or any of the other major financial centres around the world. These analysts are highly influential and have a vested interest in putting some real financial value on the difference that such human and intellectual capital (often referred to as intellectual property rights or IPR) brings compared to any other type of resource. It is also now clear that the market value of an organisation is often much greater than its book value or the sum of its tangible assets. So the big question is how much of this difference can be specifically attributed to the management and measurement of human capital?

All of this leads to HCM being the hottest management topic of the day. This guide aims to summarise the current debate and provide definition, clarity of purpose and practical help. It will synthesise many of the competing models and theories into one coherent view of the whole topic. This will then be used to offer a simple, workable methodology to get you started with some clear suggestions, recommendations and practical tools and tips. This should enable you to get to grips with HCM and get the most out of it.

Let's start by asking some simple questions about what HCM is meant to be. By doing so, it will help you to understand the full extent of the interest in HCM and its potential implications. Is it a subject of real substance, or is it just another case of business hype with HR smoke and mirrors?

If HCM is the answer, what was the original question?

HCM seems to mean a lot of different things to different people. This confusion arises out of the fact that there are many stakeholders in the HCM equation (for example, Government, board directors, shareholders, financial analysts, HR, employees, society at large) who have different objectives and different agendas (such as 'what has HCM got to offer the diversity debate?'). So let us look briefly at what some of these might be; but this list is certainly not meant to be exhaustive.

Whose agenda?

1. City analysts' and shareholders' agenda

Those who make their living out of investing in plcs quoted on the stock markets want to maximise their returns. If we ignore for a moment the speculators and those who like to play the market, there is a significant amount of funds tied up in the FTSE 100 or 250, and these are meant to be organisations with a good track record of sound management combined with a responsiveness to market changes. Often indicators such as a Standard and Poor's (S&P) rating will reinforce feelings of confidence about a company.

These analysts do not want any nasty surprises, such as Enron, WorldCom or Parmalat, but they also want a high level of confidence that their investments are going to grow. They are acutely aware of the differing fortunes of competing companies and they want to know what are the crucial ingredients of success. They are increasingly coming to the conclusion that one key difference is the way a company organises and manages its people.

This agenda is clearly to do with what HCM can contribute to measurable, bottom line, pound sign value, profits, dividends and share price in the long term. It is also possible that one day an S&P rating might be produced for HCM as a quick, overall indicator of sound, human capital management practice.

2. Boardroom agenda

Chairmen, CEOs and their boards of directors have to answer to their shareholders, so they are bound to have a similar agenda and would also like to maximise value. However, they have a slightly different perspective in that they are the ones who will have to actually deliver it. This is no mean feat. It is one thing to profess that 'our people are our greatest asset', and another to actually get the best possible return on that asset.

So there are conflicting views in those boardrooms where HCM is being discussed. Is it an opportunity, or is it a threat to their complacency with a steady but not sparkling performance? If they are ignorant about what HCM is or what they might have to do then this will inevitably breed fear and resistance.

This agenda is probably best summed up as 'we want the value from HCM as long as the price we have to pay in terms of risk, uncertainty and effort is not too high'.

3. HR's agenda

The HR agenda is multi-faceted. There is the Chartered Institute of Personnel and Development's (CIPD) agenda as a professional body. It needs to ensure that its members are given guidance and advice on any legal reporting requirements that come out of the advent of HCM. It could also take the view that its members should have the necessary knowledge and skills to provide advice to their own boards. It is not surprising therefore that the CIPD will be producing its own guide to HCM.

Meanwhile, HR directors themselves will have one foot on the boardroom agenda (how much 'pain' do I personally have to go through?) and one on the 'professional' agenda ('can I answer whatever questions are thrown at me about our 'human capital?').

The more positive and forward-thinking HR professionals will see this as a great opportunity to prove what they can contribute to organisational value and, thereby enhance their career prospects and bank balance.

Many HR academics also have their own agenda, which is to see if HCM will finally prove what they have always suggested - that people are indeed the organisation's greatest asset after all.

4. Corporate governance and reporting agenda

Agendas 1 to 3 above are probably the most obvious and straightforward. This agenda is much murkier. The high-profile business collapses of the last few years (such as Enron), the whole debacle over fat cat remuneration (JP Garnier at GSK), and the scandals surrounding mis-reporting - the latest being the Shell reserves fiasco - have all combined to put corporate governance under a very harsh spotlight. One outcome of all this is the Sarbanes-Oxley Act of 2002 (see Section 5).

You also need to be aware that in the background, a fundamental review of company law in the areas of reporting and accounting has been taking place, culminating in the Final Report of the Company Law Review (CLR) published in July 2001. One result of this will be a requirement for companies to produce an Operating and Financial Review (OFR) to report on a company's performance and future plans.

These developments have conspired to place greater emphasis on accurate and informative reports, which will inevitably have to include reports on how well a company is managing its people. It is really just coincidental that these developments have happened at a time when the term human capital has come to prominence. Hence, the people reporting requirements have now just become human capital reporting requirements.

5. Political agenda - UK productivity, diversity

The last agenda we will consider is what could be termed the 'political' agenda. As with any political issue, the agenda is likely to be a movable feast and any change in political priorities - such as a sudden drop in employment - could easily put a very different complexion on the purpose and possible benefits of HCM from a government perspective.

Two current political drivers for HCM are the need to close the UK's productivity gap with competing nations, and a desire to promote a policy of diversity. Both of these aims could be well served by an effective approach to reporting on how well human capital is measured and managed in organisations.

Of course, this also means that HCM is not just for plcs. If HCM works in commercial companies, then the Government would obviously want to learn some lessons for applying it in the public sector. The cost of human capital in the public sector is huge and any greater value would be more than welcome. So this report should not just be viewed as something for the private sector only.

The value agenda

As you can imagine, when there are so many different stakeholders, agendas and perspectives, it might seem an impossible task to reconcile what might appear to be conflicting requirements under the single banner of HCM. Yet that is precisely the very strength of HCM over all other competing management philosophies, models and methodologies (see Section 3 for more detail on this point) that makes it so revolutionary.

HCM has its own clear agenda that manages to satisfy all of the demands placed on it. It is called the value agenda. All of these different stakeholders are searching for value, therefore the only items on their agendas should be those that add value. Any activity that is not specifically designed to add value is history.

But how can we be sure that HCM will provide the answers to all their questions? One place to start would be to remind ourselves exactly what those questions were, and then provide the added value answer that HCM can offer. The list of questions below is intended to cover most of the likely questions but, again, it should not be regarded as exhaustive.

Q1. Why do some companies have a much higher value (market value = share price x number of shares) than their competitors who are doing the same things in the same markets?

Q2. We can measure physical assets (for example, buildings, offices, equipment) and we can measure sales, costs and profits, but this is all historical data. How do we know we are doing the right things for the future of the organisation?

Q3. We believe the things that really matter will be our ability to continue to motivate our people. If we do this, it should help us to innovate and allow us to make best use of their intellectual capital (knowledge and brainpower), but how can we measure whether we are doing that right?

Q4. Part of our success will come from being organised in a way that enables us to produce our goods and services very efficiently. How can we gauge whether we have the right organisation structure, systems and processes to do that?

Q5. We need to be vigilant in ensuring we are responding to changing customer needs. How will we know if we are?

Q6. We believe that diversity will bring with it many organisational and individual benefits, but how can we demonstrate that?

What is added value?

The concept of added value is extremely simple, on one level, and can be explained by Figure 1 below.

The first question this diagram asks is what is the current value of your organisation? If you work for a commercial company, the answers might include:

We made a profit of £100m last year

We have 20 per cent of the market

Our share price is at an all time high of £10.50

Our market capitalisation is £5bn

We can produce our goods at 10 per cent lower cost (£10 less) than our nearest competitor.

All of these are statements of how valuable your company is now. They are all highly measurable and all have a monetary value attached to them. This can be called the 'baseline valuation of the business'. It is a starting point for gauging added value because in 2005, 2006 or even 2010, you can ask the same questions and the difference will be a measure of how much value has been added in the interim. So:

We made a profit of £110m in 2005 - that's £10m in added value

We now have 25 per cent of the market, which is worth an extra £250m

Our share price is at an all time high of £11

Our market capitalisation is £6bn

We can produce our goods at 12 per cent lower cost (£12 less) than our nearest competitor, which is an added saving of £2 per product.

Added value has to be measured by using baseline (i.e. pre-activity) and post-activity measures. The measures have to be the same, to compare like with like. However, in essence, added value is that simple and there is nothing complicated about it. More importantly, it is the language that the key stakeholders in HCM - shareholders and financial analysts - understand.

Are there only four variables that can create value?

Figure 1 suggests the only variables you have to focus on to add value are:

Quantity increases - you make more cars or care for more patients

Cost reductions - you make cars or care for patients more efficiently

Price/revenue - you sell more cars, charge a higher price for patients

Quality - the quality of the cars is better or patients get better service.

Your first reaction to this simple view, especially from a human capital perspective, might be that brainpower, creativity, innovation are not shown in Figure 1. And yet it is obvious that such factors will make a significant difference. So why are they not on this diagram? Part of the answer to that can be found in the debate about intangibles that is at the core of some theories on HCM (see Valuing Intangibles in Section 2 )

Intangibles tend to confuse the issue of added value

Let's look at the idea of people being creative at work. Creativity sounds like it fits the definition of 'intangible' perfectly. You cannot touch it, it is difficult to analyse, and you cannot guarantee it will still be there tomorrow. Yet we all know that creativity - producing new ways of working and new products and services - is bound to be a source of value. This sounds like a conundrum but, in fact, the answer is very simple.

Creativity is only worth something when it is translated into value. The reason creativity is not on the diagram is because we will only know we are being creative in the right way, when creativity results in more output ('hey, we've worked out a different way to treat patients'); less cost ('he had a great idea for using less consumables on the ward'); increasing revenue ('customers seem to love that new colour we created for our cars and don't mind paying the extra'); or better quality of service or product ('that new braking system is much safer').

In other words, from an HCM perspective, all intangibles that are worth something become tangibles eventually. Producing a new car colour that no customer wants (albeit still using your creativity to do so) will not be translated into value (more sales).

Moreover, once intangibles are translated into tangible, added value measures, they can be included in an HCM report that will convince those who need to be convinced.

Quality and getting the balance right

Added value can be a slippery concept. What if the hospital saves cost by shutting a ward down? Is that added value? Or if the car company reduces the quality of seat covers to save money? Does that add value?

The simple answer is that added value is not about 'cutting corners' or doing less. Added value means providing more per pound - more for less, not less for less.

This is really important in HCM, and the way businesses report on their performance. Marks & Spencer, under Richard Greenbury's management, achieved more than £1bn in profit for the first time in its history on the back of savage cost-cutting. Unfortunately, while doing so, M&S lost sight of what its customers wanted and sales plummeted to such an extent that profits quickly halved.

Consequently, added value only really comes from getting the right balance between all of these four variables. It is not about robbing Peter to pay Paul.

Is the notion of added value of any practical use?

The answer to this question is a most emphatic 'yes'. The notion of added value is at the heart of the value agenda but it is also a very powerful, simple and practical tool. All it requires is for anyone, but particularly those working in HCM, to ask the question 'how will this activity/work/project add value?' This is not a rhetorical or hypothetical question. If there is no line of sight to an increase in output, reduction in cost, increase in revenue or improvement in quality, then there is no business justification for continuing on that course.

If there is a clear line of sight, then there is already a reasonable probability that the project in question will eventually be translated into added value.

Re-phrasing the human capital question as a value question

As you can see from all of the questions and different perspectives above, it is no wonder that many people believe they are all discussing the same subject, HCM, when in fact they could all be talking at crossed purposes. The only way forward is to make sure we are all trying to answer the same questions. If this is not possible then everyone should at least be fully aware when they have moved onto different, and possibly conflicting, agendas.

Since January 2003, there was one very clear agenda behind the Accounting for People Taskforce (www.accountingforpeople.gov.uk), a body set up and sponsored by the Department for Trade and Industry to look at the 'performance measures currently used to assess investment in human capital'.

In October 2003,it published its report (Report of the Taskforce on Human Capital Management, October 2003), and defined HCM as "an approach to people management that treats it as a high-level strategic issue and seeks systematically to analyse, measure and evaluate how people policies and practices create value".

This may not look as though it heralds any significant new departure in HR terms, but there is one key development here: when it refers to 'value', it means value with pound signs. The emphasis here is not on the activity of measuring, but on the creation of value, that is the ultimate objective. So, here, one of the most important questions in HCM is not how do we measure it, but how do we realise its full potential value? Measurement may be a means to an end, but it is not the end itself.

Assuming you are an HR professional, another way of looking at this definition is that the Accounting for People Taskforce is not primarily interested in the HR function, per se. It is not asking whether the HR function is efficient or following best practices, unless those practices can be see to be contributing to the creation of value. Consequently, HR professionals should no get the mistaken impression that HCM is concerned about measuring them.

Now, while we are pursuing the goal of value, there are two distinct questions that need to be answered, following the principle of baseline and post activity measurement:

What is the current value of our human capital? (which presumes we have the means for measuring its value)

How much more value can we get from our human capital?

You will notice that you cannot answer the second question until you have answered the first. If your human capital has already generated £100m, then you can ask whether there is any room for further improvement. You have to produce a baseline figure to work from so that you can show an improvement or growth in value over time. This is a simple but very crucial point in measurement and an issue we will return to later in Section 4.

For now though, we ought to have an initial stab at suggesting what HCM might be worth, otherwise why should anyone bother?