Note: This article is part of an occasional series dedicated to exploring the contribution of human capital assets (people!) to the valuation of a business. Welcome to The New ROI: Return on Individuals. If you’re just joining us, welcome. In this article we discuss the value of the assembled workforce.
“People are our most valuable asset.”
Said every chief executive officer of every company everywhere. Right?
But how do you really know that’s the case?
In professional services businesses, the assets go home every night. In fields like legal, engineering, architectural, medical and accounting, for example, where the expertise of the people is really what customers are buying, the employees are clearly the assets of the business.
These people are measured based on certain metrics like utilization rates (the number of hours billed / number of hours worked) and realization rates (actual fees collected / budgeted fees).
In businesses where products are manufactured or distributed, the people (or human capital assets as they are often referred to) are just one of many assets.
Each employee’s direct contribution to sales and profits is different, and it is even more difficult to document their performance with quantitative metrics – especially for those who are not directly responsible for sales. Once you get past the measurables like attendance, or some number of projects completed, it’s often a more subjective assessment process.
While convenient statistics to measure productivity, these numbers don’t tell the whole story about an individual’s contributions or the value that they bring to an organization.
People are intangible assets
When folks in my profession talk about determining the value of people, it is typically in the context of a business combination that’s called a purchase price allocation (“PPA”). The PPA is an accounting exercise that requires the assignment of the fair value of all tangible and intangible assets and liabilities acquired in a business acquisition.
Human capital is considered to be an intangible asset and a common way of ascribing value to people is through the assembled workforce in its entirety. The existence of a highly trained workforce in-place saves an acquirer from having to go out and recruit, hire and train a new group of employees to effectively operate the business.
Although quite valuable, the assembled workforce asset is not actually booked on a financial statement. Rather, it is recorded as a part of goodwill.
How accountants value people
In calculating the value of the workforce, valuation practitioners will often use a “Cost-to-Recreate” method. The math behind the methodology is such that if we can estimate all of the costs incurred to recreate the workforce, that total cost will reasonably represent the value of the workforce.
For example, if “Ed in accounting” costs (salary, benefits, recruitment, training, etc.) $75,000, the methodology presumes that we can find, hire and train another person just like Ed for the same $75,000.
Before I continue, I want to be very clear that this is not a criticism of how valuation practioners go about valuing human capital, or how the accounting profession recognizes that asset. Intellectually, we are simply valuing a particular asset in a particular way using the tools and methods that are available and accepted. My observation is, however, that when valuing the workforce, some implicit shortcomings in the cost-to-recreate method come to the surface:
- First is the assumption that all employees are interchangeable – i.e. one “Ed” is just as good as another “Ed.”
- The second is that cost and value are one and the same.
- Lastly, the cost-to-recreate method focuses largely on the direct costs associated with replacing people.
Chris Mercer, valuation expert and CEO of Mercer Capital, agrees with these observations. Regarding valuing human capital via the cost-to-recreate method, Chris says, “It captures a cost, but the value of people is really the benefit that they bring… and if the value of an employee didn’t exceed the cost to hire them, they probably wouldn’t have been hired in the first place.”
The cost of turnover
Inherent in Chris’s observation is that there is more to the story than just the cost associated with replacing people. Certainly, more than just the direct costs.
According to data released in 2012 by the Center For American Progress, the direct cost associated with turnover for an average employee is roughly 20% of annual salary. For more specialized personnel and executive-level employees, the costs can exceed 200%.
There are also, however, indirect costs associated with replacing employees that aren’t fully captured in the statistics. Such things include:
- Lack of productivity that the employee exhibits once they’ve made the decision to leave
- The impact on remaining employees’ morale as they question the reasons behind the departures/terminations
- The real cost of lost productivity.
The “real cost of lost productivity” refers to the fact that while estimates can be made regarding when a new employee comes up the learning curve to a reach a satisfactory level of performance, it doesn’t account for the replacement of the institutional knowledge longer-term employees have gained over time. Things like corporate culture and protocols; who are the best resources within the company for specific information; and even the boss’s preferences.
When you take into account the indirect costs, estimates are as high as 400% for the most senior people. There’s also the opportunity costs of replacing an employee with the risk of making a bad hire that can have serious consequences.
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