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Human Capital: What It Is
And Why People Invest It
T.O.Davenport. (Jossey-Bass, 1999).

Business, People and Rewards: Surviving and Thriving in the New Economy. A joint study between Towers Perrin and the Economist Intelligence Unit [Will try to get URL from Tom]

Investment in Human Capital,” T.W.Schultz. American Economic Review.

 

 

As the relationship between workers and their work has evolved, so have the metaphors we use to describe how people view their jobs, and how companies view their employees. This evolution is not just a change in terminology. Rather, it reflects fundamental shifts in the way we think—and speak—about working life.

Why should we care about metaphors? After all, a metaphor is merely a figure of speech, a way of illuminating one idea by invoking another apparently unrelated idea. Why should anyone not sitting in an English class—or standing up in front of one—pay attention to their use? The reason, simply put, is that language matters. Because metaphors are attention grabbing and packed with meaning, they are especially powerful. In the words of philosopher and humanist Jose Ortega y Gasset, “The metaphor is probably the most fertile power possessed by man.”

Business leaders, never ones to overlook a power source, are enthusiastic, if not always precise, users of metaphors. Indeed, business language is full of them. Employees aren’t just important contributors—they‘ve become their companies’ “most valuable assets.” Capable executives aren’t just hard to come by—companies are waging a “war for talent.” People don’t just bring their background and experience to their work, the contribute their “human capital.”

While all these metaphors help us understand why people are valuable to companies, the notion of people as owners and investors of human capital is particularly rich. More to the point, I think it better captures the underlying truths of working life than the idea that people are mere assets, deployed at the whim of their owners like so many forklifts. Why quibble over which is the more accurate metaphor? Mark Twain reminded us why it’s important to choose our words carefully: “The difference between the almost-right word and the right word is really a large matter—‘tis the difference between the lightening bug and the lightening.”

A Definition of Human Capital

As a term, human capital suffers the same fate as many compelling and widely adopted metaphors—broad acceptance but imprecise usage. So, I’ll make a modest contribution by proposing a definition. Human capital comprises all the intangible assets that people bring to their jobs. It’s the currency of work, the specie that workers trade for financial and other rewards. The term first appeared in a 1961 American Economic Review article, “Investment in Human Capital,” by Nobel-Prize winning economist Theodore W. Schultz. Economists, academics, and consultants have since loaded many notions into the human capital portmanteau. I propose that the best way of looking at human capital is to break it into four elements:

   Knowledge: command of a body of facts

    Skill: facility, developed through practice, with the means of carrying out a task

   Talent: inborn facility for performing a task

   Behavior: observable ways of acting that contribute to accomplishing a task.

Like all good metaphors, the idea of human capital gains potency as you explore tangential metaphors—spin-offs, if you will. Let’s have a quick look at some of the more enlightening spin-offs from human capital.

Return on Human Capital Investment

People come by their human capital through a variety of means—formal education, job training, on-the-job learning, evening classes at the school of hard knocks, and through the luck of the DNA draw. And they do with it just what you would expect someone to do with something that has value—they cash in on it. That is, an owner and investor of human capital will place this asset where it will generate the highest return.

Return on human capital investment, therefore, is the set of rewards that an employee receives in return for investing his or her knowledge, skill, talent, and behavior. Those rewards come in financial forms through pay, benefits, and stock options. Equally important are the non-financial forms: intrinsic job satisfaction, recognition for good performance, opportunities to learn through the job and advance in the organization. A little later, we’ll consider how companies should manage and deliver this portfolio of rewards.

In the human capital arena, investment and ROI work much as they do in financial circles: higher return engenders a greater inclination to invest. A lower return reduces the inclination to invest and increases the probability that human capital will be withdrawn and moved to another investment (that is, the employee will quit and take another job).

Risk

Risk is defined as exposure to the possibility of injury or loss. Financial investors consider risk when they structure their investment portfolios. Every time they make a move (or decide not to move), financial investors face the possibility that they will lose some part of their capital or forego a gain they might have enjoyed with a different investment.

Human capital investors face their own special forms of risk. In the early 1990s, when the spectre of downsizing haunted the workplace, an employee’s greatest risk was loss of a job. When this happened, the chance to earn a return on human capital investment fell to zero for some time. The investable asset wasn’t directly threatened—layoffs eliminated jobs, but didn’t make people incompetent.

In our post-millennium world, however, risk means something different. These days the greatest risk faced by employees, especially those for whom the latest technical knowledge is their most critical human capital, is not loss of a job, but rather devaluation of the asset. As long as my Java programming skills are up to snuff, I can get another job. But what if I fail to hone those technical skills or if my knowledge falls behind by as much as three months? Then I’m in trouble because my human capital drops below its maximum value and so does my ability to earn a return on its investment. Little wonder why continuous learning is so important to people who work in fast-moving industries.

Investment Contract: The Deal

An implicit contract—a deal—provides the context for exchange between worker and organization. The deal conveys what each side will provide to the other and what each will receive in return. A formal document may capture some aspects of the relationship between individual and company, but can never cover all the subtle interpersonal elements. Therefore, social scientists like to use the term psychological contract to encompass the web of written, unwritten, spoken, unspoken, and ultimately ineffable aspects of the interaction between people and their employers. The notion of a psychological contract is old wine, but its prominence is of recent vintage.

It seems that no one paid much attention to the unwritten contract until companies began to break it. Downsizing, one read a few years ago, destroyed the time-honored contract that provided a job of indefinite (but presumably extended) tenure in exchange for loyalty and reasonable performance. Today, a different contract binds workers and companies. Today’s contract requires the individual to look to the value of his or her human capital as the source of job security. The company is required to generate ROI, or the employee has the right, with no moral penalty and little frictional cost, to invest in another job with a different company.

Implications for Managers

Metaphors are only useful if they enlighten, and enlightenment is helpful only if it leads to some effective action. So, now that we’ve considered the main metaphor and some of its spin-offs, what actions should companies contemplate if they are to act in ways consistent with what the metaphor suggests?

Consider again the definition of human capital as critical knowledge, skills, talent, and behavior. By critical, we mean instrumental in executing business strategy. In a study conducted jointly by the Economist Intelligence Unit (EIU) and Towers Perrin, entitled “Business, People and Rewards: Surviving and Thriving in the New Economy,” senior managers from global corporations said that some forms of human capital most critical for delivering on business strategy are clearly lacking in today’s workforce. Figure 1 illustrates these.

Human Capital cited as critical or important to delivering on business strategy.

Notice that abilities associated with e-literacy, innovation, and entrepreneurship are expected to be crucial for strategic success in 2003, but are considered insufficient in today’s workforce. Managers should view the building of these forms of human capital as a necessity. Employees should see building them as an opportunity.

When it comes to managing risk, the time-honored financial technique of hedging has application for human capital investors. Financial investors hedge by buying securities with values that move in opposite directions when prices change. Human capital investors can do something roughly similar by investing time and effort today to develop knowledge and skills likely to rise in value in the future. Consider the skills and behaviors associated with being a team player. Respondents to the EIU/Towers Perrin study considered these forms of human capital to be both strategically critical for business success in 2003 and relatively widely available in the workforce today. But what if tomorrow’s team member must behave differently and possess skills different from those of today’s definitive team player? Participants in senior-management focus groups said that team players in the new economy must have:

   Technological expertise to engage in electronic communication

   Project management skills that extend to handling joint ventures and strategic partnerships

    Behavioral attributes that permit successful cross-functional, inter-company, and multi-regional cooperation, even when traditional authority is absent.

High-performing individuals manage their risk and increase their potential reward when they raise their sights beyond today and develop human capital that will be strategically important (and generate high return on investment) tomorrow. High-performing companies help them achieve this goal.

Companies that intend to work with their employees to develop tomorrow’s human capital must also rethink their delivery of the return on human capital investment. Even the best performing organizations, the EIU/Towers Perrin study showed, have gaps to fill in their reward programs. Figure 2 illustrates some of those gaps.

Gap between current effectiveness

It is noteworthy that respondents from high-performing companies say that challenging work and career advancement opportunities will be two of the more important forms of human capital ROI in the next few years. Both rate higher than stock options (the recent reward of choice, judging by the sturm und drang surrounding the rise and fall of employees’ equity stakes over the past year) when it comes to focusing employees on business results.

Emphasizing the most important elements of return on human capital investment will surely entail a shift in management attitude away from reliance on financial rewards. But an even more fundamental shift lies ahead, one that will require management to set aside conventional notions of “equitable” treatment of employees in favor of individualized, customized rewards that reflect individual performance and value creation. Paying for performance is not a new idea, though it is reflected more often in word than in deed. In any case, the mass-market approach to delivering return on human capital investment is dead, or soon will be.

Total customization of the individual deal is both new and daunting. But it’s on the way, to be sure, as the figures below suggest. 

To what degree are your employees able to customize

While customization of reward packages is relatively rare at present (with only 10% of respondents to the EIU/Towers Perrin study saying their companies offer at least some degree of flexibility) that will change over the next several years. More than a third of the managers believe that, by 2003, their organizations will offer employees at least some customization options. More than one-fifth thinks that their organizations will be offering high (or even total) reward program flexibility. The totally customized deal works to the advantage of both companies and employees. Employers can allocate reward investment in ways that best meet individual employee needs and respond to socioeconomic change. And, not surprisingly, employees tend to value their returns on human capital investment when they have a say in structuring them.

What’s Next?

What will happen to the legitimacy of the worker-as-investor metaphor if the economy softens? Will the next shift in our economic fortunes mean a return to the days of viewing workers as costs? Although the workplace will continue to evolve, I believe that substantial time will pass before economic factors undercut the value of human capital, or undermine the insights to be gained from studying the metaphor. In good times, companies need to attract the owners of valuable human capital, make a deal with them, provide a high return on their investment, and be mindful of the risks they incur. In cost-conscious periods, companies still need to hold on to key people and keep them engaged in jobs despite the ill fortunes of their downsized peers. The two situations call for fundamentally the same human capital management skills, applied in different ways. For their part, individual human capital investors must deal with a constantly shifting market for the intangible assets they bring to the job. Indeed, in a softening market, one reality becomes stark: you win or lose by virtue of the value of your human capital. To this extent, the financial and human capital markets are equally unforgiving.

Thomas O. Davenport is a principal in the San Francisco office of Towers Perrin. He is the author of Human Capital: What It Is And Why People Invest It (Jossey-Bass, 1999). Write him at davenpt@towers.com.

VTD022701GR

 

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