article - hr as a source of shareholder value

8/13/2019 Article - HR as a Source of Shareholder Value

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F o r t hc o m i ng , Hu man Resources M anagemen t J ou rna l , Vol. 31 (1), Spring 1997.

HR as a Source of Shareholder Value:

Research and Recommendations

Brian E. BeckerSchool of Management

State University of New York at Buffalo

Mark A. HuselidSchool of Management and Labor Relations

Department of Human Resource ManagementRutgers University

Peter S. PickusCoopers & Lybrand, L.L.P.

Michael F. SprattCoopers & Lybrand, L.L.P.

The role of the Human Resource Management (HRM)function in many organizations is at a crossroads. On one hand,the HRM function is in crisis, increasingly under fire to justifyitself (Schuler, 1990; Stewart, 1996) and confronted with thevery real prospect that a significant portion of its traditionalresponsibilities will be outsourced (Corporate LeadershipCouncil, 1995). On the other hand, organizations have anunprecedented opportunity to refocus their HRM systems asstrategic assets. Indeed, the same competitive pressures thatprovide an incentive for firms to outsource costly HRMtransactions have dramatically increased the strategic value of

a skilled, motivated and adaptable workforce, and the HRMsystem that supports and develops it. However, transformingthis crisis into an opportunity requires a new organizationalperspective on the HRM system one that is also a shared

perspective by the CEO and chief HR officer (CHRO). At itscore, this strategic perspective requires that the CHRO befocused on identifying and solving the human capital elementsof important business problems (e.g., those problems likely toimpede growth, lower profitability, and diminish shareholdervalue). The tangible evidence of this focus is an internally

coherent, externally aligned, and effectively implemented HRMsystem.

The New Strategic Role for HRMPfeffer (1994) describes how changing market

conditions have rendered many of the traditional sources ofcompetitive advantage, such as patents, economies of scale,access to capital, and market regulation, less important in thecurrent economic environment than they have been in the recentpast. This is not to argue that such assets are not valuable, but

rather in a global economy that demands innovation, speed,adaptability, and low cost, these assets do not differentiate firmsthe way they once did. Instead, relatively more influential are

the core competencies (Hamel and Prahalad, 1994) andcapabilities (Stallk, Evans, & Schulman, 1992) of employees thahelp to develop new products, provide world class customerservice, and implement organizational strategy.

Unlike conventional assets, this form of intellectual ororganizational capital (Tomer, 1987) is largely invisible(Itami, 1987) and therefore does not appear on the firmsbalance sheet.

lAlthough organizational and intellectual capital

may well be invisible, the sources of this capital are not. Theyare found in a skilled, motivated, and adaptable workforce, andin the HRM system that develops and sustains it. Hamel andPrahalad (1994, p. 232) argue that these people embodiedskills are directly reflected in conventional measures of firmprofitability.

2 Indeed, as intellectual capital has come torepresent an increasing fraction of many firms total assets, the

strategic role of the HRM system has also become more critical.Ulrich &Lake (1990) point to such HRM systems as the sourceof organizational capabilities that allow firms to learn andcapitalize on new opportunities. The HRM function thattraditionally focused on transactions, practices, and compliancewas, and is, appropriately considered a cost center. In contrast,

the HRM system that develops and maintains a firms strategicinfrastructure should be considered an investment. It is anessential element of the infrastructure that supports this valuecreation process, and a potential strategic lever for theorganization. Moreover, as one of the more malleable andunderdeveloped strategic levers available to most CEOs, theHRM system represents a policy option with very substantial

and accessible returns.

What Is the Evidence for the Strategic Impact of HRM?The strategic HRM literature tends to emphasize the

entire HRM system as the unit of analysis, in contrast to thetraditional focus on individual policies or practices. This


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Figure 1

systems-level focus is consistent with the conceptual rationale forthe presence of a strategic impact, and is a significant departurefrom traditional work in the field. Such HRM systems, oftenreferred to asHigh Performance Work Systems or HPWS, aregenerally thought to include rigorous recruitment and selectionprocedures, performance-contingent incentive compensationsystems, and management development and training activitieslinked to the needs of the business (Arthur, 1994; Huselid, 1995;Ichniowski, Shaw, & Prennushi, 1995; Jackson& Schuler, 1995;MacDuffie, 1995; Milgrom & Roberts, 1995).

3But, how,

specifically, does the adoption of a HPWS affect firm value? AsFigure 1 illustrates, the essential feature of these strategic HRM

systems is that they are linked to the firms business and strategicinitiatives. The result is an HRM system that produces employeebehaviors that are focused on key business priorities, which inturn drive profits, growth and ultimately market value.

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Much of the prior research on this subject has beenlimited to the intermediate relationships depicted in Figure 1. Incontrast, Becker, Huselid and their colleagues have focused onthe strategic impact of the HRM system, namely the ultimateeffect of the HRM system on both market-based and accounting-based measures of firm performance (Delaney & Huselid, inpress; Becker and Huselid 1992a; 1992b; 1996; Huselid, 1995;Huselid and Becker, in press; 1995, Huselid Jackson,& Schuler,1996). The use of market-based measures of firm performance

is particularly appropriate in this line of research because theyreflect the present value of the firms future cash flows, and are

therefore net of any additional costs associated withimplementing these systems. While there is no consensusmeasure of a HPWS in this emerging literature, based onresponses to more than 30 specific questions from a sample of

740 firms, Huselid & Becker (1995) created an index of thefirms HRM system reflecting the degree to which a firm haddeployed a HPWS.

5Huselid and Becker have consistently found

that firms with higher values on this index, other things equal,have economically and statistically significant higher levels of

firm performance. They further estimate that plausible changes(a one standard deviation improvement) in the quality of afirms HPWS are associated with changes in market value of$15,000-$60,000 per employee. For a firm with 10,000employees this represents more than half a billion dollars inmarket value.

The work by Huselid and Becker suggests that aproperly designed and deployed HRM system represents asignificant economic asset for an organization. It does notprovide direct evidence of how such a system creates that value,however. To date there is very little research that peels back

the onion and describes the processes through which HRM

systems influence the principal intermediate variables thatultimately affect firm performance, as described in Figure 1.However, based on recent work in the field of competitivestrategy (Barney, 1991), we would expect that if a firms HRMsystem is to be a source of sustained competitive advantage, itmust be difficult to imitate (Wright and McMahon, 1992). Thissuggests to us that organizational HPWS are highlyidiosyncratic and must be carefully tailored to each firmsindividual situation to achieve optimum impact. In other words,if a properly configured HPWS could be created by simplybenchmarking competitor firms, it could be easily replicatedby competitors and therefore not likely to provide a source ofsustainable competitive advantages.

6Cappelli & Crocker-Hefter

(1996, pp. 7) state this case very well:

We believe that a single set of bestpractices may, indeed be overstated....thereare examples in virtually every industry ofhighly successful firms that have very distinctmanagement practices. We argue that thesedistinctive human resource practices help tocreate unique competencies that differentiateproducts and, in turn, drive competitiveness.Indeed, product differentiation is one of the

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essential functions of strategicmanagement, and distinctive humanresource practices shape the corecompetencies that determine howfirms compete.

In short, we believe that both the source of the HRMeffect on firm performance and its inimitability reflect anidiosyncratic contingency.

7Namely, HRM systems only have

a systematic impact on the bottom line when they are embeddedin the management infrastructure and help the firm achieveimportant business priorities such as shortening productdevelopment cycle times, increasing customer service, loweringturnover among high quality employees, etc. The particular formof these problems, and more importantly the appropriate designand alignment of the HRM system with business priorities, ishighly firm specific. To the extent that real value creation occursas part of these firm-specific alignments, benchmarking will playa very limited role in the development of a HPWS. CHROsmight profitably look to other firms for best in class practices,

but these practices will only have a strategic impact if they are

appropriately aligned with the rest of the HRM system and with

the firms broader strategic infrastructure.Thus, we believe that an inordinate focus on bestpractices is misguided and may even be counterproductive to theextent it diverts valuable managerial effort from the difficult andtime-consuming job of developing an internally coherent andexternally aligned HPWS. Competency-building efforts shouldfocus on the firm-specific relationships described in Figure 1.Best practices (e.g., investments in training, performancemanagement and incentive compensation systems) are only apoint of departure. In other if a firm has decided to incentemployees with a particular form of team compensation it shouldbe optimally designed for its intended purposes. Within thiscontext, benchmarking can provide a useful source of ideas.

However, while becoming best in class maybe a necessarycondition for ultimately improving firm performance, it is not asufficient condition. The more crucial strategic decision is how

these team incentives align with other HRM practices, and howthe total HRM system is designed such that it supports keybusiness priorities. Without the latter, the HRM system will be

just a best in class version of an HRM function in crisis.Indeed, if the HRM system is not properly aligned, theseindividual best practices can potentially be in conflict within theHRM system, and actually diminish firm value.

As an example of this phenomenon Huselid and Becker(1995) interpret their empirical evidence of non-linearities in theHRM-firm performance relationship as an indication of roles

played by best practices and the alignment of the broader HRMsystem with business priorities. Based on their HPWS index,Figure 2 describes the relationship between improvements in therelative quality of a firms HRM system and changes in itsmarket value per employee. A more sophisticated HRMArchitecture (defined as higher values on the Huselid-Beckerscale) reflects the greater deployment of a HPWS.

8Figure 2

illustrates two broad findings. First, the impact of more intensivedeployment of a HPWS is associated with substantially greatermarket value per employee, second Figure 2 shows that thereturns from investments in a HPWS are not linear. We believe

(Source, Huselid and Becker, 1995)

the non-linearity in this relationship emphasizes the linkagebetween beat practices and strategic alignments discussed aboveAs firms make initial steps toward the development of a HPWS(i.e., moving from the lowest firms in the ranking to the 20thpercentile) the HRM system moves from an impediment to aneutral strategic influence. Here the HRM system creates value

by getting out of the way. For the broad middle rangeimproving the relative sophistication of the HRM system(adoption of best practices) has little marginal impact on firmperformance. This approach does no damage, but HRM is noreally a strategic partner. Finally, firms above the 60thpercentile arguably have all the appropriate best practices, bu

more importantly have begun to integrate this system morebroadly into the operational fabric of the firm. Here themarginal impact on firm performance is the same as those HRM

systems below the 20th percentile, but for different reasons. Inshort, we believe the impact of HRM on firm performanceamong these better HRM systems is much more than thepayoff for the adoption of best practices. It is the reflection othe payoffs to a competitive advantage that combines thesebest policies into an internally coherent system that is directlyaligned with business priorities and operating initiatives moslikely to create economic value. In essence, these results poin

both to the potential returns from affecting very significantchanges in a firms HRM System as well as the potential

difficulty of doing so.

Where the Rubber Meets the Road: The System is theSolution!

To this point we have described the theoretical andempirical support for our contention that a new role for HRMthroughout the firm is required, and presented evidence todocument the magnitude of economic opportunity associatedwith the adoption of a High Performance Work System. Buthow do we begin to capture such returns? Where do we start?

We believe that an important first step is the development o

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systems thinking among line and HR managers. In contrast tothe functional view of HR, a systems perspective reemphasizessuch interrelationships as the recruiting function being linkedwith the selection system, which in turn provides sensible inputsinto the training subsystem. Subsequently, the performancemanagement and incentive compensation system must definedesired employee behaviors and reward those behaviors inmeaningful ways when goals are achieved. Equally important,the goals and desired employee behaviors developed andrewarded by the HR system are entirely focused on achieving

critical business priorities.For the CHRO and the HR group to genuinely become

a source of value creation for the firm, however, requires morethan just an occasional reminder of the necessary relationshipamong the respective fictional responsibilities within HR.Quinn, Anderson & Finkelstein (1996) describe four levels ofprofessional intellect within an organization: cognitiveknowledge, advanced skills, systems understanding, and self-motivated creativity. Traditional HR manager competenciesinclude both cognitive knowledge and advanced skills. However,for a firms HRM system to have a strategic impact, to be asource of shareholder value, it is crucial that HR managers

develop the capacity for systems understanding. The systemsperspective is essential because it provides a

deep knowledge of the web of cause-and-effect relationships...permit[ing]professionals...to solve larger and morecomplex problems...creating extraordinaryvalue...[by] anticipat[ing] subtle interactionsand unintended consequences. (Quinn et al.,1996; p. 72)

Based on our empirical work and experiences in a wide variety

of companies, we believe the failure to appreciate these subtle

interactions and unintended consequences, what we have termedDeadly Combinations and Powerful Connections, to be the single

greatest challenge facing traditional HR managers as they makethe transition to becoming true business partners.

Deadly Combinations develop when firms adopt HRMpolicies and practices that might well make sense in isolation, butwhen evaluated within the context of other HRM practicesdeployed throughout the firm are a recipe for disaster. Simpleexamples can be found in firms that invest in sophisticatedperformance management systems, only to adopt compensation

policies that provide for little meaningful economic distinction

between high and low performing employees. Or firms thatencourage employees to work together in teams, but then provide

raises based on individual contributions. Alternatively, PowerfulConnections reflect the presence of complementarities orsynergies that can occur when economic returns from thewhole of the HRM system adds up to more than the sum of itsparts. For example, in our empirical work in over 1500companies we have found that combining above-market paypolicies with comprehensive performance management systems

has a 50 percent larger effect on firm performance than theeffects of the two policies considered in isolation. We believethis finding reflects the synergistic gains of a better applicantpool, more talented hires, and an HRM system that is able to

recognize and reward these more talented employees for theisuperior performance.

High

Firm Performance

Reliance on Promotion from Within

A more complex example of this type of synergy,reflecting both Deadly Combinat ions and PowerfuConnections, is illustrated in Figure 3. Based on our empiricalwork, the downward sloping arrow in Figure 3 shows the effectsof an organizational policy of promotion from within on firmperformance, ignoring any effects of related HRM practicesWhile promotion from within can, on one hand, serve as anessential foundation for building core competencies, it can also

degenerate into a low performance civil service culture whencompensation and advancement opportunities are not linked toperformance. The latter effect apparently predominates, and isreflected in the downward sloping arrow in Figure 3. Incontrast, the upward sloping arrow shows the effects of apromotion from within policy when it is part of an HRM systemthat includes extensive training, incentive pay, and relativelygreater pay differentials between high and low employeeperformance. In this case the civil service dimension opromotion from within has been mitigated by other elements othe HRM system that helps to develop a skilled and motivatedworkforce.

We do not anticipate that these same Dead ly

Combinations and Powerful Connections will be present inevery firm, or even most firms. Indeed if these synergies andunintended consequences are idiosyncratic there will be no one

common organizational experience, or right answer.However, the only way that any organization can hope toidentify the HRM system that is appropriate for them is to adopta systems perspective. This means that business priorities drivethe development of the HRM system and the evaluation of anyelement of that system (recruiting, selection, compensation, etc.)is always considered within the context of other elements of thesystem and the business priorities of the organization.


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Towards Human Capital ManagementWe have outlined both the conceptual and empirical

evidence supporting the view that HR can have an importantinfluence on shareholder value. In a departure from thetraditional view of HR we argue, and provide strong researchsupport for our contention that the HR system can potentiallyrepresent a strategic asset for the organization. The key torealizing this potential is to think of HR, first and foremost, as asystem that is characterized by synergies such as the Powerful

Connections and Deadly Combinations discussed above. Tocreate this value, however, requires a fundamentally differentperspective on HR; a perspective probably more accuratelydescribed as human capital management than as HRM. Theconcept of human capital management emphasizes the essentialpoint that a firms human resources and subsequently its HRMsystem can be more than a cost to be minimized. A firmshuman resources have an asset value that corresponds to thepresent value of future net cash flows that are derived from theskills, motivation and adaptability of the firms workforce. Itrequires that both the CEO and the CHRO share focus on oneessential question: How do we architect a human capital strategythat is aligned with business priorities and capable of rapidly

adapting to a shifting competitive landscape?In the past, market conditions have not required a

human capital perspective. The HRM function could largelyfocus on transactions and compliance with little opportunity cost.However, if HR managers are going to evolve into human capitalmanagers, they will require a dramatically different set ofcompetencies. For example, Ulrich, Brockback, Yeung, & Lake(1995) argue that HRM competencies fall into three domains: 1)

knowledge of the business, 2) HRM fictional expertise, and 3)management of change. They show that demonstratedcompetencies in each of these domains are associated withgreater perceived effectiveness of the HRM function. Most HR

managers receive high marks in the domain of HRM functional

expertise, but their knowledge of the business sources ofcompetitive advantage, industry dynamics, and the skill setsassociated with the management of change are often much lesswell developed. Yet these are exactly the competencies requiredfor human capital management. Similarly, Huselid, Jackson andSchuler (1996) identified two broad competencies that help HR

managers to develop effective HRM systems. Professional HRMCapabilities were related to the delivery of traditional HRMactivities such as recruiting, selection, and compensation. Incontrast, Business-related Capabilities reflected anunderstanding of the business and the implementation ofcompetitive strategy. Both contributed to HRM effectiveness,which in turn had a substantial positive effect on severalmeasures of firm financial performance. Huselid, Jackson, &Schulers conclusions emphasize our point: Professional HRM

Capabilities are a necessary, but not sufficient condition forbetter firm performance. More importantly, the Business-Related

Capabilities of HR managers (i.e., those linked to human capital

management) are not only underdeveloped within most firms, butthey also represent the area of greatest economic opportunity.

In the broadest terms this means a dramatically different

role for the HR function and CHRO. Specifically,

1. HR must focus on business level outcomes rather than HRlevel inputs. The number one priority for the value-creating HR

function is to develop the perspective and competency to solvebusiness problems. HR makes a difference when it can point tohuman capital problems that limit the ability of the firm toachieve important business priorities and can provide HRsolutions to those problems. Adopting the latest appraisalmethodology, for example, only creates value when it can beevaluated within this context.

2. HR must become a strategic core competency rather thana market follower. A high performance work system thatcreates real shareholder value is not a commodity that can bebenchmarked from other organizations. Benchmarking mightkeep you in the game, but it will not provide the intellectualcapital to create a sustained competitive advantage.

3. Strategic competencies are more important thanfunctional competencies. The most important value creatingHR competency, and the one most underdeveloped in manyfirms, is the ability to understand the human capital dimensionof each of the firms key business priorities and be able tocommunicate how solving these human capital problems will

directly affect operating performance.

4. The most important missing element in the HR functional

expertise is a systems perspective. Functional competenciesmust blend traditional HR functional expertise with a systemperspective to avoid deadly combinations and identify powerfulconnections.

Just as we have argued for a systems perspective throughout thispaper, these recommendations must also be considered as asystem composed of mutually reinforcing elements; they can notbe implemented in isolation.

This brings us back to our initial thesis. We arguedthat the practice of HRM is in crisis because its traditional roledoes not create value for the organization. Alternatively, wehave described theoretical and empirical evidence suggestingthat HRM has the potential to have an economically significanteffect on firm performance. This transformation from HRM tohuman capital management will require that both the CEO andthe CHRO think of the HRM system, first and foremost, as asource of strategy implementation and as a means to achieveimportant business priorities. This shared perspective, and thecommitment to developing the competencies in both line andHR managers to effectively implement this perspective, is thekey to realizing this potential source of competitive advantage.

EndnotesAuthors are listed alphabetically to reflect their equalcontributions.

1. Not only are investments in human capital not reflected in afirms balance sheet, they are expensed in their entirety on anannual basis. Thus, in contrast to capital investments (e.g., thepurchase of a building) that are depreciated over their usefullifetimes, investments in people lower accountingearnings (net

income and cash flow) by their full amount in the year in which theyare incurred. This provides managers whose compensation is tied to

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accounting rates of return a significant disincentive to invest in

human capital.

2. These human capital based competencies are in part the source of

the intangible capital represented by the difference between the

book value of a firms assets (i.e., shareholders initial investment)

and the current market value of those assets. The best known variant

of this measure is known as Tobins q, which is ratio of firm market

value to the replacement cost of its assets.

3. For compilations of the most recent empirical research on the

subject, the reader should consider recent special issues of the

Academy of Management Journal andIndustrial Relations.

4. A more complete description of the processes through which

HPWS affect employee behaviors, and subsequently firm

performance, is beyond the scope of this paper. Interested readers

can see Huselid (1995) for an overview.

5. A single index of the HRM system is used for two reasons. First,

it is the entire HRM system that is the appropriate level of analysis,

for reasons described above. Second, information on a particular

policy is generally taken to be an indicator of what is going on in thatelement of the larger HRM system. However, taken together these

observations can paint a relatively accurate portrait of the entireHRM system. An analogy might be indices of best places to live.

Cities are measured based on health care, schools, climate, crime,

recreation, etc. While any one of those measures is a limited

indicator of that feature of the community, when taken together they

probably describe life in that community pretty well. Just as those

indices allow some cities to be rated higher than others, so does this

HRM index.

6. Note that even in a world where these systems were easily

imitated it would still be better to have them than to not have them.

In this environment a High Performance Work System would simply

become another sin quo non for entry in the market much like low

cost and quality have become.

7. The strategy literature describes two features of organizational

systems that increase their inimitability and would apply to high

performance work systems: path dependency and causal ambiguity

(Collis and Montgomery, 1995). The former refers to policies that

are developed over time and cannot be easily purchased in the market

by competitors. The latter focuses the numerous and subtle

interrelationships in such a system that are not easily observed from

outside the firm.

8. A percentile ranking of zero does not imply that firms have no

elements of a HPWS, only that they have relatively fewer of these

attributes than any other firms in the sample.

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Author Information

For additional information on this research contact:

Professor Brian Becker

268 Jacobs Management CenterSchool of Management

State University of New York at Buffalo, 14260

716/645-3235

e-mail: [email protected]

or

Professor Mark HuselidSchool of Management and Labor Relations

Department of Human Resource Management

Rutgers University

P.O. Box 5062

New Brunswick, NJ 08903-5062

(908) 445-5445

email: [email protected]. edu

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