What human capital ROI is
Human capital ROI (العائد على رأس المال البشري), also abbreviated HCROI, is a ratio that measures what an organisation earns for every riyal it spends on its workforce. The formula in use takes revenue, subtracts the operating expenses other than workforce cost, and divides the result by workforce cost.
The ratio is open to misreading in two places. Two forms of it are in use, separated by exactly one, and its denominator is an item whose boundaries are not agreed.
A full human capital ROI calculation
Take an organisation with annual revenue of SAR 48,000,000 and operating expenses of SAR 42,000,000, of which SAR 18,000,000 is workforce cost:
- Expenses other than workforce cost: 42 million minus 18 million, or SAR 24,000,000.
- Numerator: 48 million minus 24 million, or SAR 24,000,000.
- Ratio: dividing by 18 million gives 1.33.
The result is expressed as SAR 1.33 earned for every riyal spent on the workforce. A second form in use subtracts one from that figure, giving 0.33, and the return is then stated as 33%.
The figures in this example are assumed in order to show the calculation. They are not a standard, and they are not taken from any source.
The two forms of human capital ROI are 100 points apart
Both figures are correct, and both describe the same thing. The gap between them is fixed at one, which is 100 percentage points. Anyone who copies the figure from the first form and takes it as the second will report a return of 133% when the return is 33%.
The error is easy to make. The first form can be written as a percentage, and “1.33” and “133%” differ by two characters. A figure of this kind is therefore not passed on without stating its form, and it is not compared with a figure from another source until the form used there is known. Of two figures, 1.33 and 0.40, the second may be the higher one: if 0.40 is in the second form, it corresponds to 1.40 in the first.
The definition does not favour either form. Both are in use, and what is required is a statement of which one has been used.
What human capital ROI reduces to
Expand the formula: revenue minus the expenses other than workforce cost, divided by workforce cost, minus one. That simplifies to revenue minus all expenses, divided by workforce cost. In other words, the second form is operating profit divided by workforce cost, and nothing more.
The figures above confirm the identity. Operating profit is 48 million minus 42 million, or SAR 6,000,000, and dividing that by 18 million gives 0.33, the same figure as before.
Two consequences follow. First, the figure moves with the margin, and it can do so without any change in HR practice: in a year when selling prices rise, the return rises although nothing has changed in the workforce. Second, the first form reaches exactly one, and the second form exactly zero, at the break even point, where total revenue equals total costs. An organisation running at a loss therefore has a negative return in the second form, however well it manages its people.
How the numerator is arrived at is explained under operating profit, the profit a business earns from its core operations before interest and tax.
The denominator decides any comparison of human capital ROI
Workforce cost has no single definition. Some limit it to wages, and others add the further items that make up an employee’s total cost to the company: benefits, contributions, recruitment and training. Spending on the contingent workforce is included in it by some and left in general expenses by others.
The effect is plain. Move SAR 3,000,000 of the workforce cost in the example into general expenses. Workforce cost becomes 15 million, the expenses other than workforce cost become 27 million, the numerator becomes SAR 21,000,000, the ratio 1.40, and the return in the second form 40%.
The return has risen from 33% to 40%, and not one riyal has changed in the organisation: not the revenue, not the expenses, not the headcount. What changed is that one item moved from one column to another. Comparing this figure with another organisation’s, without knowing where the boundaries of the denominator lie in both, is therefore a comparison that describes nothing.
Deciding what counts as workforce cost is an accounting decision for the organisation, and its effect on the result is shown above.
Human capital ROI measures labour intensity as much as performance
Compare three organisations using the same formula:
- The first has the figures from the example above, and its return is 0.33.
- The second is half that size on every line: revenue of 24 million, expenses of 21 million and workforce cost of 9 million. Its return is also 0.33.
- The third has exactly the revenue and expenses of the first, but its workforce cost is 9 million and its other expenses are 33 million. Its return is 0.67.
The first and third organisations earn the same operating profit, SAR 6,000,000. Even so, the third shows double the return of the first, because more of its spending goes to machinery and less of it to people. The ratio rises as the work depends less on the workforce, regardless of how well that workforce is managed.
It follows that comparing this figure across two activities of different kinds measures the difference between the activities, not the difference in management. A factory can come out ahead of a services office on this figure, and that is not a judgement on either of them.
How human capital ROI responds to a rise in pay
Raise workforce cost alone by 10%, to SAR 19,800,000, and leave everything else unchanged. Total expenses become SAR 43,800,000, operating profit SAR 4,200,000, and the return 21.21%, down from 33.33%.
A 10% increase in a single item has lowered the figure by 12.12 points, more than a third of its value. The reason is that the item sits in both the denominator and the numerator: the denominator grows and the profit shrinks at the same time.
The figure therefore registers every pay rise as a fall in performance, whatever its cause and whatever it brings in. An organisation that makes this figure a target someone is held accountable for creates a standing reason to resist every pay review. That is an effect on incentives, not on the calculation.
What human capital ROI does not show
- Where the effect arose. Of two organisations with the same return, one may spend heavily and earn heavily while the other spends little and earns little, and the figure does not tell them apart.
- Anything about a particular group. The ratio is a figure for the whole organisation. Applying it to a single department requires a share of revenue attributed to that department, and such a share may not be possible to establish for a department that does not earn revenue directly.
- A trend from a single year. A trend appears only over several years, because a single year’s movement can be dominated by that year’s prices or demand.
- A justification for cutting cost. Reducing the denominator raises the ratio arithmetically, and it may reduce the numerator the following year, so an improvement can appear in one year and its reverse in the next.
When human capital ROI carries meaning
The real use of the figure is comparison over time within a single organisation, with the definition held constant. If the denominator and the method of calculation stay fixed, a change in the figure from one year to the next becomes a question worth answering: did the margin move, did workforce cost move, or did both?
It is more useful to present the figure with its two components beside it: operating profit and workforce cost, each separately and in riyals. The reader can then see which of the two moved, which the ratio cannot show on its own, because it combines two movements in a single figure.
For comparison between organisations, we have no published source for the Saudi market on which to base a reference value for human capital ROI, and we do not take the absence of such a source in our references as evidence either way. Any comparison also depends on which form was used and where the boundaries of the denominator were drawn.
What human capital ROI is not
- Revenue per FTE divides revenue by a headcount, whereas human capital ROI divides by an amount of money. Revenue per FTE changes when headcount alone changes; human capital ROI does not change with headcount unless cost changes. An organisation that replaces two employees with one employee on double the wage sees revenue per FTE rise while human capital ROI stays where it was.
- Return on investment, which divides the net profit from an investment by its cost, is calculated on a sum invested in a specific project whose effect is then tracked. Workforce cost is a running expense, not an investment with a return to be monitored. The formula was borrowed, but its conditions were not borrowed with it.
- Economic value added deducts the full cost of capital, debt and equity, from net operating profit after tax, while human capital ROI deals with a single item of expense. Economic value added is a judgement on the organisation; human capital ROI is a ratio between two of its figures.
What distorts a human capital ROI figure
- A definition that changes between years. Including an item in the denominator one year and excluding it the next produces movement in the figure with no source in the business. In the example above, moving one item shifted the return from 33% to 40%.
- Revenue that has not been earned. The revenue used is what was earned in the period. Mixing it with amounts the organisation has only contracted for inflates the numerator with money not received.
- Workforce spending left out of the denominator. An organisation that moves work to contractors and keeps their cost outside the denominator sees its return rise for no real reason.
- A year of major change. In a year with a merger or the closure of a line of business, the figure moves for reasons that have nothing to do with the workforce.
Before a human capital ROI figure is presented
Three things are written alongside every return of this kind: which form was used, what was included in workforce cost and what was left out, and the period covered. A figure presented without these three cannot be compared with anything, neither with a previous year nor with another organisation.
The two components of the figure are then presented with it, in riyals. If the return rose and operating profit rose with it, that is news about the business. If the return rose while workforce cost fell, that is news about spending, and the two do not support the same decision. The ratio alone says that something improved, but not which of the two, and not whether the improvement will last.
This is an explanation of the concept, not legal advice.
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