Quantifying Return on People

It’s time to update the financial rules to put what truly matters at the center.

People are the foundation to a successful business. One that will be resilient. One that will continue to expand it's moat over time by out maneuvering it's competition or disrupting itself before competitors do. The people will be the ones who deliver the best customer service, build game-changing products, and craft systems to make the appearance of "cost efficiency". 

Yet, many are confused about how they can measure this. I've spoken to 100+ companies/professionals in the start-up ecosystem in Canada and one of the biggest points of concern I receive is: "Dan, that's great. Sure, I get it. But how can I measure this return on investment?"

I responded to continuous objections with: "You will see it in higher returns on invested capital over the decades you operate the company."

Of course, what they are telling me is that they can't invest in their people with the 10-year time horizon. The inherent answer they wanted was "Here are the 10 things that will happen with 80% certainty that will generate x% gains to your top and bottom line in the next quarter". I get it. The company may have investors who are fixated on quarterly financial growth and don't "walk the talk" when it comes to their "long-term time horizon". I mean, when have you ever heard investors say "Oh we have a short-term time horizon". 

When I study historically successful businesses, common metrics for assessing such success are shareholder value (i.e. share price for public companies) and/or consistently high returns on invested capital (ROIC).

"What gets measured gets managed" - John Doer

So what is ROIC? How do you measure it? Various investors have different ways. But a holistic equation is: Net Operating Profit After Tax (NOPAT) / Operating Capital

Operating capital includes debt (specifically interest-bearing debt) and shareholders equity. In other words, it's the total assets without the "non-operating piece" like cash, stock investments, discontinued operations etc.. 

The numerator is thus determined from the income statement and the denominator is determined per the balance sheet. 

Here is where it gets interesting. 

Where do "people" fit inside all this? 

When I say "people" I'm referring to their salaries, their benefits, the investment to programs to develop them further etc.. 

Well, they are all expensed in the income statement. Hence, people become labeled as a cost. They form the collective number that reduces the numerator for calculating ROIC. They collectively reduce the net operating profit after tax. Yes, the purpose of investing in your people is to generate higher NOPAT. But isn't it weird how there is this conflict where increasing investment in people is considered an expense that also reduces NOPAT?

Companies love to "say" that people are their biggest assets. Yet, they are all expensed. You might think I'm being nit picky here but when push comes to shove and you have to calculate that ROIC number to determine the viability and success of your business, you bet you'd be focused on increasing the numerator and decreasing the denominator. 

Companies are not "asset-light".

If you've been in the investment community you'll be familiar with the term "asset-light". Its a common piece of reference to the modern-day software-based business. I refrain from using "technology" since every business is a technology company. 

Sure, software companies don't need giant factories or massive data centers to operate. But they employ armies of engineers who develop the "light assets". The cost of a factory vs an army of top engineers can actually be quite similar depending on the company. Yet, the factory is listed as an asset under "property, plant and equipment" on the balance sheet and these engineers are expensed. 

The factory is considered to be an asset that will amortize over 10 to 20 years on the balance sheet. Also note, the balance sheet shows the financial health of the company by accounting for everything it has built and owned over it's life. The employees are considered annual costs on the income statement. The income statement merely shows the results of one financial year. There is a reason why Warren Buffet advises young investors to start with the balance sheet when looking at companies whereas the investment bankers on Wall Street or your finance professors who've never invested before will tell you to start with the income statement. Long-term vs. short-term. 

The fallacy is in believing modern day technology companies are asset-light because of the way we account for the true asset. The people. These companies are not asset-light by any means. They are very asset heavy with living, breathing individuals who are just treated like the annual expense like a bag of groceries you buy. 

Change the optics to change behaviour. 

If people truly are assets, then let's make it so. 

Let's move all costs associated with people into assets. So salaries, benefits, programs for people development and the whole sort. 

Then call it what it should be: Long-Term Investments 

Change the label. Change the narrative. Only once we actually acknowledge people as assets in the financials will we be able to change our behaviour towards investing in people within the organization. 

This means we will move people from the numerator of the ROIC calculation to the denominator. 

Now it's the people producing the numerator (i.e. NOPAT). Instead of them being the cause for it's immediate decrease. 

The lesser evil.

"But Dan, wouldn't companies then start dehumanizing people and start treating them like "tools" under assets and seek to squeeze returns out of them?" - Nitpickers (aka excuse-brigade)

Oh sure. But you don't think they've been doing it already? Do you think labeling people as annual expenses really made them any different? Maybe this time they'll think about developing the people first before "squeezing" them for return. Maybe now, people won't be considered an annual cost that can be financial engineered by cutting and adding heads wherever to meet financial targets. 

This is not a solution to make problems go away. 

Rather, I'm proposing a complete overhaul on how we measure business success. I'm proposing we put people at the center of the success of a company. Instead of putting the software or brand (i.e. intangible asset) at the center and reason for high ROIC, I'm saying let's put people at the center of that and make that the story. 

Nothing will stop short-term focused managers from squeezing every drop of efficiency out of their people. This is a mindset shift that needs to be made at a higher level. This is a question of how to change behaviour to think long-term rather than short term. If the intention of the leaders is to create a business that will thrive for decades and they end up trying to squeeze every drop of value out of their people, then it's not because of a human-centric ROIC. It's because they're just lying to themselves. Don't blame the system when the problem is you. 

Leaders who truly want to build a company for the long-term will naturally embrace this change. The leaders who don't have an exit strategy but a continuation strategy should rejoice at the opportunity to now put people at the center of the balance sheet as their primary asset. I may be preaching to the choir here but preaching to anything else has never seemed to work. 

Measuring ROIC on people…. ROP

It's not that we don't have a way of quantifying the return on investing in our people. It's that the old financial laws never accounted for people being an asset and they were considered mere cogs in Ford's assembly line or Jack Welch's ruthless operating machine. 

Once we decide to question the financial rules and intentionally put people at the center of it, everything we measure will become about the people. 

Rewrite your own financial history. Put people at the center of it as an asset. What is your Return on People? Your ROP?

 

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EssaysDaniel LeeOMD VenturesBusiness