How to Measure Human Resource Costs
Measuring Human Resource costs (HR costs, also called Human Resource costing), is a key component of HR accounting. In this article, we’ll explain what Human Resource costing is, why you should measure costs, how to do it and why just measuring Human Resource costs is not enough.
Traditionally, the human resource department has been regarded as a cost center, or fee burner. For this reason, there’s always a lot of emphasis on cost reduction within HR. This is where Human Resource costing comes in.
The first question is how we define cost. According to Flamholtz (1999), cost is a sacrifice incurred to obtain some anticipated benefit or service. This means that all cost has an “expense” and an “asset” component. This is what Human Resources accounting is all about: measuring the expenses and asset components of cost.
There are multiple ways to do this, but let’s first understand why we measure Human Resource costs.
Why measure Human Resource costs?
There are four main reasons why you’d want to measure Human Resource costs:
- Monitor departmental costs
- Measure impact and overall success
- Predict future costs
- Calculate a return of investment (ROI)
Monitor departmental costs
First of all, you want to monitor departmental costs. This is perhaps the most important reason to learn about Human Resource costing.
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Monitoring costs is not specific to the HR department. In this day and age, every department and manager need to know their costs. For example, this can be required for budgeting purposes. At the start of the year a department receives a certain budget and at the end of the year it needs to report how this budget was spent.
This budget helps to answer questions like: Was the money allocated for the appropriate goals? Did the money allocation match the initial budget? If not, why was there more or less money allocated?
Through monitoring Human Resource costs, it’s easy to show how they are changing. This is directly related to our next point: If costs increase, does our effectiveness also increase?
Measure Human Resource costs efficiency
If HR costs increase while HR effectiveness decreases, we have a problem. This means that HR efficiency goes down.
Efficiency is the number of resources required to achieve a certain goal. If many resources are used to reach this goal, efficiency is low. If only few resources are used, efficiency is high.
To give an example: Two organizations are trying to lower employee absence. One of the organizations provides a free fitness subscription to everyone. The other removes unhealthy snacks from the canteen and provides free fruit. Both interventions lower absence by 5%. However, the costs for the first organization are 4x higher than the second. In other words: the second is more efficient.
That being said, the second reason to measure costs is to get an idea about the efficiency of HR actions. Note: this doesn’t tell you anything about the impact or overall success of these actions! We all know examples of projects that cost a lot of money but didn’t turn out successful.
Predict future costs
A third reason to measure Human Resources costs is to predict future costs. This is quite straightforward: if the same number of people do the same things next year as they did last year, the costs are expected to be equal.
When hiring new people, you can estimate the costs for the larger population. If the number of employees increases by 25%, your HR support costs will also increase by roughly the same percentage.
Of course, the reality is more nuanced. Later in this article, you will read about the value of money over time. Money is subject to inflation which, over time, reduces the value of the money today.
HR costing to calculate an ROI
Calculating an ROI is the final reason why HR professionals are interested in estimating Human Resource costs. Cost is a key element in the ROI formula.
An example: After talks with the company doctors, HR identifies that there is a high frequency of vascular diseases in the organization. This is mainly due to the company’s predominantly middle-aged population.
In response, a step-counter scoreboard is launched to combat this issue. This scoreboard indicates the steps per department and team which leads to some ‘healthy’ competition. If you can calculate the costs and estimate the benefit of such an intervention, you can calculate the ROI.
If the ROI is larger than 1 (which equals 100%), then it’s positive. If it is smaller than 1, say .5 (50%), it’s negative. If only 50% of the costs are recouped then it’s a bad investment.
The ROI calculation is tricky and difficult to make. Indeed, there’s quite a lot of critique on the emphasis placed on this calculation. Consider the following:
“What is the ROI of email?” You can imagine that this question is impossible to answer. However, none of us wants to go back to writing letters and sticky notes to colleagues.
Classifying Human Resource costs
When we talk about classifying costs, we’re talking about concepts from economics. In their book Investing in People: Financial Impact of Human Resource Initiatives, Wayne Cascio and John Boudreau list (among others) these costs.
- Fixed and variable cost
- Opportunity cost
- The value of money over time
- Estimated value of employee time
- Cost-benefit and cost-effectiveness analysis
- Utility as a weighted sum of utility attributes
- Conjoint analysis
- Sensitivity and break-even analysis
Explaining each of them will take too long, but I’ll quickly go over the first three as they’re the most relevant for HR practitioners.
Fixed vs. variable HR cost
The most important distinction for any project is the one between fixed and variable cost.
Fixed costs are the costs that remain constant, regardless of the activities in the project. Variable costs change as activities change.
For example, creating a training session involves a certain fixed cost. However, the number of times the session is given is related to variable cost. This is why the cost of training 200 people in 10 workshops is higher than the cost of training for 20 people in 1 workshop. The cost of creating the material is the same, but by giving 10 workshops instead of 1, the variable costs decreases 10-fold.
HR opportunity cost and savings
Opportunity cost refers to the potential gains that might have been realized if resources were directed to other ends.
For instance, training your salespeople doesn’t only cost you their salary (AKA the estimated value of employee time). No, it also has opportunity cost: in the time that they spend in training, they might have also closed a deal. This is your opportunity cost.
To quantify these costs, you should make a list of all the activities that the employee can’t do because of the intervention. Next, you can quantify the opportunity costs for each of these activities. For example, if a salesperson works 5 hours less because he is in training, and it takes him on average 200 hours to create a deal that brings in $40.000, the opportunity cost of the sales training would be $1.000.
Value of money over time
We all know that money doesn’t retain its value because of inflation. However, if money is not invested in an HR intervention but stored on a bank, it will create more money. This means that money in the bank usually has a constant, positive return on investment. I write usually. At the time of writing, this doesn’t hold true as inflation is currently higher than interest.
So, the value of money fluctuates over time due to inflation and interest. This is important to keep in mind when you calculate the payback period or the return on investment. The method for doing this is referred to as the (net) present value.
Behavioral Human Resource Costing
The aforementioned methods are used by Wayne Cascio to do behavioral Human Resource costing. When we apply human resource costing, there are two considerations:
- Outlay cost (material) + the cost of time
- Fixed cost + Variable cost + Opportunity cost
The easiest way to calculate the cost of time is to specify all the tasks that need to be done to complete a project. You then need to estimate the number of hours for each task and quantify the cost of time and the opportunity cost.
Next, define fixed and variable cost and you should then have a good overview of the total cost for a project. This is the input you need to calculate the aforementioned ROI.
Human Resource Costing without benefits
Human Resource costing is an important and established mechanism to manage cost. However, there is an important aspect that you should keep.
We started this article by stating that HR is often seen as a fee burner. The risk is that HR focuses too much on cost reduction and efficiency. In the end, HR shouldn’t be judged by cost efficiency – and shouldn’t strive to achieve this.
What matters, in the end, is value added. If HR can show added value then costs are irrelevant. Let me explain this.
When increased Human Resource cost shows an increased positive return, the business will be happy to invest more in HR. In this case, investing in HR leads to more productive people!
To prove this added value, HR needs to shift its focus from efficiency metrics to HR and business outcomes.
Examples of efficiency metrics are:
- Cost per hire
- Cost of HR per FTE
- Time to hire
- Training expenditure per FTE
So, is it actually desirable to reduce these metrics? Lowering your cost per hire is easy; hiring high performers isn’t. Reducing training expenditure is also simple, but making sure people’s performance improve… That’s another story.
In order to add real value, HR should shift away from analyzing and reducing cost and instead focus on showing and creating value. This has everything to do with the HR value chain and this is also where HR analytics comes in. Analytics helps to answer the question: how can we improve our business performance?
I wrote this to provide a comprehensive overview of the topic of Human Resources costs. To read more about HR costs I would recommend Wayne Cascio and John Boudreau’s book Investing in People. In their book, they describe all the above in much more detail and provide a number of very tangible examples on calculating the financial impact of HR initiatives.
To read more about HR analytics I recommend the article “What is HR analytics” and the article “Predictive Analytics in HR”. In a few weeks, I will publish more about the HR value chain and how it relates to analytics. I will include the link as soon as I publish this article.