By Haig Nalbantian, Richard Guzzo, Dave Kieffer, Jay Doherty
The CEO knew it was a bold play, but he was determined to get it past the board.
"Ladies and gentlemen," he said, "I propose to invest 36 percent of next year's sales - roughly $5 billion - in a venture I'm confident will produce great gains for the company."
He knew he had to take the high ground before they started asking questions.
"Let me say at the outset that I can't estimate a specific return on investment, but we will be able to benchmark our spending against other companies, so I am confident we can manage this venture effectively."
There was silence.
He was relieved.
They were stunned.
Strange as it may seem, an unspoken version of that dialogue takes place every year in every company from Germany to the United States to Japan. This is what it would sound like if CEOs had to ask their boards for permission to fund all the investments associated with their workforce - equivalent to an average of 36 percent of an American company's revenue each year. The question for companies goes like this: Is the return you're getting on your various human capital investments exceptional, marginal, or negative? Unfortunately, that question seldom is asked and virtually never is answered. That's why for many companies human capital is the biggest investment about which they know the least.
The reason executives know so little about their human assets isn't a lack of interest or concern. Indeed, CEOs and senior managers spend most of their time dealing with people problems. The problem has been their inability to measure, assess, and predict the outcomes of workforce tactics in the same way they do with other parts of the business. The tools simply have not been available. They didn't miss the boat. There wasn't any boat.
The only good news in this is that there has been parity among companies in their inability to measure and manage human capital factors. The bad news is that this situation is changing dramatically. Measurement and management tools are now available. Companies that adopt them and learn to use them well will gain substantial advantages over organizations that are slow to catch on.
Every company has tangible assets (financial and physical) and intangible assets (brands, customer relationships, and people). In the past, tangible assets were prime sources of competitive advantage, but their power to differentiate or confer special power has faded. For example, it was not long ago that executives struggled to obtain the capital they desired to run their companies. Nowadays capital flows relatively easily even during significant economic downturns. In early 2003, in a distinctly down economy, companies continued to get the money they wanted, ranging from the $900 million Volkswagen was putting into new manufacturing facilities in China,2 to $21 million in private financing for Chicken Out, a fledgling restaurant chain in Maryland.3 Access to financial capital doesn't differentiate enterprises or give a business a competitive advantage over its rivals anymore.
Nor does technology set most companies apart for very long. Until recently first movers with new technologies could establish competitive advantages they could ride for years, as FedEx did with its logistics/ tracking system. Today advantages rooted in new technology are shortlived.
What one company has often can be acquired or replicated easily by others, making technology no longer special, just required.
At the same time the competitive landscape is tumultuous. Almost unthinkable things are happening: smaller companies taking on bigger ones, less developed countries going toe to toe with larger ones. The Royal Bank of Scotland, like a latter-day Robert the Bruce, charged into England to buy Nat West, and it's now expanding overseas. Chile is crating off its counterseasonal produce to northern markets and hooking those markets on its year-round fishery. Lowe's is chiseling away at Home Depot's seemingly uncontested market dominance. Big pharmaceutical houses find the performance of upstarts like Forest Labs depressing. China continues its Mao-defying revolution into a new economic dynasty. Nothing can be taken for granted anymore.
Thus, earlier sources of value creation and advantage - access to capital, technology, and economies of scope and scale - have become much less critical. What's left - the last unexploited source of advantage - is the largest part of most companies' intangible assets: human capital and the system each company uses to manage it. Nobody has ever denied that people are important. Companies routinely profess that "people are our most important asset" although many behave otherwise. However, in a world where knowledge and connections to customers matter more and more, human capital - a company's stock of knowledge, technical skills, creativity, and experience - is becoming increasingly important.
A great workforce alone is not, however, the source of advantage. If it were, today's best-endowed companies would simply outpay all others, staff themselves with the best people, and enjoy a permanent advantage. Obviously, this doesn't happen. The reason is that the real and competitive advantage comes not merely from the people, but more importantly from the way firms manage them. We call that set of management tactics, policies, and practices an organization's human capital strategy. That strategy - that system - is the last asset with which companies can gain enduring advantages.
Human capital strategy is the sum of all actions - in both line and staff functions - used to manage people throughout an organization. It is the people analogue to a firm's business model or strategy.
Human capital strategy consists of six factors that most affect business results (Figure P-1). For details on the empirical basis for these factors, see Appendix A, "The Research Roots of the Six -Factor Framework."
From the executive suite to the mail room, the nature and quality of individuals in the workforce obviously influence the performance of an organization. Specifically, this factor represents the human capital itself, the collective mix of attributes individuals bring into the company and then develop over time.
Dominant work processes have both direct and indirect effects on organizational performance. Two companies in the same industry may organize their work quite differently; for example, General Electric builds jet engines on an assembly line, and Allison builds them in small work groups. Those differences often require different kinds of talent.
This factor characterizes how organizations direct the work of employees across dimensions of managerial direction (high control) versus individual discretion (low control).
The flow of information and knowledge in an organization also drives productivity. This factor includes both internal dynamics (up, down, across) and external dynamics (to and from customers, suppliers, regulators, etc.).
This factor focuses on important business decisions (not on day-to-day job-level decisions) that affect major areas of strategy, operations, finance, marketing, and sales.
The motivational component of human capital strategy is reflected in an organization's reward structure: both the financial and the nonfinancial motivators that influence employees to work hard, innovate, and develop.
All organizations have a human capital strategy made up of these six elements, whether intended or not. The factors come together in unique combinations to fit the individual companies; thus different patterns work best for different enterprises.
Some drivers are critical for success, but all of them always are in play. At its best, a company's unique human capital strategy is a major barrier to competitors.
We emphasize that these six factors operate as a system in which they interact with, balance, and complement one another and their various parts. Of course, this human capital strategy system exists within the context of larger systems, just as one's family "system" resides in a social system, an ecosystem, and a political system. In the case of organizations the human capital system must fit and complement other systems - the company's marketplace, its business model, and its strategy for financial and physical asset management (including technology). Effective decision making must take into account those points of context.
We will talk more about this system's reality in Chapter 1 because ad hoc or silo-based decisions are always suboptimized, and usually dysfunctional, when they are made without regard to the overall system.
Together with the market and the business model context, the human capital system inherently shapes the unique character of a company.
That creates two potent competitive advantages. First, the sum of a company's human capital practices is relatively stable and persistent, typically more enduring than the effects of technology and financial capital. Second, because it is unique to its context and goals, a successful company's system for managing human capital is very difficult to copy. Indeed, what works well for Company A is unlikely to work for Company B. A copycat may try to adopt two or three "best practices" from a top company, but that approach will not produce great competitive advantages. Why? Because the best practices of the highly successful company are part of its system of interrelated practices and values. It is the sum of a company's whole system that makes a company great. Thus, copying one or two discrete practices produces one of two outcomes: The first result is that the transplanted tactic works but generates no competitive advantage because, since it's easily adopted, it quickly becomes a new standard used by most companies. The second, more likely outcome is that it fails - sometimes quietly, sometimes stunningly - because the "borrowing" company can't copy all the other factors that support and interact with the adopted tactic at the great company. In other words, it doesn't fit into that company's unique context.
Our work shows that these two competitive advantages - longevity and inimitability - hold true even for close competitors in the same industry. Think about trying to copy a successful rival's entire system. Consider what would happen if BMW decided that the only way for it to be ultimately successful would be to transform itself into another Toyota and then beat Toyota at its own game. Or if Oracle aspired, as impossible as that might be, to copy Microsoft. Or Komatsu chose to model itself after Caterpillar.
Each would struggle for years to emulate its competitor. It would have to change long-standing values, practices, and policies. It would have to match its workforce to the new strategy. It would have to train people for new ways of doing things. Key people would leave in disgust or have to be replaced because they weren't "wired" to lead or perform in the new system. There would be major turmoil before there were results. It would take years - if it were even possible. (Paradoxically, companies can change their business models more easily than they can change their human capital strategies.)
Thus a company that gets its system of people management "right" has an extraordinary competitive advantage over its rivals. It will obtain better performance from what is often its largest asset and won't have to worry about its rivals copying the key to its success. In doing this, a company is playing to its strengths.
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