The Hidden Leverage of Human Capital

More than 20,000 times last year in the United States, according to the Bureau of Labor Statistics, midsize and large companies responded to adversity by slashing on average about 100 staff members at a time. Considering all the news coverage about the economic downturn and the poor job market, that might, at first glance, seem like a dog-bites-man story. But that is a lot of jobs. Did circumstances always merit the drastic actions? If so, were the actions taken deliberately and carefully, with all appropriate respect toward the people involved? What sorts of provisions were made to ensure that key talent was protected? These questions are important because they go to the heart of how companies avoid lasting damage in the marketplace and build long-term value.

Trying to get a handle on the answers from publicly available data is problematic, as even a broad-based research effort would be brought to a halt at the gates of internal company performance information and organizational dynamics. But it is a safe assumption that many of these 20,000 organizations did destroy value somewhere along the way by cutting capacity that they soon had to replace, by making poor choices as to who should go and who should stay, by being careless in communicating the rationale for change and protecting the motivation levels of surviving employees, and by missing the opportunity to rethink their business model to optimize their positioning for the recovery ahead.

Organizations such as Wal-Mart Stores, Cisco, Charles Schwab and even American Airlines have recently tried to rehire laid-off employees.1 But in so doing, the churn they generate often serves to demoralize employees and create an environmental uncertainty that compromises staff engagement, loyalty, customer service —and ultimately, company performance.

The broader issues here go well beyond layoffs. Is there a right way to manage a company through a time of challenge or tepid economic growth? What general guidelines can be discerned from the lessons of the past? And what sorts of decisions can managers take today to improve the odds that their companies will emerge as the winners of tomorrow?

Slash and Burn: Re-Engineering and Core Competencies

It used to be an article of faith that re-engineering initiatives, analytically evaluated and quickly implemented into an organization’s operations, could serve as a magic bullet by helping companies realize previously unimagined efficiencies. In concert with operational streamlining, the conventional wisdom of a decade ago also advocated a devolutionary focus, whereby organizations, while earmarking core competencies for attention, at the same time took drastic steps to move outside the company those areas that didn’t fall within the core.

Perhaps the exemplar of the era was the former head of Scott Paper Co., “Chainsaw” Al Dunlap. Starting in May 1994, in an effort to rebuild shareholder value, he let go more than 11,000 employees and shrank the company by selling off and outsourcing various business units and functions. Wall Street loved it for a while, as market value tripled, but ultimately it became clear that the way the restructuring had been handled rendered it difficult for the company to deliver sustained performance, and Scott Paper had to realistically evaluate its ability to survive as an independent entity. In 1995, it reached a conclusion — the company was sold to Kimberly-Clark, a longtime rival.

In this vein, while many “ruthless” organizations achieved notable efficiencies, the best re-engineering success stories — as measured by long-term company sustainability achieved —came to be viewed as those that not only emphasized a tough focus on business drivers, but also combined it with a more human touch. Jack Welch at General Electric Co., for example, while restructuring and selling underperforming units, made significant investments in management development and training, and communicated to employees the logical and rallying message that GE should be number one or two in any business in which it competed.

Similarly, Archie Norman at Asda, the U.K. supermarket group, averted bankruptcy by both flattening the organizational structure and articulating a clear long-term strategy based on everyday low pricing. In so doing, he embarked on creating an atmosphere of trust and openness.

It seemed paradoxical, but the qualities of what came to be viewed as superlative corporate leadership were best captured in a headline in the Financial Times that read “Wanted: Ruthless Axeman with People Skills.”2

This context is useful as the starting point for articulating a broad-based model for management success in the current economic environment.

A Broader Leadership Model for the New Millennium

There is a sailing proverb that says, “Races are won at night and in a light wind.” A quiet time, after all, is the one in which the boat can be best prepared. It’s appealing to think of this quasi-recessionary time as the light night wind, with people training to work better as an effective team, loads balanced, equipment optimized, communications tested to be crystal clear.

Four broad areas of preparation are critical: strengthening key relationships across customers, employees and shareholders; leveraging downtime by capitalizing on underutilized staff for innovation initiatives; refocusing staff on what’s important at the company by prioritizing strategic roles and clarifying individual goals; and building return on compensation by forging stronger links between the pay people get and the results they achieve.

Strengthening Key Relationships

While strategic models of company stakeholders almost universally focus on customers, employees and shareholders, there is widespread disagreement as to where priorities lie within this list. The strongest strategies focus on all three groups of stakeholders and follow through with this approach in tough times as well as easier ones.3

Strengthening key relationships starts with keeping a finger on the pulse of frequently changing customer and employee needs. A good way to embark upon pulse taking is executing well-designed, customized surveys to better track the unique requirements of different customer and employee groups and how those requirements change over time. The real value of customized surveys is to help focus company resources on those customers and employees for whom company efforts yield the highest returns — whether they be key customer groups or high-performing employees whose perspectives are often obscured in more traditional, broad-based, generic questionnaires.

That said, in a challenging environment, follow-through on relationships means doing more than just surveying. Since customers and employees believe that companies reveal their true colors at a time of crisis, poor survey follow-up, or indeed any perceived mistreatment, can alienate those stakeholders permanently. Thus, what comes to the fore in relationship building —more than the newfangled concept of management — is its trusty cousin, leadership.

Leaders from Winston Churchill to Rudolph Giuliani, John F. Kennedy to Warren Buffett have a lot to impart to business-people with regard to building effective relationships in a crisis environment. They stood up and were visible. They didn’t anticipate failure yet stuck to the facts even when the facts were dire. And for the most part, they didn’t overreach. Winston Churchill’s brutal honesty was combined with optimism — “blood, toil, tears and sweat” but always an upbeat feeling that England would survive “however long and hard the road may be.” Former New York City Mayor Giuliani’s comment that the World Trade Center death toll would be “more than we can bear” was interspersed at the same time with his steady campaign to rally a city’s spirits. Mobilizing a fatigued group through a difficult time, after all, has its own historical best practices.4

Finally, together with leadership (perhaps, indeed, component parts of it), communication and engagement are critical to strengthening relationships. Communications across, and proactive engagement of, customers, employees and shareholders in helping to solve specific business problems go a long way toward smoothing the implementation of effective solutions.

Leveraging Downtime

In challenging times, managers are often faced with employees who suddenly find themselves with too much free time on their hands. In the old days, when this situation persisted, some of these folks would have had to be let go, due to onerous fixed-cost structures. But today’s managers have a tool their predecessors lacked: variable pay.

In the last decade, many companies have been able to significantly leverage their costs by migrating to a variable-pay model, in which compensation kicks in only if company, division and/or team results dictate. The result has been increased flexibility, in a tough business environment, to keep what might in the past have been at-risk employees on staff, albeit sometimes less busy, at reduced pay levels.

Across the nation, despite the large layoff figures cited at the outset, this phenomenon has had a dramatic ameliorative effect on unemployment rates. One estimate puts the benefit at a full percentage point of employment nationally; that is, what was a 5.5% unemployment rate in fall 2001 would have been 6.5% had it not been for the new prevalence of variable pay nationwide.5

What does this mean for successful management in a business downturn? For starters, managers should be attuned to the risk that the good news about being able to preserve years of individual experience within company knowledge banks could be offset by unproductive employee downtime.

Almost every company, especially if it is coming out of particularly heady times, has a few areas of relative neglect to which it can now profitably allocate that downtime. These areas —most often infrastructure, marketing and operations — are ones for which experienced staff, in particular, are well positioned to offer unique insights to help the company build for the future.

Organizations should be asking some broad, basic questions and involving not just senior management, but cross-functional staff groups at all levels. Are internal company tools and procedures adding sufficient value? Have we done enough to ensure our customers fully understand how our products and services can help them be more successful? Are we optimally aligned, organizationally, to serve the customers, market segments and geographies we serve today? Strategic initiatives undertaken to tackle questions like these serve a double purpose: In leveraging the wisdom of key staff, they prepare the company optimally for the future and harvest most people’s enthusiasm to play more diverse organizational roles and develop their own capabilities.

Refocusing Staff on What’s Important

The question “What’s most important in an organization?” can elicit surprising responses. BEA Systems, which in 2001 reached $1 billion in sales faster than any software company had previously (surpassing even Microsoft’s 1980s pace), has a new CEO, Alfred Chuang, who has what some might call a ruthless perspective. “We focus on two things,” he says. “Building product and selling product. I know that a lot of other functions are involved in that process, including marketing, servicing and infrastructure. But if you are not within the line of sight between the inception of the idea and delivering it to customers and making them happy, your job is not that important.”6

BEA has a track record of success it’s hard to quibble with, but it is critical for companies to go through an examination of not just employee roles, but also their people. Just as there are more strategic roles (for example, R&D in pharmaceuticals) and less strategic roles (tellers in retail banking), so there are also key people in organizations whose impact on performance can be significant, regardless of role.

How do companies determine who these people are and focus them adroitly? The key is to transform performance management from perfunctory end-of-year paper pushing to a disciplined, strategic and value-added process.

Elevating performance management starts with clearly defining and differentiating between core competencies and results —and balancing them appropriately. Some law firms, for example, rate partners exclusively on project sales and reward them for those sales through base and incentive pay. More-sophisticated law firms blend other considerations into the evaluations of a partner’s results delivered — for example, sales in conjunction with profitability. But best-practice firms, when looking at a partner’s longer-term contribution to the firm’s sustained success, consider the extent to which he or she demonstrates competencies such as attracting and retaining an enthusiastic team of junior people, broadening firm offerings into new clients and practice areas, and enhancing client satisfaction.

The “A” partners in those firms are the ones who deliver high performance on both long-term competencies (people development, new practice areas, client satisfaction) and current results (sales, profits). This competencies/scorecard framework —viewed pictorially with competency results on one axis and scorecard results on another, with people graphically positioned at their approximate performance levels — provides a roadmap for people development that is much better supported by the long-term economics of the business.

For unfortunate cases in which job cuts are absolutely required, this methodical framework for identifying critical resources stands an organization in good stead. It makes possible a matrixed analysis of strategic jobs against priority people, which in turn yields a valuable blueprint as to what cuts should be targeted.7

Building Return on Compensation

If what is sometimes called “talent management,” as outlined earlier, is done correctly, the foundation for wise compensation decision making is already laid. Base-pay progression can be readily and sensibly linked to competency achievement, and incentive pay to annual (or semi-annual or quarterly) results. To the extent that it is tied closely to drivers of business success, built upon commonly understood criteria, and applied consistently over time, compensation — frequently viewed by managers as a sunk cost — can instead be considered an investment with a quantifiable return.

Some years ago, my colleagues and I had a team working with a subsidiary of Kodak — a photofinisher called Qualex Inc. Qualex provided overnight wholesale photofinishing services predominantly to large stores (at which retail customers had dropped off their film for developing). Every evening, Qualex would receive drop shipments of large quantities of film from the stores and (using predominantly low-wage employees) splice the film together, run rolls of negatives through the photo-development process, and by morning redistribute the pictures to the stores from which the film had come.

Across its approximately 50 locations, though, the company had a problem — significant turnover, averaging nearly 60% annually, with the added problem of spikes in turnover during the summer, just when its sales volume tended to be highest. (To make matters even worse, the company was losing the very people it could least afford to lose — the most technically proficient — as these were the people whose pay was least competitive with pay in comparable companies.). The visible business effects were shaky productivity and quality results, which, above and beyond the inherent costs, often had the secondary cost of forgone revenue because of the company’s inability to meet productivity levels contractually specified in service-level agreements.

Implementation of customized rewards helped solve the problem. Rather than bring Qualex’s compensation to market levels with traditional base-salary increases (historically, this had been done for years, with little operational effect), the company designed and offered to its employees generous summertime pay premiums. These premiums constituted significant rewards for employees’ productivity during the period and their perseverance in the role all the way through to summer’s end. Later on, new, annual group incentives tied to specific productivity and quality goals were layered into employees’ pay. Because all of the new variable-pay components represented meaningful amounts, they garnered significant employee attention and had quite a noticeable effect on reducing turnover and improving operational performance.

While the costs of the new programs were significantly higher than previously awarded salary increases (about $20 million vs. $8 million), regression models linking pay to turnover to results predicted that the higher investment would demonstrate a $20 million operational return through improved productivity and quality. The historical $8 million annual salary increases, on the other hand, would have had no discernible return, because that practice would have perpetuated the old turnover, productivity and quality problems. Qualex got its expected return and wound up with more satisfied and motivated employees, working in a more positive environment and doing a better job for customers at a net lower cost.8

Admittedly, this type of solution is not always as straightforward to implement in environments where metrics like productivity and quality are less readily available or less appropriately measured at the individual and team level than they might be in a manufacturing or processing setting — environments such as IT architecture. However, it is safe to say that improved alignment between the value drivers in the business and the manner in which employees are rewarded is almost always possible. And given the dominance of pay as an expense-line item, such action, if implemented well, usually has a substantial, quantifiable, bottom-line effect.

Broad compensation overhauls like the one at Qualex are not always necessary to enhance return on an organization’s compensation dollar. Since variable-pay plans do already exist in many companies, they often can be amended to ensure that plan payouts awarded to employees will generate return. One way to accomplish this is to ensure that plans are driven by goals over which, as closely as possible, employees have some line of sight (for example, cost management, rather than company profitability).

There are several other considerations in tailoring variable-pay programs for higher return. Shortening plan-performance periods can be helpful, especially for cases in which substandard performance occurred some time ago but within the current performance period — demotivating employees to perform now because no matter what they accomplish, they still won’t receive incentives. In addition, payments for achieving stretch goals may be enhanced, and supplementing semiannual or annual payouts with spot awards can more swiftly recognize employees for special contributions.

The Real Value of Human Assets

It’s become a cliché to say that the service economy revolves around human assets, but even in manufacturing and production environments, wherein traditional machinery and equipment assets loom large, the caliber of people makes an enormous difference to the inherent value of an enterprise.

It’s impossible to overstate the contribution of people — especially when they are aligned with corporate goals, fully engaged in making the enterprise effective, and well suited for their individual roles. Consider that in the past 20 years the market-value-to-book-value ratio of the S&P 500 has gone from around 1:1 to around 6:1. That increase has caused many academics to begin to develop new models of company value that include human-capital components to better account for a corporation’s true worth.

In good times and bad, it is critical that companies play their cards right with all their key stakeholders — including employees. The costs of failing to do so are high. A 1999 survey of more than 1,000 companies in Britain showed results that for many observers at least partially explained that country’s slight lag in the marketplace. The responses of about 1,000 human-resource directors in Britain indicated that more than 60% of staff are so poorly engaged that most employers would not rehire them. And nearly a quarter of survey respondents didn’t believe that their work force gave their companies a competitive edge.9

Whether this is a result of hiring poorly or of a failure to develop good people into appropriate roles, managers in this situation have to overcome significant obstacles to success. And managers not in that situation need to make sure they avoid it.

After all, in the United States at least, there have been nine recessions since World War II and nine recoveries: a perfect record. It’s foolish not to think of this period as an opportunity to lay the groundwork for an exciting future.