Valuation of Human Capital

Valuation of Human Capital

Valuation of Human Capital

Research By - Navin Bhutoria

"Our employees are our greatest assets, and the ability to attract and retain them is the key driver

of our future success."

Sound familiar? This is now a routine sentence for any company reporting on its health and its

future. But for many of those companies, its meaning and implications are limited to that

sentence. Let's step back to quantify more precisely what it means to have human capital, to

attract and retain it.

The human capital can be defined as "the knowledge that individuals acquire during their life and

use to produce goods services or ideas in market or non-market circumstances."

Good managers know that measurement is a prerequisite for good management: We've heard the

axiom that, "What gets measured gets managed." This suggests then that the fundamental source

of wealth creation--human capital--is seriously under managed in most organizations. That is

because most organizations' systems of measurement, shaped in part by accounting and reporting

requirements, are still unduly influenced by measurement concepts dating back to the industrial

era when physical capital was the primary source of wealth creation. Using these out-of-date

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Valuation of Human Capital JBIMS

measurement systems to manage today is roughly analogous to steering a car with the rear view

mirror.

There have been only three eras in all of economic history: the agrarian era, the industrial era, and

the knowledge era. Each era has been defined by the factor of production that has served as the

foundation for wealth creation. Not surprisingly, in the agrarian era, land was the primary source

of wealth. In the industrial era, the primary sources of wealth were machinery and, to a lesser

extent, natural resources. In the knowledge era, human capital is the source of wealth. [A

definitional note: human capital is the embodiment of productive capacity within people. It is the

sum of people's skills, knowledge, attributes, motivations, and fortitude. It can be given or rented

to others, but only on a temporary basis; its ownership is non-transferable.]

The accounting and reporting systems that have developed over centuries reflect this evolution,

albeit with a lag. In most of the developed nations, the currently accepted accounting principles

and their related reporting requirements rest on the foundational assumption that physical assets

(land, machinery, buildings, natural resources and inventory) generate wealth. Human capital

does not even appear on the balance sheet.

There is, of course, a reason for this that transcends history. Unlike all other factors of production,

human capital is the only factor that cannot be owned. Although that is as it should be, the

omission of human capital from the balance sheet can play mischief in the wise allocation and

management of resources.

One need not look far back in economic history to find a painful example of this mischief. As the

U.S. underwent major restructuring throughout the 1980s and into the 1990s, corporations that

announced massive layoffs typically enjoyed dramatic increases in their stock prices. Some of the

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Valuation of Human Capital JBIMS

increase was undoubtedly the result of the perception (right or wrong) that fat was being cut.

Some of the increase, however, was the tautological result of the fact that when people are cut,

costs decrease and, as a result, earnings increase, at least temporarily. In other words, layoffs

could be used to drive short-term increases in stock market prices

...