BCG outlines new rules of the game for firms with high employee cost and low capital cost
27-Jun-2005 :
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The lead article in the June issue of the Harvard Business Review and the research report on which it is based defines a new and rapidly growing sector of the economy: "people businesses." According to the new report, by The Boston Consulting Group (BCG), people businesses were the highest-growth sector of employment in advanced economies over the past decade and now account for 25 percent of private-sector employment and well over half of employment in advanced economies.
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BCG defines "people businesses" as organizations for which employee costs are predominant, capital costs are low in comparison and R&D; investments are modest. Jobs in people businesses cover a wide range of both high and low value-added employment. Examples of leading people business sectors are: IT services; financial advisory and brokerages; accountancy, law and consulting; advertising agency groups; employment agencies; facilities and security management; and hotel and hospital management to name a few.
The top ten for-profit people businesses, as measured by employees, have about as many employees as the top ten worldwide companies, as measured by market capitalization. And the top ten state-owned and not-for-profit people businesses, now managed more and more like commercial enterprises, employ as many people again.
The growth in the number of large people businesses is the result of both industry growth and substantial industry concentration. For example, the top seven advertising agency groups have increased their global share from 20 percent in 1996 to more than 60 percent today. But people businesses are not limited to service or "knowledge" industries. Even heavily industrialized companies like automakers find that employee costs usually exceed capital costs and that diversified companies have units dedicated to employee- intensive activities such as the sales force and customer support.
"People businesses are becoming a more important sector for the economy and for the stock-market," said Felix Barber, co-author of both the report and HBR article and a Zurich-based senior adviser to BCG. "But the 'rules of the game' for people businesses are different than those for more traditional industries in how performance is measured and employees are managed."
For the report, BCG identified and analyzed more than 100 for-profit companies throughout the world with revenues of $1.2 billion or more in people businesses. BCG's report focuses on four challenges for people businesses.
Performance measures
Traditional, capital-oriented financial metrics, such as "return on assets" or "return on equity," provide poor performance benchmarks for people businesses. It is not difficult to achieve a high return on capital in a business requiring little capital. People businesses often achieve a return on capital of more than 100 percent. A new approach to measuring employee performance is needed in which people businesses answer the same questions about employees that they would normally answer about capital investments — especially since sales per employee and profit per employee are easily distorted. Barber and his co-author, BCG vice president Rainer Strack, propose a new scorecard that calculates economic profit using employee costs rather than a capital denominator.
People management
In high value-added people businesses, there are often wide variations in productivity among individual employees and small teams — not just a few percent but as much as 500 percent. On average for people businesses, a five percent improvement in employee productivity increases economic profit by 50 percent (because economic profit is typically 10 percent of employee costs). So BCG asserts that human resources management should not be treated as a support function, but rather transformed into a core process driven by line managers. "People businesses require far more granular information and understanding than traditional businesses do," says Barber. "The leverage from getting the people management system right is five to ten times what it is in other businesses because people are five to ten times more important in relation to invested capital."
Rewards
Because employee costs are such a high percentage of total costs in people businesses, they are much more sensitive to pay and productivity than traditional businesses. Barber and Strack predict that people businesses will increasingly need to use compensation, particularly variable performance- related compensation, as a lever for managing people and profits. They point out that a dollar of profit-variable compensation costs shareholders, on a risk-adjusted basis, substantially less than a dollar of fixed salary.
Also, the most productive people businesses typically pay their employees more. When variable compensation is included, differences in average compensation for comparable employees in directly competitive businesses and in the same geography can be as great as 20 percent. The true performance gap between industry leaders and laggards is often much larger than profit differences suggest.
Strategic advantage
Top performing people businesses require excellent operational management systems to get the most from their people — but that is not enough. BCG found the best performers who achieve 'productivity per employee' of more than 30 percent above employee costs (as compared to an average of 10 percent for an average people business) go beyond operational excellence to achieve strategic advantage. Because human capital does not offer opportunities for acquiring economies of scale, and because employees themselves receive the benefits of higher personal productivity, achieving strategic advantage requires transforming people business economics by leveraging human capital with processes, customer franchise, intellectual property or traditional fixed asset investment.
Finally, pricing strategy now plays an integral part in the growth of people businesses. Large people businesses don't necessarily have a cost advantage over their smaller competitors, so the pricing of products and services needs to ensure they capture the additional value they create for customers. In addition, industry pricing structures change over time so people businesses must be vigilant about following these shifts and attempt to influence the trends to their advantage.
Barber and Strack point out that the relationship between management, shareholders, and employees is being reexamined and re-articulated by leaders of people businesses. It is a new management high ground fueled by the powerful fact that human beings and not capital are the crucial ingredient in many growth businesses. To truly engage employees, companies need to meet their own business objectives and their employees' personal objectives.
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