Better hires, less waste: a potential profit bonanza; What are turnover and mediocre employee performance really costing your organization? The CFO of a firm that designs and develops workforce selection systems offers thoughts about how and why it's vital to find out.

In recent years, enlightened CFOs have begun to take a closer look at their organizations' personnel costs. The reason for this is twofold. For one, in many cases, personnel costs, including payroll, represent an organization's greatest expense. Moreover, given the considerable size of these costs, they can represent a significant drain on profitability.

What CFOs are finding as they look more closely is that personnel costs cannot and should not be treated as the exclusive domain of human resources (HR). Instead, they should be viewed in terms of their larger impact on the organization as a whole. Consider, for example, the costs associated with employee turnover, which can be in the eight-to-nine-figure range. In fact, one Fortune 25 organization's estimated turnover cost is in excess of $1 billion! That's a significant hit on the bottom line and one with cost implications that, of course, extend far beyond the HR department.

But turnover is only one cost driver that demands greater focus from CFOs. Another is the expense associated with hiring or keeping "less than the best" employees. The effects of these costs are exacerbated when the organization doesn't take action to improve the performance of low-performing employees or delays terminating them.

[ILLUSTRATION OMITTED]

To understand what a powerful cost driver turnover can be--a cost driver that is, in fact, a profit drain--as well as the full implications of hiring less-than-the-best employees, a more comprehensive view of personnel costs is needed. By assembling all the costs of hiring, employing and replacing people, a strategic cost picture emerges that reveals potential for profitability improvement.

As these costs reside across many budgets, CFOs need to initiate a cross-functional team to identify and compile the true total. Such an effort is analogous to the Six Sigma approach to quality.

Understanding End-to-End Personnel Costs

The first step is to identify the relevant cost centers. For a salesperson, HR has hiring costs; sales has turnover, compensation and productivity; Legal bears costs associated with any legal actions related to the salesperson's performance or termination; G & A has unemployment insurance costs.

A conceptual model of the personnel costs that an organization incurs might include three categories--hiring process costs, performance costs, and separation costs (see Figure 1). Hiring process costs include advertising, headhunters, testing, interviewing, etc. Separation costs include severance, unemployment, legal costs and the value of management's time during the termination process. Performance costs include real costs and opportunity costs associated with how well employees perform.

This model also includes two cost drivers, turnover and differential performance. When per-unit process costs are multiplied by these cost drivers, what emerges is an overall cost picture that has activity-based elements.

Differential Performance And Turnover

The variability in employee performance, or differential performance, represents a potential profit improvement as the organization either has more people than it needs or is missing an opportunity to grow. Differential performance is actually linked to turnover, as less-than-the-best employees often will either leave on their own, or be terminated. This cost driver comes into play quite often, since high-quality employees are typically the hardest to find, putting pressure on managers to hire mediocre employees rather than star performers.

As touched upon above, from a macro perspective, there are two types of turnover--desired and undesired. Desired turnover often happens in the first 12 to 24 months of an employee's tenure and is largely due to a selection process failure, as the organization hired someone that was not compatible with its norms of behavior. When this happens, the employee may realize the poor fit and leave, or the organization may terminate him or her.

In either case, the organization has wasted both the costs associated with hiring the poor performer (hiring process costs) and the training and opportunity costs incurred while the employee was in the learning phase of his or her job. Furthermore, desired turnover is often accompanied by separation costs. How many executives and professionals has your organization hired, only to dismiss them within 18 months? How much do these poor hires cost your firm?

On the other hand, unwanted turnover of high performers is often due to leadership failure. Watson Wyatt Worldwide reports that the top four reasons cited for turnover include dissatisfaction with pay, dissatisfaction with management (typically employees' direct managers), inadequate promotion opportunities and inadequate opportunities to develop skills. In each case, there is a leadership failure, as the manager should have been listening to, and engaging in meaningful discussions with valued employees to assess and mitigate turnover risk.

[FIGURE 1 OMITTED]

The good news is that turnover can be reduced through proper selection system design and leadership development. Research by the author's firm has revealed that a typical company can reduce turnover by an average 48 percent through properly designed HR systems.

The right balance between understanding job requirements, candidate sourcing, identifying the needed experience and motivational fit, testing, interviewing and leader behavior is key to achieving these results. Also, costly interviews are often overused, meaning that improvements in the selection process--resulting in the need for fewer interviews--can be made while simultaneously reducing hiring process costs.

Impact of Differential Performance

In its landmark 2000 study, "The War for Talent," McKinsey & Co. concluded that high performers out-produce average performers by anywhere from 40 percent to 70 percent. Specifically, this study applied this gap to sales jobs, operational jobs and management roles. If you think about it, it's not hard to understand why this gap is so great. Jobs aren't what they used to be--they're more complex.

To the extent that your employees need to integrate complex information to make a decision, as is typical of most "knowledge worker" positions, a quality hire will make you more competitive. If your organization accepts "average" or subpar performance rather than the best-possible performance from its people, you are providing your competitors with a cost advantage.

For knowledge workers, when it comes to profitability, what you pay them is important, but their output you get from them is even more important.

A Cost Model of the Mediocre Hire

Figure 2 shows a table of the revenue of salespeople who are past the ramp-up phase and should now be producing at their full potential.

Category A represents the top performers, generating $2 million in sales per year. Their performance level is important to note, as it is the benchmark against which the others' performance can be measured. Category B salespeople have an average performance of $1.5 million per year, while Category C salespeople generate just $1.2 million per year, producing $0.8 million below those salespeople in Category A.

Typically, the sales manager spends disproportionate effort to improve Category C performers as compared to others. Category D and F performers, meanwhile, were likely bad hires and will end up turning over.

Using this realistic example, the cost of the differential performance between "the best" and "the rest" is $68.25 million ($200 million minus $131.25 million). If you could initially close the gap by only 10 percent--$6.825 million--would it make it worthwhile to hire better people and develop those salespeople you already have so that they can perform at a higher level? I think you would agree that the answer is, "yes."

As many large organizations have hundreds or even thousands of salespeople, it's easy to see the dramatic profitability drain from differential performance. In addition, there also are many other jobs for which each employee's performance can be tracked and compared to the high-performing benchmarks. You might be shocked to see just how much your organization may be losing due to lower-performing people.

While sales represents the easiest example of how to compute differential performance costs, the same calculations can be conducted for any job by replacing sales with other units of output. Units of output for an accounts receivable clerk could be invoices processed, while for a customer service representative the measure might be number of calls handled per week.

In jobs that are not knowledge-driven, output may not be as important as other factors. For instance, a fast-food restaurant may value customer service, attendance, work habits and teamwork--the factors that set the high-performing employees apart from the rest.

The calculations for the value that are provided by various jobs typically will require that the CFO partner with HR and with experts from other departments who are knowledgeable about individual jobs, and the appropriate units of output or other factors to target. While this might sound cumbersome, looking at groups of jobs (such as project engineers) can expedite the process. The actionable outputs, however--the knowledge of how much differential performance is costing your organization--are exceedingly valuable and justify the time and effort invested.

You might question whether it is possible for an organization to have only "A-level" performers. The answer is, probably not. But, then again, you were able to successfully hire at least a few top performers. If you can hire a few A-levels, why not twice as many? Or four times as many? By analyzing the incumbent top performers, you can identify the target and create a selection system to raise the quality of hires. It can be done. And as the above example illustrates, there are tremendous cost advantages to be realized.

Capitalizing On the Opportunity

Armed with an understanding that your organization can reap a profit bonanza by identifying and addressing its performance costs, the next step is to make it happen.

As the CFO, you stand to be a key player and can help drive the initiative by doing the following:

* Raising awareness and championing the cause. You have the insights and perspective necessary to credibly bring the issue to the attention of your executive team. At DDI, the author pushed and prodded the management team to attack selling costs by using differential performance concepts.

* Helping HR build the business case. One thing that you won't be able to do as a CFO is to diagnose the specific causes of turnover or differential performance. But by having a model that shows the costs and opportunities, you'll have a baseline and will be able to target areas for improvement. For instance, HR is typically squeezed to reduce hiring costs, but armed with the right information, you might be able to determine that spending more on selection may result in an overall cost improvement.

* Monitoring Progress. Often, people initiatives get lost without the necessary supports of a sponsor, accountability and measurement. Our firm's selling cost target is on our balanced scorecard, and in the performance plans of the sales organization's leaders. So that senior leaders get the message, yearly bonuses are tied to selling-cost reduction. We're still not where we need to be, but we're making progress.

Difference Between Good and Great

In his influential best-seller, Good to Great, Jim Collins wrote, "The old adage 'people are your most important asset' is wrong. People are not your most important asset. The right people are." When it comes to your organization's cost competitiveness, the difference between good and great is the quality of your people.

How important is raising the productivity of your lower performers? Are your hiring processes cost effective? Are you losing top performers through turnover? As a CFO, it's worth it to you--and your organization--to find out.

William A. Koch is Vice President and CFO at Development Dimensions International Inc., a Pittsburgh-based firm specializing in the design and development of personnel selection systems. He can be reached at 412.257.3885 or [e-mail].

RELATED ARTICLE: takeaways

* CFOs are realizing that personnel costs can't be the realm of human resources alone, and need to be viewed in terms of the impact on the entire organization.

* At major companies, turnover-related costs can be as high as $1 billion a year or more. Another, lesser expense comes from keeping poorly performing employees.

* When per-unit process costs are multiplied by certain cost drivers, what emerges is an overall cost picture that has activity-based elements.

* Research shows that a typical company can reduce turnover by an average of 48 percent through properly designed HR systems and less use of costly interviewing.

Figure 2 MIDWEST REGION SALES

EE        #    SALES/  CATEGORY  DIFFERENTIAL
CATEGORY  EES  EE      TOTAL     Performance

A          10  2,000    20,000        0
B          25  1,500    37,500   12,500
C          50  1,200    60,000   40,000
D          10  1,000    10,000   10,000
F           5    750     3,750    6,250
TOTAL     100          131,250   68,750