Measuring return on your most valuable asset.

We often hear businesses state that their "people" are their greatest asset. Yet, more often than not they fail to measure the value of this asset. They use traditional financial measures such as return on equity or return on assets to determine performance.

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Unfortunately, these traditional financial measures fail to measure the performance and value of the people who make up the bulk of the value in a service oriented industry.

Is there a way for us to measure the return on our "people" assets?

Let's use an example to illustrate how we can measure return on assets in a people-oriented business.

Certified registered nurse anesthetists (CRNAs) who are employed by their hospital are seeking to expand their vacation time from four weeks to six weeks per year. An examination of other CRNA groups in their region showed that most have six weeks of vacation each year.

But the hospital administration is reluctant to increase the vacation time, since they recently increased CRNA salaries. Two of the CRNAs have been offered positions elsewhere and will leave if the vacation time is not increased. The market for CRNAs is highly competitive, so replacements cannot easily be recruited.

At a meeting of the senior leadership group, you as the vice president for medical affairs are asked to offer your opinion. Should the hospital grant the additional vacation time?

Analyzing the situation

Felix Barber and Rainer Strack of the Boston Consulting Group devised a means of reformatting a traditional measure of economic profit to one that is meaningful for people-intensive businesses. (1)

From a traditional, capital-oriented perspective, economic profit equals the difference between return on investment (ROI) and cost of capital (COC), multiplied by invested capital (IC), such that:

* Economic Profit = (ROI-COC) X IC

If we replace ROI with its equivalent of earnings (E) divided by invested capital (IC) or E/IC, we arrive at:

* Economic Profit = E - (COC X IC)

Since earnings (E) equals revenue (R) minus personnel costs (PC) (assuming supplier cost and depreciation cost are negligible), then:

* Economic Profit = R - PC - (COC X IC)

Barber and Strack then use algebra to factor in the number of people employed (P), so that:

* Economic Profit = {[R - (COC X IC)]/P - PC/P} P

They conclude that [R - (COC X IC)/P] is a measure of employee productivity, PC/P represents average cost per person. The result being economic productivity is the difference between employee productivity (EPR) and average cost per person (ACP), multiplied by the number of people employed (P), or:

* Economic Profit = (EPR - ACP) X PI

CRNA equation

With information about the revenue generated by the CRNAs, the average cost per CRNA, and the number employed, we can use this formula to calculate the economic productivity of the CRNAs.

Assume each CRNA, on average generates $240,000 in revenue each year. The average cost per CRNA with benefits is $140,000 per year. There are twelve CRNAs employed.

Economic Profit = ($240,000 - $140,000) X 12 = $1,200,000

While we have determined the value of our people asset, namely the CRNAs, how can we use this information to make a decision about the added vacation time?

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First, we need some additional information. Assume the CRNAs work 40 hours per week, average two cases per each 8-hour work period, and take four weeks of vacation per year. Knowing this we can calculate the revenue per case:

* Revenue per Case = ($240,000/year) / (10 cases/wk X 48 weeks/year)

* Revenue per Case = $500

Next, we calculate the employee productivity with the two additional weeks of vacation.

EPR = (10 cases/wk) X ($500/case) X (46 weeks/year) = $230,000

Knowing EPR, we can calculate economic profit with the added vacation.

Economic Profit = ($230,000 - $140,000) X 12 = $1,080,000

Subtracting the economic profit with six weeks of vacation from the result with only four weeks of vacation reveals a loss of $120,000. However, to give an accurate opinion, we must in our analysis determine the economic profit, if the vacation remains unchanged and two CRNA's leave.

Economic Profit = ($240,000 - $140,000) X 10 = $1,000,000

Maintaining the current vacation time and losing two CRNAs, results in a loss of $200,000, as compared to our loss of $120,000 by granting the additional vacation time. Therefore, from a purely economic standpoint, it makes sense to grant the CRNAs the additional two weeks of vacation time.

It may also make sense from a human resources standpoint as well, since it may serve to raise morale and prevent loss of any employees. This might be different if the market for CRNAs was not competitive and replacements could be found easily for the two who will leave if the vacation time is not increased.

By looking at economic profit from an employee productivity and cost perspective, we are able to place a "value" on our most important asset in a people-intensive, service-oriented industry, like health care.

These calculations, in turn, can help us to make rational financial and human resource decisions. As such, senior managers in people-oriented businesses must move away from traditional financial measures and continue to develop and apply new performance measures and management practices that allow them to make the most of their greatest assets.

David P. Tarantino, MD, MBA, is the executive medical director of Shock Trauma Associates, P.A., a 50+ physician, multispecialty practice associated with the University of Maryland School of Medicine. In addition, he is the chief executive officer of The MD Consulting Group, LLC, a health care management consulting firm in Baltimore. He can be reached by phone at 410-328-2036 or by e-mail at [e-mail]

Reference

1. Barber F and Strack R. "The Surprising Economics of a "People Business." Harvard Business Review, June 2005.

By David Tarantino, MD, MBA