The Surprising Economics of a “People Business”

From the June 2005 Issue
The Surprising Economics of a “People Business”

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Why the Old Rules Don’t Apply


People businesses play a significant role in developed economies. They account for around 25% of private sector employment in North America and Western Europe and well over half of employment growth during the past decade. Because of consolidation in traditionally fragmented industries—such as advertising, contract catering, and financial advice—people businesses today are often large, publicly quoted companies. (See the exhibit “The People Business 40.”)

The People Business 40

People costs exceed capital costs in an array of other businesses, as well. For example, at an airline, employee costs are typically about one-and-a-half times the amount of capital costs, despite airlines’ giant equipment purchases. (Although fuel is a major cost for airlines, fuel expenditure isn’t a good lever for improving performance because, as a commodity, fuel is sold at roughly the same, though often volatile, price to all players in the industry.) Even at a heavy-industry company like an automaker, employee costs usually exceed capital costs. At a minimum, most diversified companies have large units engaged in employee-intensive activities—for instance, sales and customer service—that give those units many of the economic characteristics of a people business.

These characteristics are often ignored or unappreciated by top managers. Companies mistakenly focus on capital productivity rather than employee productivity and rely on capital-oriented metrics, such as return on assets and return on equity. These aren’t much help in assessing a people business, as they tend to mask weak performance or indicate volatility where it doesn’t exist. A struggling advertising agency or software company may show what seems like a satisfactory return on assets largely because it has so few of them. Similarly, even modest capital investments or productivity improvements may cause big swings in ROA for a company whose asset base is relatively small. For example, if employee costs are five times assets—not uncommon in a people business—then it takes only a 5% increase in employee productivity or a 5% reduction in employee costs to increase profits by 25% of assets.

Capital-oriented metrics aren’t much help in assessing a people business, as they tend to mask weak performance or indicate volatility where it doesn’t exist.

Return on equity is often an even more questionable benchmark of operational performance. For example, because they have so few other assets, many people businesses that have grown by acquisition find that goodwill, for which accounting conventions vary considerably, accounts for a substantial share of their total capital. Indeed, after subtracting goodwill, many of these companies are left with negative equity. Given this and other difficulties, interpreting the return on equity of people businesses becomes an arcane science.

Just as problematic are the conventional metrics designed to measure employee productivity. While more suited to people businesses, they usually don’t carry much weight with top management. That’s because the most common ones, such as sales per employee and profit per employee, are easily distorted. Sales per employee, for instance, is strongly influenced both by outsourcing and by the level of capital investment. If a company outsources activities performed by half its employees and the cost of outsourcing is the same as keeping those activities in-house, sales per employee doubles but productivity doesn’t budge. Similarly, if a company makes a capital investment and replaces employees with machinery whose capital costs exceed the costs of the employees replaced, an increase in sales per employee may be accompanied by a fall in productivity.

We are hardly the first observers to note the measurement and management challenges posed by the increasingly people-heavy and capital-light nature of business. But in our view, most efforts to take account of this shift focus on the wrong things. For example, attempts have been made to “fix” the balance sheet by including intangible assets. While these attempts certainly have value, they miss a crucial point: The critical resource of most businesses is no longer capital—that is, assets that a company owns and utilizes at as high a level as possible. Rather, the critical resources are employees whom a company hires and must motivate and retain. The fact that companies don’t own their employees, as they do their capital assets, is why methods for valuing “human capital” on balance sheets are so tortuous.



At a certain point, struggling to make things fit into an existing model no longer makes sense. Liberated from the straitjacket of capital-oriented approaches, a people-intensive business can measure and manage performance by focusing on employees as employees, without having to pretend that they’re “capital” or that their value comes entirely from the creation of intangible assets.

People-Oriented Measurement and Management


Performance Measurement.


The logic isn’t complicated. You start with sales per employee and subtract supplier costs (including outsourced activities) per employee and capital costs (including depreciation and a capital charge to cover the cost of debt and equity) per employee. The remainder is a measure of employee productivity. Subtract employee costs per employee, and you have economic profit per employee. (For an explanation of the process and how it can be applied to an actual company, see the sidebar “Measuring the True Performance of a People Business.”)


People Management.


Given the high financial stakes, people management needs to be a core operational process and not solely a support function run by the human resource department. Line managers have a vital role to play in improving employee productivity, in terms of both business issues (such as whether to concentrate on large or small accounts) and management issues (such as how to create an organization and work environment that foster productive output). If success in a capital-intensive business comes primarily from making the right investment decisions, success in a people-intensive business comes from hiring the right people and putting in place processes and an organization that makes them productive.

Managers also need to ensure that employees’ interests are aligned with a company’s business objectives and their execution. Companies often use surveys and other tools to assess how well they are meeting employees’ personal goals. Too often, however, these tools focus only on traditional HR issues, such as work/life balance, benefits, and training. But employee satisfaction and engagement are more likely to be destroyed by conflicts at work than by conflicts between work and “life.” A sales manager is charged with selling products from several divisions, but each division gives him a sales target that assumes he will focus on that division’s product. Another manager’s career depends on a promotion within two years, but she oversees a new service line that will take at least four years to gain traction in the marketplace. The right survey can help spot such conflicts between employee interests and company objectives. Diagnosing and addressing them—however uncomfortable for the senior line managers who may be the source of the problem—is crucial to keeping employees engaged and productive.

Finally, people can’t be effectively managed in the absence of relevant performance information—information that can and will be acted upon. It’s astounding how little of this exists at many companies. We’ve already seen that the major metric, employee productivity, is often calculated using misleading methods. But consider this as well: If employees are, indeed, a company’s “greatest asset,” you might expect to find some hard information about them in the annual report: How many employees are there? How much do they cost? How productive are they? After all, you’ll find detailed answers to equivalent questions about a company’s capital assets. The most you’ll find in many annual reports—at least in the United States, where only banks are required to report their employee costs—is a round estimate of total head count. And even that number is suspect, as Finance and HR often have different methods of defining and counting full-time employees. While more information is available internally, there still are usually big information gaps in areas such as wanted-versus-unwanted attrition, average tenure of employees, and allocation of training funds.

Of course, people businesses need more than people-specific information: For example, customer-related metrics are central to any company and are often needed to measure the productivity of individual employees. But all too often, the problem is not a lack of information but the failure to use it. Information generated and reported by a company remains just that—reported. In one company we worked with, the HR department had nearly 50 employee-related metrics at its disposal—for example, unwanted attrition—but only a handful were actually used by line managers in making operations-management decisions.


The economics of people businesses raise unique compensation challenges. Just as people businesses are particularly sensitive to employee productivity, so are they many times more sensitive to pay than traditional businesses. Indeed, the unwitting chief executive who focuses on investing in a company’s “human assets” to achieve competitive advantage may be surprised to find that employees (unlike inanimate assets, such as manufacturing plants and brands) expect to receive all the returns. Furthermore, in a people business, compensation involves more than how much to pay employees; it is also the primary determinant of shareholder risks and returns.

Variability is at the heart of people-business compensation because productivity differs dramatically from one employee to another, depending on an employee’s capabilities and the efforts of individuals or teams. Compensation that recognizes this variability and that is calculated and paid accordingly, on an annual basis, is an appropriate strategy when it comes to most employees in people businesses.

Performance-based variable pay needs to reach far down into the organization. In people-based businesses, unlike typical capital-based businesses, mid- and low-level employees can have a tremendous impact on performance, regardless of investment decisions made by the CEO. A good store manager, for example, can improve store productivity by 5% of sales. This may sound obvious, but it isn’t by any means appreciated universally. People businesses embedded in asset-intensive corporations, in particular, often operate with little variable compensation. And we have seen some surprising inconsistencies in people-based businesses: For instance, a large retail franchisor that also operated and managed many of its own stores offered the store managers almost entirely fixed compensation, while its franchisees’ earnings were sharply dependent on the performance of the stores they managed.

An emphasis on variable compensation in a people business has benefits beyond the obvious one of generating those operational improvements that can so dramatically boost performance. It can also significantly reduce the volatility of earnings and thus make the company more attractive to investors by reducing their risk. Because employee costs represent such a large portion of total costs, even small changes in the level and structure of compensation can have a major impact on the level of profits. Take a typical people business with operating profits that are 15% of employee costs. If, over the course of an economic cycle, the company pays out 85% of employee costs in fixed salaries and 15% of employee costs in the form of profit-variable bonuses, operating profits will be half as volatile as they would be if the company paid out, over that cycle, an equal amount but all in the form of fixed salaries. The compensation for this shift in risk from shareholders to employees: Companies with strong performance typically pay their employees better than their competitors.


Economies of scale and experience in people businesses have tended to be less significant than in industrial businesses, where processes are embodied and learning institutionalized in machinery or software. That means large people businesses don’t necessarily have cost advantages over smaller competitors—indeed, often quite the reverse. A people-oriented business such as a software company, with a big investment in future-focused and largely fixed-cost activities such as R&D, will clearly see a cost benefit as sales volume increases. But a strictly defined people business, with its near-term value creation, generally won’t. This makes it critical for people businesses to price their products or services in ways that enable them to capture a share of any additional value they create for customers.

The most basic approach is pricing by the hour—what you might call a body shop model. Even high-skill businesses such as IT services commonly “shop bodies” at an hourly rate to customers that want to manage capacity flexibly. The value added by the company above that created collectively by its employees typically is limited—as is the return to the company.

A potentially more attractive pricing scheme is the fixed-price-for-output contract. A company that works more effectively and thus delivers a product or service at a lower cost or of a higher quality than its competitors (or its customers) can benefit from this approach. By completing the work in less time and with fewer people, the business adds value beyond that delivered by the employees. One way for an organization to achieve this is to focus on a particular activity in order to accumulate experience and know-how—think of a company that offers a specific medical procedure, such as dialysis, at hundreds of clinics. This will typically lead to higher returns because, with the right management, experience will improve the speed, quality, and cost with which the service can be performed.

For organizations whose advantage lies in providing a potentially very high value-add for the customer, a success fee or commission may offer the best returns—especially when customers have a lot at stake and the value of the service offered could far outweigh what customers are charged. Some of the highest rates of return on employee costs are earned by financial services advisers operating on a commission basis in highly leveraged activities such as investment or private banking. Although the percentage-based fee for, say, managing the funds of wealthy individuals is relatively small, the absolute amount of the fee is substantial. (Of course, when the stakes are lower, the reverse may be the case: A typical employment agency must take a relatively large percentage of an employer’s pay to a new employee in order to earn an adequate return.)

Since industry pricing structures can change over time, people businesses should try to influence them to their advantage. In advertising, for example, the typical pricing structure has shifted from a percentage of a client’s advertising spend (good for agencies that develop long-running campaigns, but risky) to fixed-fee structures (which limit the agency’s returns on superior value creation for the customer) to, more recently, pricing based on a fixed fee but with a performance incentive specifically related to the success of the campaign.

Implications for Strategy

These progressively more advantageous pricing strategies suggest a number of larger business strategy issues raised by the economics of a people business. Because the most important “assets” of such a business can walk out the door when they choose, the company needs to leverage its people with something that it creates, something that is scale sensitive, something that will allow shareholders to share returns with employees.

Truly successful people businesses—those with economic profit that is 30% or more above their employee costs, rather than the typical 10%—have created assets that make the companies much more than the sum of their employees. For example, H&R Block, which provides personal tax preparation services in the United States, has invested heavily in its brand—it spends nearly $200 million a year on marketing and advertising—and has developed such innovative services as the first widespread e-filing of income taxes. Rentokil Initial, which provides hygiene and pest control services, has standardized processes and uses its high network density in the United Kingdom to create a cost advantage in customer service. Software company SAP converted previously customer-specific software development activities into standardized products with reusable elements.

Each of these companies, despite the people-intensive nature of their businesses, moved far beyond an offering based on the short-term value of individual employees’ work, in the process becoming less like strictly defined people businesses. In fact, the goal for many people businesses looking to increase returns will be to move out of that category by leveraging the value of their people-oriented activities to build intellectual or brand capital—or even physical capital, such as the data centers of IT services companies. Ironically, as companies develop proprietary content and add value beyond that which their employees provide in their daily work, top management may conclude that shareholder value can best be created by outsourcing or franchising people-intensive activities. In the case of business services companies, this would complete a cycle that started with their providing, on an outsourced basis, those very services for someone else.

Such a shift reflects the constant evolution of an increasingly people-based economy and highlights the need for senior managers of people-intensive businesses—as well as the investment community—to creatively develop and apply a new set of performance measures and management practices.


Felix Barber ( is a Zurich, Switzerland–based senior adviser and

Rainer Strack ( is a partner and managing director,