The Basics of ROI
In previous columns, we have discussed the term "return on investment" (ROI) and described the use of ROI as an important metrics category. In this column, we will address the philosophy of applying the ROI Methodology to the human resources (HR) field.
ROI is a financial measure classically defined as the earnings divided by the investment, times 100, expressed as a percent. Essentially, this shows the monetary return on investing in a particular project or program. The developers of the ROI for the finance and accounting field (who used ROI to show the return on capital expenditures such as buildings, equipment and companies) have always stated that ROI itself is an imprecise measure. It should never be used alone to make a decision about purchasing capital equipment, a building or a company—a balanced profile of data is needed.
That same philosophy is used in the application of ROI in the human resources field.
The Four Critical Elements of the ROI Methodology
Before you can implement ROI in your human resources program, you need to understand the four basic elements of the ROI Methodology: 1) Types of Data, 2) The ROI Process Model, 3) The Rules and 4) The Applications.
The following are definitions of the types of data captured for a project or program:
- Reaction: Data that reflects how the stakeholders reacted to the project and if they found it relevant and valuable.
- Learning: Data that determines how much the various stakeholders have learned to make the project successful. This is usually measured in skills, knowledge and changes in attitudes.
- Application: Data that describes what stakeholders must do differently to make the project successful. This is measured by the application of skills for knowledge and the execution of tasks, action items, processes and technology.
- Impact: Data that involves the consequences of the application expressed in measures, such as productivity, sales, quality, cycle time, absenteeism, turnover, customer satisfaction and employee engagement.
- Return on Investment: Data consisting of the monetary value of the business impact described above (#4) compared to the cost of the project. Note:These five data sets are captured as a chain of impact for a positive ROI. A human resources program can be evaluated along this chain of impact and the evaluation can stop wherever is appropriate; however, it must go through all five data sets for ROI.
- Intangibles: Data items that cannot be credibly converted to money with minimum resources. The data then becomes an intangible if it is connected to the project.
These six data items provide a balanced profile of success for any HR project. To make the ROI data credible, a technique to isolate the effects of the programs on the business impact data must be utilized. For example, if a retention solution is implemented and the employee turnover reduces, the key question becomes: "How much of the actual reduction is linked directly to the retention solution?" The answer requires filtering out the effect of the HR program from other influences.
The chain of impact, converted to steps for collecting, analyzing and reporting data, is indicated in Figure 1.
The ROI Methodology shows the 10 steps that are necessary to calculate ROI, beginning with the detailed description of the HR objectives and ending with reporting the results. Along the way, data is collected and analyzed to develop a credible evaluation of an HR project. The objectives are often defined with the five data measures, from reaction to ROI objectives.
The first evaluation/planning phase involves developing a data collection plan and an ROI analysis plan. Next, the collection of data is employed through a variety of processes from simple surveys, questionnaires and interviews to more involved data collection, such as observation, focus groups, action planning and monitoring the performance records in the organization. After the data is collected, the most important challenge is to isolate the effects of the program on the data. To this end, a variety of isolation techniques is used, including the classic research approach of using a pilot group and comparing it to a control group not involved in the program. Additional methods involve analytical techniques and even estimates from a variety of groups. It is vital that the effects of the project are always isolated from other influences.
The next step involves converting the data to money, using a variety of techniques and precise rules. These monetary benefits are compared to the fully-loaded cost of the project to calculate ROI.
Finally, the measures at the impact level that could not be converted to money are listed as an intangible and results are reported to a variety of stakeholders with the focus on the key client.
This is just a snapshot of the ROI Methodology for HR. There are many publications that provide more detail. See Proving the Value of HR: How and Why to Measure ROI by Jack J. Phillips, Ph.D. and Patricia Pulliam Phillips, Ph.D., Society for Human Resource Management (SHRM), 2005.
Every process needs rules. The rules are the standards for the process and with the ROI methodology; they are labeled the guiding principles. The rules provide guidance for those individuals who are conducting studies for consistency and credible results. The standards have a conservative flair about them and essentially understate the results that were actually achieved. Consequently, management buy-in is often achieved with this conservative approach. The guiding principles are listed below:
12 Guiding Principles for the ROI Methodology
- When conducting a higher-level evaluation, collect data at lower levels.
- When planning a higher-level evaluation, the previous level of evaluation is not required to be comprehensive.
- When collecting and analyzing data, use only the most credible sources.
- When analyzing data, select the most conservative alternative for calculations.
- Use at least one method to isolate the effects of a project.
- If no improvement data are available for a population or from a specific source, assume that little or no improvement has occurred.
- Adjust estimates of improvement for potential errors of estimation
- Avoid use of extreme data items and unsupported claims when calculating ROI.
- Use only the first year of annual benefits in ROI analysis of short-term solutions.
- Fully load all costs of a solution, project, or program when analyzing ROI.
- Intangible measures are defined as measures that are purposely not converted to monetary values.
- Communicate the results of ROI methodology to all key stakeholders.
The ROI methodology, which was introduced almost two decades ago to the human resources field, continues to be applied in many areas of HR. Figure 2 below shows a list of the HR areas where this methodology has been used. Literally hundreds of studies are done each year showing executives the value of HR. The ROI methodology also helps HR executives and top officials understand their contribution and make adjustments and improvements on the various projects and programs. From the HR standpoint, ROI in human resources helps build respect for the function, gain executive support and change the image of HR from a compliance legalistic function to a contributing, viable member of the organization.
- Learning and Development - Organization Development
- Career Development - Orientation Systems
- Competency Systems - Recruiting Strategies
- Diversity Programs - Safety & Health Programs
- E-Learning - Self-Directed Teams
- Executive Coaching - Skill-Based/Knowledge-Based
- Meetings and Events - Technology Implementation
- Wellness/Fitness Initiatives
Figure 2 - ROI Applications
There you have it—the four critical parts of the ROI methodology: The definitions of data arranged as a chain of impact; the process model of how data are collected, analyzed and reported; the rules for the process that provide consistency and standardization; and the rich and varied applications of ROI for human resources. More detail on the ROI methodology will be presented in future columns, particularly as critical parts of the process of are addressed.