Workforce Analytics Academy Part II: Net Present Value:
Another Key Financial Concept for HR
The most recent topic of our series focusing on analytics highlighted Return on Investment (ROI) as a traditional performance measure that can be used to compare the economic impact of multiple investment activities. We encouraged HR professionals to apply it when provided the opportunity to present financial justification of planned or ongoing HR initiatives.
There is another key financial metric, however, that is equally valuable when it comes to understanding the business value of an HR project: Net Present Value (NPV). While ROI measures the efficiency of an investment by comparing its net benefits with its original costs, NPV recognizes that returns generally occur over an extended period after the initial investment outlay and, as a result, must be discounted.
Time is money
We have all heard the old saying that time is money. A dollar today is worth more than a dollar tomorrow, and nowhere does this concept ring more true than in the world of finance where spending decisions have cost and benefit implications for several years in the future. CEOs and CFOs have been using NPV projections for decades to determine the long-term financial impact of competing proposals from nearly all departments, including operations, sales, IT, and marketing. Human Resources must not be left behind.
NPV is defined as the sum of the present values of individual cash flows in a time series. The rate used to discount future cash flows to the present value is called the discount rate or cost of capital. NPV is an indicator of how much value an investment adds to the firm, and as such, proposals with a positive net present value should be accepted, while those with a zero or negative NPV are normally rejected.
The list of potential uses of these two key concepts, ROI and NPV, in the Human Resources arena is limitless; they can be applied to assess a variety of HR initiatives, including:
- The impact of leadership development initiatives on executive performance
- The value of projected benefits from work/life programs on employee retention
- The evaluation of two or more HR strategies aimed at reducing bad attrition
A word of caution
Like with any other assessment, the results of an NPV analysis are only good as the underlying assumptions. Making reasonable assumptions, especially over longer time periods, can be difficult and risky as even a small change could alter the overall recommendation.
Both the NPV and ROI calculations can appear challenging and complicated to those not experienced in economic impact analysis and may require assistance to ensure all supporting assumptions are defensible and projections are accurate. It is the analytical framework that HR professionals should get familiar with as they attempt to create financial justification for proposed or ongoing HR programs and initiatives. Understanding how investment decisions are made will only help them become better business partners and gain recognition as a significant contributor to the organization’s strategic success.