Why Finance Likes Compensation Ratios

by David Creelman | Posted | Total Rewards

Why Finance Likes Compensation Ratios

If you follow any of the discussion about what HR should report to boards and investors you will have noticed that someone always suggests reporting a ratio like “total compensation / revenue”. In fact, the discussion is not so much about whether this ratio is useful, but about whether a slightly amended ratio like “total compensation / return on capital employed” would be even better.

The number one reason finance people like these ratios (and remember, boards members and investors usually are finance people) is that they are comfortable dealing with them, especially ratios in dollars. A survey by Financial Executive International Canada showed finance professionals liked this kind of dollar based ratio but were left cold by a metric like “number of high performers leaving”.

I find this shocking, however the correct interpretation is not that they think high performers leaving is unimportant, they just think it doesn’t have anything to do with them; it’s outside their realm of expertise.

How compensation ratios can go wrong

It is easy to see how looking at a ratio like “total compensation / revenue” could lead to bad business decisions. Total compensation is largely fixed while revenue can be quite variable. If revenue takes a dip then the ratio suddenly looks bad and leadership is on HR’s back demanding to know “What’s gone wrong with total compensation?” If this way of thinking leads to ill-considered downsizing then the company will just dig itself deeper into trouble.

An important principle in HR metrics helps avoid this problem: Never assume you need to maximize or minimize a metric; use it only as a piece of evidence to guide decision making.

Consider a metric like total number of employees. It is useful to know, however it is not a number we should try to maximize or minimize. Similarly we need to get past the idea that a low “total compensation / revenue” number is good and a high one bad. It depends on the situation. Treat the number as part of a bigger story and avoid knee jerk reactions that lead to poor decisions.

Where compensation ratios add value

As argued by Andrew Lambert and myself in a study of Organisational Effectiveness for the UK-based Performance and Reward Centre (PARC), one way a board should provide oversight is to keep a lookout for the common organizational diseases.

It is nice to think about having a really healthy organisation, but perhaps the board is doing its job if it simply makes sure nothing is going seriously wrong. After all, it can be vastly simpler to check whether someone has a disease than try to rate them on some scale of how healthy they are.

One disease of organisations is that they continually add headcount. The reason for this is simple enough, every manager has lots of work and feel it will be easier if they had more bodies. It is a problem for modern organizations, was a problem in times past, and almost certainly will be a problem for future organizations.

The “total compensation / revenue” is one indicator that may help detect this disease. If we see a trend where that ratio slowly gets bigger, with no good business reading, then it is a signal the organization may be getting fat.

Some key takeaways

The fact that boards and investors love ratios like total compensation / revenue leaves HR with three takeaways:

  • Be prepared to communicate with financial professionals in a language they are comfortable with;
  • Push back against the tendency to try to maximize or minimize any given metric; and
  • Be prepared to work hard at educating finance professionals about the business importance of HR metrics (such as turnover and engagement) they are uncomfortable with.

Your turn: How does HR communicate with financial professionals in your organization?

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