Ludwig-Maximilians-Universität, München

A Literature Review on the Impact of Investment in Human Capital on Economic Success -
How do Human Resources Practices Affect Organisational Performance?

Master Thesis

by

Gina Roberts

2004

Contents

1 Introduction ... 4

2 Theoretical Background ... 7
2.1 How is Human Capital Conceptualised in the Management Literature? ... 7
2.2 The Human Capital Project ... 8
2.3 The Story so Far: Theoretical Perspectives on Human Resources Management ... 9
2.3.1 Current State of Research on HR Practices and Firm Performance ... 9
2.3.2 Four Theoretical Perspectives Explaining why Human Resources Practices matter for Organisational Performance ... 11
2.3.3 Multi-Level Model Linking HR Systems to Organisational Performance ... 14
2.4 Methodological Issues ... 18
2.5 Research Questions ... 21

3 Method ... 22

4 Results ... 26
4.1 Strategic HRM ... 27
4.1.1 HR Orientation ... 27
4.1.2 HRM Effectiveness and Business Strategy ... 29
4.1.3 Best Practice and Strategic Fit Models of HRM ... 30
4.1.4 High Involvement Work Practices in South Korean Culture ... 33
4.1.5 Quality Enhancer Strategy: Total Quality Management ... 37
4.1.6 Total Quality Management and Downsizing ... 39
4.1.7 Labour Market Flexibility ... 41
4.1.8 Role of HRM and Perception of Top Management ... 44
4.1.9 Presence of an HR Executive on the Board and Growth rate ... 46
4.1.10 HRM Practices and Work Climate ... 47
4.1.11 Synthesis of Findings on Strategic HRM and Contingency Variables ... 50
4.2 Human Resources Development ... 53
4.2.1 Training Effectiveness: Horizontal and Vertical Transfer ... 53
4.2.2 Financial Analysis of HRD ... 54
4.2.3 Company and Individual Returns to Investment in Education ... 56
4.2.4 Alignment of Training with Corporate Strategy ... 57
4.2.5 Alignment of Training with Strategy and Training Transfer ... 59
4.2.6 Transfer of Training back to the Job ... 61
4.2.7 Investment in Training ... 63
4.2.8 Synthesis of Research on Human Resources Development ... 64
4.3 Technology and HR Practices ... 67
4.3.1 Human Resources Strategy for the ICT-Driven Business Context ... 67
4.3.2 The Influence of HR Specialist Involvement on Information System Success ... 69
4.3.3 The Impact of Work Practices and Technology on Productivity ... 70
4.3.4 The Interrelationship of Technological Change and Human Resources practices on Labour Productivity and Firm Performance ... 72
4.3.5 Synthesis of Results on Technology and HR practices ... 73
4.4 Diverse Workforces and Flexible Working Conditions ... 76
4.4.1 Diversity, Business Strategy and Organisational Performance ... 76
4.4.2 Team Racial Composition, Member Attitudes and Team Performance ... 78
4.4.3 Quality of Work Life and Business Performance ... 81
4.4.4 Historical and Theoretical Context of the ‘Win-Win’ Paradigm of Economic Performance ... 82
4.4.5 Coverage and Effectiveness of Family-Responsive Workplace Policies ... 84
4.4.6 Synthesis of Result on Diversity and Flexibility ... 85
4.5 Methodological Issues in the HR-Performance Relationship ... 89
4.5.1 Reliability of HR Measures: Sources of Measurement Error ... 89
4.5.2 Single or Multiple Raters and Rater Bias ... 92
4.5.3 Multiple Raters and Level of Empirical Analysis ... 93
4.5.4 Reliability Estimates at Lower Levels of Empirical Analysis ... 95
4.5.5 Measurement Error in Cross-sectional and Longitudinal Data ... 97
4.5.6 Synthesis of Methodological Issues ... 99

5 Discussion ... 102
5.1 Interpretation of the Results with Reference to the Research Questions ... 102
5.2 Causational Relationships and Enabling Factors ... 106
5.3 Evaluation of Methodological Issues ... 108
5.4 Limitations of the Current Research and Suggested Future Directions ... 110
5.5 Implications for HR Directors and Corporate Strategy ... 115
5.6 Conclusion ... 117

6 Abstract ... 118

7 References ... 119

8 Appendices ... 123

1 Introduction
Human Capital refers to the know-how, capabilities, skills and expertise of the members of an organisation (Dzinkowski, 2000). A Google search of Human Capital reveals scores of consulting companies that promise to develop, measure and manage the Human Capital of their clients’ organisations. It seems that Human Capital is even more relevant to members of the business community in 2004 than it was upon its initial conception over forty years ago. Becker, 1992 Nobel Prize winner for economics, pioneered the debate about Human Capital in the 1960s, concentrating on Human Capital largely in terms of investments in on-the-job training and education. Why then, are organisations showing a heightened interest in promoting and managing human capital?

Theory and research suggest that Human Capital influences organisational performance both indirectly and directly, making the topic of relevance to anyone who has a vested interest in understanding what makes a firm perform. Practices that enhance Human Capital can affect organisational performance indirectly by shaping the skills, attitudes and behaviours of employees. The collective interaction of employee skills, attitudes and behaviours determines the performance of the organisation (Ostroff & Bowen, 2000). Human Capital can also have a direct impact on organisational performance by creating structural and operational efficiencies (Ostroff & Bowen, 2000).

A recent Accenture survey¹ revealed that although business executives firmly believe that people are their most important asset, most executives are at a loss to prove that investments in people lead to improved business results. This quest for empirical evidence is complicated by the fact that Human Capital is an intangible asset that is not easily captured in financial statements but is nevertheless incorporated into market value. In 1995 IBM bought Lotus for US$3.5 billion – 14 times its book value, signalling that marketplaces put important value on intangible assets, such as Human Capital, when estimating the likely success of a business (Rylatt, 2003).

Indicators for measuring the levels of Human Capital within an organisation include reputation of company employees with head-hunters, years of experience in the profession, employee satisfaction, proportion of employees making suggestions that are implemented and value added per employee (Dzinkowski, 2000). But these indicators are insufficient since they do not place an estimate on the bottom-line value of Human Capital. The challenge that researchers of human capital have is to demonstrate empirically that investments in Human Capital affect a company’s growth and value to its shareholders. Champions of Human Capital in organisations, such as Human Resources directors, are in need of this empirical evidence to justify to board members, CEOs and ultimately shareholders why financial investments aimed at enhancing Human Capital should be increased or at least maintained. Support through concrete figures is particularly vital to gain credibility in firms where shareholder value is still the dominant mentality over and above a more pluralistic and exclusive stakeholder approach. Objective measures are also crucial in organisations that follow a ‘hard’ approach to HRM where top management manage the organisation rationally and utilise employees as a vehicle through which to achieve business objectives (The Michigan Model, Fombrun, Tichy & Devanna, 1984 cited in Pinnington & Edwards, 2000) as opposed to a ‘soft’ approach which considers the needs of employees and focuses efforts on fostering employee commitment to the organisation (The Harvard Model, Beer, Spector, Lawrence, Mills & Walton, 1984; Guest, 1987; both cited in Pinnington & Edwards, 2000). The Accenture Institute for High Business Performance has addressed this problem by developing a Human Capital Development Framework that measures Human Capital process, capabilities, key performance drivers and business results to arrive at an assessment of the key variables that influence the relationship between a company’s Human Capital assets and its financial performance (Cantrell & Thomas, 2003).

Human Capital has evolved into a particularly pertinent subject for knowledge and technology-based societies, such as those found in Western Europe, North America and South East Asia. For companies to gain desired productivity increases from the introduction of advanced and complex technologies, they require a workforce with the necessary skills and knowledge to use them. Thus the value of formal education, technical schooling and on the job training has increased in societies where significant economic growth has been achieved through major advances in technical knowledge (Becker, 2002). This is not to say that Human Capital is not important for developing countries and emerging economies. On the contrary, returns to education, particularly for elementary schooling have been found to be even higher in developing countries (Jones, 2001).

Companies realised from the 1990s onwards that the Human Capital within their organisations could be utilised as source of competitive advantage that adds economic value to the firm. In today’s knowledge economy, the people that make up an organisation are seen as wealth and capability generators who can profoundly affect market appeal, reputation and performance (Rylatt, 2003). The potential economic significance of HRM has been increased by strategically fitting HRM practices with business strategy. HR communicates the strategic direction of the organisation to employees and defines and transmits organisational culture that supports organisational objectives by signalling the desired corresponding employee attitudes, behaviours, motivational and affective responses (Ostroff & Bowen, 2000).

The research question posed in this thesis takes on the challenge to find empirical evidence that investment in human capital has a positive impact on intermediate as well as accounting and share-value economic (bottom-line) indicators of organisational performance, both directly and indirectly. This literature review summarises, integrates and evaluates research published between 1998 and 2003 pertaining to the impact of Human Resources on indicators of employee and firm performance. The articles reviewed here are not exclusive to organisational/industrial psychology but also contribute to the discourse taking place in the domains of business administration and economics. This thesis is, therefore, of interest to academics and professionals working in the domains of organisational/ industrial psychology, business administration, economics, human resources, management consulting and strategy.

2 Theoretical Background
2.1 How is Human Capital Conceptualised in the Management Literature?
Edvinnson, St Onge, Armstrong and Petrash (1997, cited in Dzinkowski, 2000) discuss Human Capital as a sub-component of intellectual capital in their ‘value platform’ model of intellectual capital management.

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1 Accenture High Performance Workforce Study, 2002-2003, a survey of 311 CE0s, C00s and senior vice presidents, cited in Accenture (2003) Human Capital Development, Research Note Issue one, Nov 1, 2003.