Enhancing Return on HR Investment: Risk Management With Real Options Approach

Abstract

Return on human resources (HR) investment may not remain stable over time for organizations, due to changes in business conditions. The “real options” approach enables organizations to evaluate investment opportunities of HR in uncertain environments and highlights how these investments create value through future choices (i.e., HR options). HR options are “investments in the human capital pool of an organization that provides the capability to respond to future contingent events.” This research applies this logic to analyze the uncertainties associated with HR in organizations and discuss how organizations manage these uncertainties through HR “options” that are capabilities generated by various HR management practices. With appropriate HR capabilities, organizations are able to manage uncertainties proactively. Research emphasizes that certain HR management practices create HR options in terms of reducing uncertainties of return, volume and costs. Research also underscores that effective compensation and benefits practices reduce uncertainties of costs significantly.

Keywords

human resources real options uncertainty flexibility HR options

Introduction

With the increasing focus on identifying and evaluating risks in organizations, risk management has become a key strategic priority. Risk management is considered to involve the identification, analysis, evaluation, control and monitoring of risk. In a current scenario of increased complexity and rapidly changing environment, effective risk management may be a source of competitive advantage for organizations. Businesses adopt and integrate risk management practices into their operations, and accordingly various standards such as the International Organization for Standardization, ISO 31000: 2009 (Risk Management Principles and Guidelines) along with a multitude of tools and frameworks emerge.

However, this focus on risks has primarily focused on financial and physical assets, largely neglecting the area of human resource management (HRM). For any organization, human resources (HR) are assets that can provide value and competitive advantage; however, such assets have associated uncertainties and risks. There is growing recognition that one of the key risks in a business is related to management of HR. As HR inherently involves a level of uncertainty, and as risk management’s main focus is uncertainty, forging the two fields of risk management and HR is important. HR risk comprises an event, consequences and probabilities (or uncertainties) when dealing with the HR of an organization.

Returns on HR investment may not remain stable over time for organizations due to changes in business conditions. The “real options” approach enables organizations to evaluate investment opportunities of HR in uncertain environments and highlights how these investments create value through future choices (i.e., options). Research applies this logic to analyze the uncertainties associated with HR assets in organizations and discuss how organizations manage these uncertainties through HR “options,” which are capabilities generated by some HRM practices and their combinations.

Manage Uncertainties: Financial Options Versus Real Options Approach

Financial Options

Options are created due to uncertainties about the returns from investments. In financial markets, options are contracts written on financial assets (stocks, commodities, foreign currency, etc.) to manage risks of depreciation of value or to avail of the benefits of future appreciation of value through “calls” or “puts.” “Calls” (options to buy) are contracts that give the owner the right, but not the obligation, to buy the underlying asset at a predetermined strike price within a future expiration date. “Puts” (options to sell) give the owner the right, but not the obligation, to sell the underlying asset at a strike price within the expiration date.

Investors often maintain a combination of these two types of contracts to minimize risks and maximize opportunities for returns from financial investments. If the market price of the financial asset (e.g., stock) remains below the strike price, the holder will not exercise the option. So the seller of the option retains the stock and keeps the premium as profit, while the buyer only loses the premium. If the market price rises above the strike price, the option will be exercised. The holder will buy the stocks and sell them at the market price, thereby making profit. The seller also makes profit but loses the opportunity of greater profits. Put options work exactly the opposite way. The buyer of a put option expects the market price of the stock to go below the strike price so that the option holder can buy the stock from the market at a lower price at a future date and sell it at the strike price with profits. The seller on the other hand expects the market prices to go up, so that the option is not exercised and an option writer retains the premium as profit. Consequently, if the market price goes above the strike price, the put option will not be exercised.

Real Options

The term real options coined by Myers¹ extends the theory of financial options to the realm of strategic decision making. The basic underlying principle of real options remains the same as financial options—that is, risk minimization and opportunity maximization. Real options approach is a method of evaluating and managing strategic investments decisions in an uncertain business environment. It seeks to quantify numerically each of the investment options available in a particular situation.

Real option is a useful tool for making decisions on what to and where to invest in. Real option helps to keep investment options open and enable riskier approaches to be explored, without making long-term commitments to them. It also enables analysis of the range of options available both now and in the future, while identifying in advance investment cutoff points. As events unfold, many options will not be worth pursuing, but a few could be blockbusters. Most organizations actually possess a portfolio of real options within and across five categories: the option to defer, the option to grow, the option to alter scale, the option to switch and the option to abandon.

Real options are up-front investments that allow management to capitalize on favorable opportunities and mitigate downside risks by proactively managing uncertainty over time in a flexible manner rather than by trying to avoid uncertainty. Real options deal with managing investments in real assets under uncertainty and offer enormous potential for guiding investments for creating sustainable market value for firms operating in uncertain environments. Real options are used in strategic management areas such as market entry timing, modes of entry, organizational forms (e.g., joint ventures, acquisitions, etc.), foreign direct investment, multinational corporation performance, cooperation versus competition trade-offs and so on.²

Real options extend financial option theory to options on real (nonfinancial) assets. Real assets are similar to financial assets because they generate returns, are valuable, require capital investment, carry the risk of depreciation of value and have the opportunity of appreciation of value. Although, there are many similarities between financial options and real options, there are also several dissimilarities. The major dissimilarity between financial options and real options lies in the fact that real options are created on real assets and real assets may have “intangible” or “invisible” components. The major differences between financial options and real options are given in Table 1.

Table 1.

Financial Options Versus Real Options.

Financial options	Real options
Financial options are almost perfectly tradable because of efficient financial markets.	Real options are not perfectly tradable as market imperfections and asymmetries are present in their markets.
Financial options are written on financial assets (e.g., stocks, currency and commodities).	Real options exist implicitly in the resources, capabilities and processes of the firm and hence written on tangible or intangible assets.
Price of financial asses varies over time, and the exact valuation of financial options is possible.	The exact valuation of real options may not be possible even after a long time because of inherent invisibility (or intangibility) and complexity.
Financial options have specific maturity dates, and premium is paid at the time of the contract.	Real options typically involve unknown or uncertain expiry dates.
Financial options are explicitly written contracts and provide option holders the right to buy or sell financial securities at a set price on a future date.	Real options may not be written and exist implicitly in the resources, capabilities and processes of the firm.
Financial options attributes	Real options attributes
Call option/put option	Option to invest/divest
Price of financial asset	Present value of project
Produce option income on the stocks owned through the covered call strategy	Project cash flow
Exercise price	Present value of investment
Variance of asset returns	Volatility of project’s returns
Time to maturity	Length of deferral time
Short maturity (in months)	Longer maturity (in years)

Source. Table developed by author.

Real options are investments that are discretionary in that they provide organizations with the right, but not the obligation, to undertake some future action (Madhani, 2018)³. It implies that there are ways to hedge against risk and to reduce uncertainty. Based on capabilities provided by “real options,” the organization may choose to adjust, reduce, increase or abandon the investment in the future, thereby stabilizing returns from such assets. To explain how real options reduce business risk and uncertainty, they are categorized according to the functions they serve: (1) timing options, (2) switching options, (3) growth options and (4) learning options. Timing options create choices for the time of investment and are further classified as (i) options to defer, (ii) staging options, (iii) scaling options and (iv) options to abandon. Illustrations of various types of real options are given below.

Options to defer: Options to defer investments reduce risks by allowing for a delay in investments till the value of the investment becomes more apparent. Hence, it involves waiting until further information availability and thus reduces market uncertainty.

Illustration

A petroleum refinery company takes a lease for oil drilling sites rather than outright purchase. It is deferring the investment decision till the end of the lease period as it still has the option to purchase the site. This keeps the opportunities open for the company in case oil is struck at the site.

Staging options: Options for staging investment entail a series of investment outlays rather than a single outlay up front. Here, organization breaks up its investment into incremental phases, where the payoff occurs only after the project is completed. This creates the option to “default” at any given stage, thereby limiting the risk of nonperformance of the asset.

Illustration

A pharmaceutical company makes investment in research and development for drug discovery and development process for bringing a new drug to the market.

Scaling options: Options to alter operating scale (i.e., scaling options) involve expanding, contracting, shutting down or restarting production or operating facilities. This enables the firm to capitalize on growth opportunities, as well as to reduce the scale of operation, in response to changes in the demand and supply conditions.

Illustration

These options are typically found in natural resource industries, such as mine operations, as well as in cyclical industries like fashion apparel and consumer goods.

Options to abandon: Options to abandon (or exit options) are part of options to alter operating scale in the sense that they allow for shutting down of the operation.

Illustration

A chemical company with a patent for a new chemical product has begun to commercialize the product, but the manufacturing process does not meet environmental regulations regarding toxic chemicals.

Switching options: Switching options create choices regarding combinations and sources of input and output. Options to switch (i.e., flexibility options) inputs or outputs mix allow the firm to respond to the changes in demand/supply conditions as well as to reduce costs and to improve quality.

Illustration

A two-wheeler manufacturing company may want to switch production plans to manufacture a particular model of bike in high demand.

Growth options: Growth options involve investments that create growth opportunities and are created because the future of these investments is uncertain. Growth options involve investing in an initial market, product line or technology to develop a platform for future growth opportunities. By buying the initial options (e.g., a patent, or by investing partially in a new venture), the firm gains access to the potential upside while limiting the losses they would incur from unfavorable outcomes.

Illustration

A mobile telephony company develops 5G communication networks to deliver better speed and connectivity for exploiting future opportunities.

Learning options: Learning options are limited investments made to test the market. This refers to starting with a prototype project for testing customer response and, if successful, following up with a full-scale project.

Illustration

A tea processing company develops cherry flavored tea, and before investing in full production facility, the company undergoes its test marketing.

As described earlier, real options aim to minimize risks and uncertainties associated with investments in real (physical and human) assets. Apart from physical assets, real options also found application in the field of HRM. Real options are deployed by firms to hedge risks related to their HR investments. Various types of real options, such as switching options, growth options, learning options, timing options and scaling options, are used for managing risks and uncertainties associated with investments in HR.

Managing Environment Uncertainty With HRM Practices: Creating HR Options

Environmental uncertainty is caused by unexpected events that put the organization in an unstable state. As environment uncertainty is difficult to accurately predict, it puts the organization in a position where it must rapidly adjust to a changing environment or else perish. Such heightened demands on organizations have subsequently called for corresponding HR of flexible, versatile and capable individuals. HR attributes such as enhanced skill levels, greater work-related flexibility and productivity and increased capacity to respond to fast-changing business dynamics can provide competitive advantages. HR are valuable for the organizations because of their ability to create, use and share knowledge. Hence, developing a critical mass of employees who are knowledgeable or skilled may constitute a potential source of competitive advantage for the organizations.

As shown in Figure 1, in the presence of high environment uncertainty, investments in HR necessitate the creation of real options for investments in HR (also called “HR options”). HR options are “investments in the human capital pool of an organization that provides the capability to respond to future contingent events.”⁴ This definition clearly posits HR options as a subset of “real options.” As environment uncertainty increases, the returns from investments in HR become more unpredictable, resulting in the creation of more HR options to demonstrate more flexible HR investment—that is, higher HR flexibility (Figure 1). HR flexibility is focused on adapting employee attributes (e.g., knowledge, skills and behaviors) to changing environmental conditions. HR flexibility is considered as one of the important aspects of organizational capability as it helps an organization to adapt to changing environmental contingencies. During period of high environmental uncertainty, HR flexibility and accompanying performance management practices enhance effectiveness of organization in terms of higher performance.⁵

Figure 1.

HR options: Managing environment uncertainty with hr flexibility.

Investments in HR by organizations to create built-in flexibility provide more than one option (i.e., HR options) for future courses of action. HR options provide a strategic organizational capability to adapt to future contingent events and flexibly manage uncertainties arising from fluctuations in the value of the underlying human capital. As a critical organizational capability, HR flexibility can be seen as real options that enable organizations to adapt to diverse and changing requirements from the external environment and manage uncertainties proactively.

Real options create alternative choices for decisions regarding investments in real assets. These choices are time deferred, so the organization is able to base its decisions on actual circumstances that may occur in the future rather than on the expectation (or inaccurate approximation) of the future. Since the future is uncertain, these deferred choices greatly reduce the risk that investments will lose their entire value or will become worthless. Real options give the owner the rights to real assets without making the full investment at the present time period and to keep the opportunities for future investments open.

Real options investments refer to those investments that are in the form of physical and human assets, as opposed to financial instruments. There is one fundamental difference between human assets and other physical forms of real assets; that is, firms never fully possess human capital, it basically resides in people and is lost when people leave the organization. This only increases the risk associated with investments in human assets; thus, this attribute signifies the relevance of options theory framework for risk management in HR. Differences between real options and HR options are given in Table 2.

Table 2.

Real Options Versus HR Options.

Dimensions	Real options	HR options
Options written on	Real assets (tangible or intangible)—e.g., projects, products, technology, etc.	Knowledge, skills and behaviors of employees; volume (i.e., number) of employees and cost of employees
Value of option	Underlying asset has value	Employees add value through application of their knowledge, skills and behaviors
Variability of asset value	Value of assets varies over time	The value of employee competencies (applicability of knowledge, skills and behaviors) vary over time
Function of options	Risk management tool for investment	Risk management tool as well as future adaptability
Purpose of options	Speculative investments on future courses of actions	Investment for future skills and behaviors, variability of volume and costs
Instruments used	Patents, alliance, acquisitions, joint ventures, etc.	Combinations of HRM practices, such as skill acquisition, recruitment and selection, training and compensation management
Rights under the contract	Right to develop, abandon or switch projects	Scope to modify HRM practices according to future requirements
Premium	Partial investment in the current period	May involve extra cost in the current period
Utility of options	Allow firms to buffer against greater loss of value with lower sunk cost	Allow firms to buffer against future obsolescence of knowledge and skills and help develop appropriate behaviors to reduce uncertainty related to human resource in changed circumstances

Note. HRM = human resource management.

Source. Tabulated by author.

As real options are based on real assets, tangible or intangible, certain HRM practices generate HR options for managing HR, which is a real asset with intangible components. HRM practices are defined as “a set of distinct but interrelated activities, functions and processes that are directed at attracting, developing and maintaining (or disposing of) a firm’s human resources.”⁶ HR options are derived from certain HRM practices, such as selectivity in staffing, job rotation, performance-based pay and so on. Such HRM practices act as “options” on human capital (i.e., HR options), which minimize risks and maximize opportunities in HRM. These HR options help ensure stability of returns from human capital and thus sustain competitive advantage. There is positive linkage between HRM practices and firm performance as organizations that invest in some HRM practices are more likely to have financial returns than firms that do not invest in it.⁷ HRM practices also enhance organizational effectiveness⁸ as they represent organization capabilities that create value for the organization by developing enabling human skills and behavior.⁹

HRM practices generate alternative choices for the firm in the management of their HR. For example, for skill acquisition the choice is between recruiting or contracting out. The recruitment and selection function also have the choices of recruiting for specialized or generalized skills, initiating a wide or narrow search, and internal versus external selection. The training function also has the choices of behavior or skill training; broad-based or specialized skill training and in-house, on-the-job or external training. The compensation management function offers the choice of the extent of fixed versus variable pay, the degree of variability of pay as linked to various performance parameters. All of these decision choices emphasize different types and levels of risk with regard to the value of the resulting HR. All these HRM practices and its combinations create real options acting on HR (i.e., HR options) and provide alternative decision choices for the firm.

HR Investment: Various Types of Risks and Uncertainties

Firms typically respond to adverse business conditions by downsizing, thereby losing valuable human capital. All firms cannot easily adjust the capabilities of its human assets to changed business conditions; only those who have made investments in appropriate HR capabilities are able to respond. According to the “real options” approach, firms should develop HR capabilities (i.e., combination of resources and processes) to manage uncertainties proactively so that they can respond when sudden changes occur. These capabilities are, in essence, HR options because they reduce the costs of adjustments when changes occur, preserve value and create flexibilities of decision and operation. Therefore, the value of HR options lies in allowing the firm to respond proactively to the uncertainties of human assets. Various types of uncertainties related to HR investment are (1) uncertainty of returns, (2) uncertainty of volume and combinations and (3) uncertainty of costs. These uncertainties of HR investment are explained below.

Uncertainty of returns: Uncertainty of returns is caused by uncertainties regarding the future value of an asset or the cash flow generated from it. The future value of human assets can be uncertain (e.g., performance of employees may vary or job requirements may change causing a misfit between the person and the job) and hence affect cash flow generated from it.

Uncertainty of volume and combinations: Uncertainty of volume is caused by uncertainties or fluctuation regarding the number of employees demanded according to market conditions while uncertainty of combinations is caused by unexpected demands for skills that the employees do not possess.

Uncertainty of costs: Uncertainty of costs is caused by uncertainties regarding the costs of human assets, in the form of wages, salaries, benefits and so on (e.g., high fixed costs vis-à-vis low cash flow of the firm) and represents uncertainty of cost of continued investments.

These uncertainties can arise from changes outside the firm (i.e., external factors) or changes within the firm (i.e., internal factors). Irrespective of the source or the type of uncertainty, the basic argument of real options theory is that firms can make investment decisions in ways that can reduce downside risk and/or enhance the scope to capitalize on the opportunities that the uncertainty creates. Risk is uncertainty about outcomes or events, especially with respect to the future. Risk impairs forecasting and planning activities and makes it harder for decision makers to plan future actions. A firm’s investments in its human capital involve risks because the performance of or the returns from human capital is uncertain and these may vary over time. Based on real options theory, various types of risks and uncertainties associated with the management of HR and illustrations of relevant HR options are given in Table 3.

Table 3.

Managing Uncertainties of HR Investment With HR Options.

	Sources of uncertainties			HR options
Types of uncertainties	Individual	Organization	Market	HR options
Uncertainties of returns 1. Demand for future skills 2. Skill obsolescence 3. Turnover 4. Lower productivity 5. Lower quality of hire and higher cost of hire	1. Employee dissatisfaction 2. Lack of commitment 3. Inability to learn new skills 4. Voluntary turnover 5. Better opportunity elsewhere	1. Changing skill profile and mismatch with market requirements 2. Turnover of critical skill group 3. Inability to generate/accommodate new skills and learning 4. Inability to institutionalize knowledge 5. Lack of employee training and development plan 6. Breach of psychological contract and lack of concern for employees 7. Poor reputation of firm 8. Lower job security	1. Changing career patterns 2. Demand for new skills 3. Procyclical hiring 4. Uncertain supply of new skills 5. Shortage of skill set during expansion stage of business cycle	1. Competitive pay 2. Employee participation 3. Voice mechanisms 4. Attractive benefits 5. Training and development 6. Selectivity in recruitment 7. Countercyclical hiring 8. Broad-based skills 9. Employee engagement
Uncertainties of volume and combinations 1. Variations in number of employees required 2. Uncertainties in deployment of employees	1. Absenteeism 2. Turnover due to strong job market 3. Resistance to change in work assignment	1. Variations in demand for number of employees in different units 2. Lack of slack/buffer 3. High human capital leverage	1. Variations in demand for and supply of products due to external environment variables	1. Job/territory rotation 2. Full-time versus part-time employees 3. Use of contingent and contractual employees 4. Team-based work
Uncertainties of costs 1. Variations in total employee outlay vis-à-vis cash flow	1. Overuse of benefits 2. High fixed pay (guaranteed pay)/bonuses for employees	1. Variations in profitability 2. High fixed cost and operating leverage	1. Business cycles stages such as recession period 2. Competitive pressures for cost reduction 3. Life cycle stages such as maturity and decline stages	1. Variable pay plan 2. Performance-based incentive plans 3. Enhancing HR flexibility 4. Optimal mix of financial and nonfinancial rewards

Note. HR = human resources.

Source. Adapted from Bhattacharya and Wright.¹⁰

Managing Uncertainties of HR Investment: Deploying Various HR Options

A firm’s investment in HR options is made through HRM practices that can build HR capability, comprising skills and behavioral repertoires of employees, to flexibly respond to future uncertain events. HR options enable the firm to develop and deploy human capital in order to limit downside risk and create opportunities for greater returns in the future. HR options are generated through certain HR practices. However, not all HRM practices have option value, as those practices that do not address the issue of management of uncertainty do not possess any option characteristics and, hence, do not qualify as HR options. Different HR options according to various types of uncertainties are explained below.

A. HR options and uncertainties of returns: Uncertainties of returns may arise from obsolescence of existing skills and demand for new or improved skills (e.g., growth and learning HR options are deployed to manage such uncertainties) as well as due to high employee turnover and decline in employee productivity (e.g., turnover and productivity HR options are deployed to manage such uncertainties). These HR options are explained below.

a. Growth and learning HR options: Training for new or upgraded skills, selectivity in recruitment for broad-based skills (rather than specialized skills) and skill-based compensation plans represent “growth” and “learning” HR options to minimize risk of skill obsolescence and maximize future growth opportunities through generation of new skills. Selectivity in recruitment refers to setting higher standards for choosing the employee to hire. Skill-based pay creates opportunities for developing multiple and broad-based skills, manages risks of skill obsolescence and generates options because employees are rewarded for learning new skills and developing broad skill sets.

Employee selection that emphasizes cognitive skills and learning abilities (selectivity in recruitment for broad-based skills) rather than narrow functional skills required by current jobs enhances employee skills and behaviors adaptability. Comprehensive training plans that put premium on development of learning abilities for continuous skill upgradation and new skills as demand changes enhance organizational flexibility. Investment in employee training also decreases uncertainty of sales and increases future value of salespeople.¹¹ Similarly, career development policies that encourage growth of firm-specific skills, development-oriented performance management systems that value and reward skills and behaviors adaptability, skill-based pay, new skill acquisition or development of competencies required for the future are major drivers of growth and learning HR options.

b. Turnover and productivity HR options: Voluntary turnover of employees due to booming job market or current job dissatisfaction, cause loss of critical skills and depletes the firm’s human capital base. The employment stability can be enhanced with HR options of selective as well as countercyclical hiring. Countercyclical hiring strategy involves selective hiring during down economy. It also reduces pressure to hire candidates when good applicants are scarce and available at premium (problems related to procyclical hiring conducted during booming economy).¹² Workforce hired during a recession may not switch jobs (i.e., lower turnover) after the recovery starts because of “status quo” in decision making.¹³ Such “status quo” behavior of workforce will also benefit the firm in terms of higher productivity caused by availability of better training and development opportunities when business demands are relatively low.

Overall job dissatisfaction related to pay/promotion/supervisory relations, job content and so on is predictor of voluntary turnover, as well as loss of productivity. Turnover and productivity management HR options are created by HR practices such as highly competitive pay, career growth opportunities, group-based performance pay, merit-based promotions, attractive benefits packages (retirement plan with high employer contribution, health insurance, life insurance, disability insurance, cafeteria plans for dependent care and medical expenses, child care assistance, tuition remittance for self or dependents, etc.), flexible work arrangements, open communication systems (i.e., information sharing and grievance redressal system) and participatory work practices (i.e., job enrichment, quality circles, team-based work design and suggestion schemes) are various HR practices for attracting employees and motivating them to stay with the company. These practices improve employee morale and satisfaction with their job and contribute toward higher employee productivity and retention.

Illustrations

The following illustrations explain how firms reduce uncertainty of returns by deploying various HR options.

Starbucks: Starbucks announced Starbucks College Achievement program in 2014 in which it will pay all tuition costs for employees in the United States who want to earn a 4-year, online bachelor’s degree from Arizona State University, even if it leads to a career that has nothing to do with Starbucks. As 70% of Starbucks’ U.S. employees are students or aspiring students, this program will help Starbucks see lower attrition as the reimbursements are processed on a semester basis, provided that the person is still employed with Starbucks. An employee can graduate and then move up the ranks at Starbucks. There are currently more than 7,000 partners in the Starbucks College Achievement Program, and as of December, 2016, more than 400 members have graduated. Starbucks’ goal is to have 25,000 students graduate from this program by 2025.

Although, this program is expensive as Starbucks will invest at least $250 million into it through 2025, the positive branding that comes with such a program offsets those costs. The stronger employer brand also helped Starbucks in increasing sales as people are more willing to spend money on companies they believe have good values. Employer brand strongly influences a firm’s ability to attract quality applicants and also have a positive effect on applicant pool quantity. According to the Starbucks’ own internal research, one of the reasons people choose Starbucks is the way they treat their employees. Starbucks’ retention rate went up after this program and more people than ever before applied for jobs at Starbucks. Such growth and learning HR options at Starbucks allowed it to attract larger pools of quality associates and also enhanced the effectiveness of their overall staffing systems.

Costco Wholesale: Costco Wholesale deployed turnover and productivity HR options to reduce uncertainty of returns. Costco paid an average of $20.89 an hour to its employees compared with its competitor Sam’s Club (by Walmart) that paid an average hourly wage of $11.83. Costco is also known to offer better health and retirement plans as compared with the competitors. In return for its generous wages and benefits, Costco is known to see low employee turnover (17% compared with 44% at Sam’s Club), higher store productivity (Costco generated $21,805 compared with $11,615 at Sam’s Club—in the United States operating profit per hourly employee) and the lowest shrinkage (employee theft) figures in the industry. Costco also has not seen any major employee relations issues despite the fact that some part of its workforce is unionized. Costco’s practices are clearly more expensive, but they have an offsetting cost-containment effect.¹⁴ Costco deployed HRM practices such as highly competitive pay, better health benefits and a comprehensive retirement plan and, thus, created turnover and productivity management HR options. Such HRM practices by Costco and subsequent deployment of HR options improved employee morale and satisfaction, reduced shrinkage and resulted in higher employee productivity and retention.

Progressive Insurance: The Progressive Insurance strategically used recession period to selectively hire college graduate “generalists” with little or no industry experience; provided them training and transformed these cheap raw recruit into a well-trained workforce. Training of employees is regarded as an investment for the future, and such investment benefits the organization in a period of uncertainty. Hiring of fresh graduates, or college pass outs, by organizations is usually regarded as a long-term HR investment strategy, because fresh graduates typically require up-front training and a longer duration of time to reach full productivity levels. By hiring countercyclically when they are not needed immediately, organizations provide new hires with enough training and development time and also give them a chance to adjust to the culture of the organization. During the 2001 recession, Progressive Insurance countercyclically hired and trained more than 3,000 external claims representatives at low cost. In this way, Progressive deployed growth and learning HR options as well as turnover and productivity HR options to manage uncertainty of returns.

B. HR options and uncertainties of volume and combinations:

With optimal salesforce size and corresponding structure, sales organizations reduce uncertainties of volume and combinations by attracting, retaining and motivating the “right” type of salespeople; building long-term relationship with customers; gaining market share and enhancing profitability.¹⁵ When a firm offers products that require different configurations of HR skills, it is exposed to uncertainties of both volume and combinations. Uncertainties of volume have no effect on the skill composition of employees. In contrast, uncertainties of combinations call for changing the skill mix of HR. The firm may face surplus/shortage of employees with a given skill at a given location or division of the firm (e.g., creating a buffer through additional bench strength is normal practice in Indian software industry for meeting the fluctuations in workload). Uncertainty of volume or combinations is caused by uncertainties regarding the volume of operation or combination of resources.

HR options to manage uncertainties of volume and combinations involve HR practices that contribute toward numerical and/or functional flexibilities and include employment of contingent, temporary/contractual, or part-time workers, scalable training facilities, multitasking, tasks reallocation, task-based temporary project teams and job rotation. Many firms formally or informally rotate employees among different kinds of jobs to develop the flexibility of skills, so that when the need arises, employees may be easily reallocated. Under team-based work, temporary teams are formed for particular projects or jobs. Thus, there is a continuous shifting of employees that helps the firm maintain its flexibility and manage costs.

Uncertainties of volume arise because of fluctuating demands in terms of numbers. Deployment of temporary, part-time or contractual employees is HR options that allow the firm to “alter operating scale” (i.e., vary the total number of employees) according to the fluctuations in demand. Such HR options reduce hiring costs, cut overhead administrative costs of training, selection and staffing and increase organizational flexibility. Use of contingent employees creates capabilities that allow the organization to alter operating scale (i.e., vary the total number of employees) according to fluctuations in demand or create timing options to manage uncertainties of volume by “deferring” or “staging” the HR investment or create switching options to manage uncertainties of skills by deploying contract employees instead of hiring full-time regular workforce. These HR options relate to capabilities to vary scale of operation (i.e., scale HR options), timing of investment in HR (i.e., timing HR options) and to switch from one skill to another depending on the change in demand mix (switching HR options).

Illustrations

The following illustrations explain how firms reduce uncertainty of volume and combinations by deploying various HR options.

Isis Pharmaceuticals: Isis Pharmaceuticals relied on short-term contract labor and temporary workers during an extended expansionary period of economy when wage pressures were high and labor became scarce. Traditional approach to hiring, also known as procyclical hiring, involves hiring only when the economy is strong or there is an upturn in the economic activity and also that the firm has an open position to fill while decrease in hiring during recession or economic downturns. Hence, when economy is strong, everyone is hiring, thereby making it difficult for the firm to find enough well-qualified applicants. Increased demand will increase the competition among firms over available qualified labor pools, thus resulting in higher wages. Hence, Isis Pharmaceuticals avoided procyclical hiring of regular (full-time) employees during booming economy.

However, once the recession hit, Isis Pharmaceuticals aggressively hired from the now much deeper talent pool on a permanent basis. Rising unemployment that accompanies a recession deepens the pool of qualified labor and reduces wage pressures. Such, countercyclical approach allowed Isis Pharmaceuticals to staff a higher quality workforce at lower wages during recession to stockpile talent against future needs to provide the firm with a competitive advantage once the recession is over. In this way, Isis Pharmaceuticals hired a better caliber employee, established a more committed employee–company relationship and created a talent base in preparation for economic recovery.¹⁶ Isis Pharmaceuticals used timing HR options to reduce uncertainty of volume and combinations. It also helped Isis Pharmaceuticals to reduce uncertainty of returns as well as uncertainty of costs.

Tesco: Tesco, the leading retailer in the United Kingdom, has implemented an innovative “store swap” program to reduce their external recruiting costs, enhance employee retention and benefit cash-strapped part-time employees who are also university students. This program has been based on analyzing, diagnosing and identifying the needs for and availability of HR, so that Tesco can reach its objectives. A single phone call to a national hotline allows students to transfer from the store where they normally work during the school year to a store in their home town during the holidays, then transfer back when university classes resume. Such reallocation of employees has saved costs, while preserving human capital.

Low employment variability may contribute to building of trust and loyalty among employees, with a number of long-term efficiency advantages such as organizational commitment, higher willingness to learn new skills, high involvement and commitment to continuous improvement and quality initiatives. By avoiding unnecessary employment variability, Tesco has reduced the substantial transaction costs associated with activities related to adding and cutting employees. The program helped Tesco retain trained staff by making temporary internal recruiting as easy as possible. Tesco used switching HR options to enhance HR flexibility.

Avon: Avon smartly used a weak economy to hire more women in the workforce and build slack/buffer to reduce variation in demand for number of employees and types of employees. It was also envisaged that in a down economy, Avon’s products would also be more attractive to all those women who would not be able to afford department store shopping during these tough times. Job cuts, shrinking bonuses and scaled-back hours have pushed more people than ever to become direct sales representatives. During the 2001 recession, the number of direct sellers increased to 12.2 million from 5.1 million during the 1991 recession. During the 2001 recession, Avon’s management recognized that the downturn would result in “an ever larger pool of women” to recruit to sell its cosmetics, perfumes and other products. To bring this talent into the workforce, Avon revitalized an old program called “Sales Leadership” in which the company’s top performers are taught how to recruit, train and supervise their own group of representatives. The results of this bold countercyclical hiring strategy was impressive as sales grew by almost twice the historical average, net income increased by 20% and, subsequently, Avon’s shares rose by 16%, outperforming competitors and the market index. This was not a 1-year phenomenon as increase in earnings per share and sales continued for a couple of years. Avon used scaling HR options to reduce uncertainty of volume and combinations.

C. HR options and uncertainty of costs:

Organizations face uncertainties related to cost when there are greater fluctuations in firm performance but the costs are relatively fixed. Employee costs constitute a major portion of overall costs of the firm. If employee costs are mostly fixed, then it is a big drag on the firm’s cash flow, especially in case of fluctuating firm performance. In such cases, these firms would create options to manage employee costs.

Uncertainty of costs is caused by continuing costs of HR investments. It is the variations in the ratio of the total outlay for HR relative to firm revenues. High as well as fixed HR costs and fluctuating firm revenues due to changes in market demand, economic downturn, increased market competition and so on give rise to uncertainty of HR costs. In such cases, these firms create HR options of variable compensation plans to manage employee costs. These plans create the opportunity that employees would accept variations in their pay according to variations in firm performance. Such HR options to manage employee costs are found in variable pay plans and performance-based incentive plans.

Today more than 90% of U.S. companies have broad-based variable pay programs. Variable pay provides greater flexibility to organizations in managing their compensation costs during volatile business cycles. In Aon Hewitt Survey,¹⁷ 85% respondents agreed that variable pay plan helped or somewhat helped in improving business results. Such plans range from individual bonus plans/merit pay plans to group/unit/firm performance-based plans (e.g., profit-sharing and gain-sharing plans). Performance-based variable plans generate options to alter costs as it better align employees’ interest with that of the firm, leading to greater transparency, commitment and adaptability on the part of the employees. When there are high uncertainty of performance (e.g., jewelry sales), full-commission (100% variable pay) plans are used, while under less uncertain conditions, commission is added to base pay (e.g., financial services sales).

Uncertainty of costs is caused by various factors such as hiring a large permanent workforce and paying them high levels of guaranteed pay and offering liberal fringe benefits (including postretirement benefits) and poor recruitment and selection practices or seniority-based retention during downsizing as it makes the firm’s cost structure rigid and uncompetitive. Uncertainties of costs can be managed by designing optimal mix of fixed and variable pay¹⁸ as well as financial and nonfinancial rewards¹⁹ in the pay structure of employees.

Downsizings and layoffs of organizations have unintended negative consequences for individuals as well as the organizations, such as reduced job performance and low organizational commitment, trust and loyalty. Such practices by an organization break the implicit psychological contract between the employer and the employee—a contract that implies long-term employment in return for hard work and loyalty. The organization is expected to provide stable employment and opportunities for individual development and promotion of workforce. Employees’ perceptions of a layoff as a violation of the psychological contract may lead to several organizational problems, such as low morale, low trust and low productivity and correspondingly a negative impact on the financial performance of the organization. Any downsizing initiative by organizations also leaves the organization’s survivors (the employees left behind) overloaded, and often with work they have not been trained to do. Workforce reductions by layoff may produce feelings of insecurity and stress among the surviving employees. Consequently, morale and productivity of employees often decline and some may leave, which can have a significant impact on the top and bottom lines of the organization. Employees may begin to feel that they are less valued or respected in the organization and cultivate feelings of mistrust toward their employers, with a subsequent decline in morale. Hence, controlling downsizing with effective HRM practices will reduce uncertainty of costs.

Illustrations

The following illustrations explain how firms reduce uncertainty of costs by deploying various HR options.

Nucor: In a period of recession or economic downturn, the demand for the goods and services of the organization and, in turn, the demand for the workforce will go down. Hence, many organizations resort to downsizing and layoff of employees. However, layoff will reduce overheads in the short term, but it may result in much heavier long-term costs.

Nucor is the largest steel producer in the United States. Although, Nucor is in a highly cyclical industry, it has adopted a unique policy of promising its workers no layoffs. Such policy enhances the reputation of a firm as a stable employer and potentially improves the firm’s ability to attract and retain qualified employees and can positively affect recruitment outcomes. It also reduces organization uncertainty, lowers the opportunity costs of employees and encourages employees to stay longer with the firm. Nucor is able to shave its labor costs during downturns in three ways.

A “share the pain” program allows the company to taper its labor costs in recessions without loss of productive capacity. All employees—from the production line to the executive suite—readily take pay cuts. Nucor allocates the pay cuts according to a “progressive” schedule: Executives earning higher salaries take larger pay cuts on a percentage basis.

All employees—from the executive suite to the steel mill floor—willingly accept cutbacks in the number of hours worked in recessionary times in exchange for long-term employment.

The company cross-trains its workforce so that it can be shifted to other functions, such as maintenance or modernization efforts, as downturns occur.

With all these steps, Nucor was able to taper its labor costs very effectively and weather recessions without loss of productivity. Nucor used switching HR options and options to defer to reduce uncertainty of costs.

Infosys: India’s second largest IT services provider Infosys has used sabbaticals to reduce costs while protecting its highly skilled workforce. Educational sabbaticals at reduced pay increase the skills and capabilities of employees, boost morale and increase loyalty, while trim employee costs. During the economic downturn of 2007 to 2009, Infosys offered its employees who had worked for the company for at least 2 years the opportunity to take a 1-year sabbatical to engage in philanthropic activities. The employees who took advantage of this offer were paid 50% of their salary. In this way, Infosys retained its employees, improved its image and also reduced employee costs.

In 2015, Infosys has launched an initiative called “Zero Bench” to help its employees find short-term assignments. In the IT industry, the bench refers to the section of a firm’s employees who are not working on any project for the time being (a person could spend anywhere between a couple of weeks to up to 12 months on the bench) but remains on the rolls and receives regular salary. This bench could consist of fresh graduates or senior techies. During bench period, employee gets time to learn as well as focus on some internal initiatives. A strong bench is an indication that the firm has ready resources and can begin execution immediately. But having too many people on the bench means employees are underutilized, and this would negatively affect the profitability of the firm. Under “Zero Bench” initiative, employees who have tasks to perform can post their requirements based on their projects, and benched employees can sign up to help finish the task. With this initiative, Infosys has improved employee utilization rate (which refers to the part of the workforce actively working on projects and not on the bench) by ~5% (i.e., 76.6% in 2012 to 81.7% in 2017). Infosys used switching HR options to reduce uncertainty of HR costs.

Case Study: Managing Uncertainty of HR Investment in IT Service Firms

IT software firms in India are exposed to almost all types of environmental uncertainties as they represent high-velocity industry. Human capital is key resource of IT firms and also represents largest cost (typically 60% to 70% of total costs). As HR constitute an important source of competitive advantage as well as a significant part of total costs in IT firms, such uncertainties strongly affect the value of human assets of a firm. These environmental uncertainties are related to uncertainties of returns (due to rapid obsolescence of skills and demand for new skills), uncertainties of volume and combinations (due to rapid fluctuations in product mix requiring numerical and functional flexibilities of workforce) and uncertainties of costs (due to competitive pressure and high HR cost).

In a study of 108 IT software firms in India, researchers Sanyal and Sett²⁰ found that sample IT firms made significant use of HR options of different types. Uncertainties of returns, uncertainties of volume and combinations and uncertainties of costs were managed with various HRM practices (e.g., training, job rotation, bench strength management, job design, employee participation, grievance handling, competitive pay and contingent financial rewards). This study empirically investigated the linkage between use of HR options and the firm’s operational and financial performance. The study found that HR options, such as options related to growth and learning; turnover and productivity options and scale, timing and switching options, all had strong positive correlations with the various dimensions of both operating and financial performance of the IT software firms. Similarly, HR option related to variable employment cost had significant and positive correlation with operating cost efficiency, market share and overall firm performance. The study also shows that HR options definitely create value as they explain 37% and 42% of the variance in operational and financial performance of the firms, respectively.

Conclusion

This research focuses on risk management in HR, analyzes the different types of risks and uncertainties associated with HR and identifies various sources of uncertainties in HR investment. Extending the concept of real options, the research considers HR as a strategic asset and emphasizes certain HRM practices as creating HR options in terms of reducing uncertainties related to returns, volume and combinations and costs. HR option is in fact real option, since it allows the organizations to pay smaller price for the adjustment. There is a premium associated for creating these HR options as many of these HRM practices involve additional investments on HR. These HR options may manage more than one type of risks and have synergistic effects when they act in “bundles” of multiple interacting options. However, when there is no synergy among various HR options related to different types of uncertainty, such as uncertainty of returns, uncertainty of volume and combinations and uncertainty of costs, it results in suboptimal performance. In this scenario, hedging one type of uncertainty will increase other related uncertainties (e.g., managing uncertainty of volume and combinations may lead to increased uncertainty of costs). Thus, there is need to study interactions and interdependency of various HR options to mitigate overall risks. The ability of the organizations to operate flexibly in dynamically changing business conditions is crucial on the long run. The underlying logic of HR options proactively manages HR uncertainty and provides an alternative view of value creation. The research emphasizes role of HR options in hedging HR related risks and uncertainties and explores deployment of various HR options in business organizations.

Footnotes

Declaration of Conflicting Interests

The author declared no potential conflicts of interest with respect to the research, authorship, and/or publication of this article.

Funding

The author received no financial support for the research, authorship, and/or publication of this article.

Notes

Author Biography

Pankaj M. Madhani has earned bachelor’s degrees in chemical engineering and law, a master’s degree in business administration from Northern Illinois University, a master’s degree in computer science from Illinois Institute of Technology in Chicago and a PhD in strategic management from CEPT University. He has more than 30 years of corporate and academic experience in India and the United States. During his tenure in the corporate sector, he was recognized with the “Outstanding Young Managers Award”. He has also received “IBSAF Best Teacher Award” twice (2013 and 2017). He has published various management books and more than 300 book chapters and research articles in several refereed academic and practitioner journals. He is a frequent contributor to Compensation & Benefits Review and has published more than 21 articles on sales compensation. He is also the editor of The IUP Journal of Corporate Governance.