Evidence for increasing the focuson strategic risk in HRM audits

Daniel A. VerreaultJohn H. Sykes College of Business, University of Tampa, Tampa,

Florida, USA, and

MaryAnne HylandSchool of Business, Adelphi University, Garden City, New York, USA

Abstract

Purpose – To communicate the development and results of strategic human resource management(HRM) research to the audit research community in order to stimulate audit research specific to HRMaudits.

Design/methodology/approach – Prior research that served as impetus for this paper is discussed.The findings of other studies are presented to make a case for the business impact of strategic humanresource management practices.

Findings – Studies on the competitive environment of firms, theoretical development in HRM,empirical work on the link between HRM practice and firm performance, and emerging models basedon intellectual capital, suggest that there are compelling reasons for internal audit to devotesubstantial resources to the evaluation of strategic risk in HRM audits.

Research limitations/implications – The literature is still developing. The literature presentedhere is not an exhaustive list and does not include all findings, but rather what are perceived to be themost important findings.

Practical implications – Both “high performance work systems” and “strategic fit” should guideinternal audit in planning, designing audit programs, and executing strategic audits of humanresources consistent with the risk management paradigm.

Originality/value – This paper bridges a gap between the human resource management literatureand the internal auditing literature.

Keywords Internal auditing, Risk management, Human resource management

Paper type Literature review

IntroductionThe purpose of this paper is to cite evidence that there are important issues relevant tothe specification and investigation of strategic risk in HRM audits that may beunder-emphasized in much of current audit practice. Consistent with the increasingimportance attached to management of a firm’s intangibles and emerging models ofintellectual capital drivers, we believe that excellence in human resource practicesgreatly increases the potential for organizational success.

We list six reasons for internal auditors to develop expertise in the assessment ofhuman capital management, and for audit researchers to develop more understandingof how such expertise can be encouraged, accomplished, and measured:

The Emerald Research Register for this journal is available at The current issue and full text archive of this journal is available at

www.emeraldinsight.com/researchregister www.emeraldinsight.com/0268-6902.htm

The authors gratefully acknowledge the monetary support and data collection assistance of theInstitute of Internal Auditors Research Foundation.

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Managerial Auditing JournalVol. 20 No. 5, 2005pp. 524-543q Emerald Group Publishing Limited0268-6902DOI 10.1108/02686900510598876

(1) Compensation expense is approximately 15 percent of an average firm’soperating expenses (Bontis and Fitz-enz, 2002). The amount is certainly material.Internal audit (IA) must be keenly aware that leveraging human assets is evenmore important than returns on fungible capital. It is human capital that is scarceand less easily duplicated in a knowledge-based economy and it is human capitalthat acquires, manages, and drives returns on the firm’s tangible assets.

(2) Research shows that the variation in enterprise performance tied to themanagement of human resources could be substantial. An increasing body ofliterature and research addresses the importance of various sets of workpractices on organizational performance (Lawler, 1992; Pfeffer, 1994, 1998;Huselid, 1995; Delaney and Huselid, 1996; Ichniowski et al., 1997, Ichniowskiand Shaw, 1999, 2003; Pfau and Kay, 2002; Laursen and Foss, 2003; Bontis andFitz-enz, 2002).

(3) Elements of human capital management are central to the successfulimplementation of most other management initiatives and the achieving ofthe firm’s strategic goals. The importance of human resources as firm assetswas appreciated by the accounting profession before the development of mostcurrent management initiatives (Flamholtz, 1985). Balanced Scorecard (Kaplanand Norton, 1996) models contain measurements related to employees. SeePhillips and Stone (2000) and Becker et al. (2001) for fully developed HRscorecards that seamlessly link to well-accepted financial performancemeasures. Valuation models (Copeland et al., 2000, Stewart III, 1991)recognize that enhanced performance of human capital is a key contributor tofirm value. Stewart and Copeland recommend capitalizing some element oftraining and development costs as a signaling device for management and as away to better measure periodic return on invested capital.

(4) Firm value increasingly rests on intangibles (Hurwitz et al., 2002, Hand and Lev,2003). Human capital is an important part of the intangible value of a company.Roos et al. (2004) believe that intellectual capital models coupled with rigorousmeasurement have the most potential to reveal causal links between HRpractices and firm performance. Fitz-enz (2000) presented a model of intellectualcapital that is tightly integrated with financial measures that may be calculatedand tracked by internal auditors. Bontis and Fitz-enz (2002) derived a causalmap of factors that enhance or weaken intellectual capital. IA’s consideration ofstrategic risk in HRM audits could be strengthened by the development of anintellectual capital management and development framework.

(5) A focus on human capital practices provides a strategic lens through whichinternal audit (IA) functions may view the human resource management (HRM)function. Knowledge of current theory and practice related to human capitalwill aid the auditor in risk assessment and risk management of HRM issues.The result for IA will be better service to the HRM client, projects of increasedscope and import, and audit reports linked to firm performance and strategy.

(6) Analysis of human capital practices fits closely with “a rigorous andcoordinated approach to assessing and responding to all risks that affect theachievement of an organization’s strategic and financial objectives. Thisincludes both upside and downside risks” (Miccolis et al., 2001, p. xxii).

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Potential disconnect between the risk-managing paradigm and actual riskassessmentsThe motivation for this paper is an apparent disconnect between the conceptualstrength of the IA risk managing paradigm and the specific outputs of that process inthe form of audit findings in HRM audits. Hyland and Verreault (2003) proposed amodel illustrating the value creating potential of the IA-HRM pairing. Additionally,survey results from 161 IA respondents described their self-assessment of their ownunit’s level of risk managing philosophy and their assessment of the extent to whichtheir own firm’s HRM function exhibited a strategic outlook. See Figure 1 for themodel. IA respondents generally ranked themselves high in adopting a risk managingaudit philosophy and assessed their firm’s HRM functions as moderately high instrategic outlook. Sixty-nine percent of the usable responses were in this “valuecreating” quadrant. The “motivating” quadrant, which combined a risk managingapproach to internal audit with a non-strategic approach to HRM fit 25 percent of theusable responses. The cost minimizing and limiting quadrants received 4 percent and 1percent of responses respectively. A total of 94 percent of IA functions self-classifiedtheir units as risk managing in their audit approach.

Based on these positive overall self-assessments we expected that specific strategicHRM findings would be relatively commonplace. IA respondents were then asked tocite audit findings that might be classified as strategic. Analysis of responses indicatedthat the ability to actually cite any concrete finding relating to strategic goals wasextremely limited. Respondents were asked to provide examples of first, an auditfinding that reflected the consideration of strategic risk in IA’s audit process andsecond, an audit finding that recognized a strategic action that had been implementedby HRM. Only 35 percent and 22 percent respectively of respondents provided anyanswers to the two specific questions concerning the inclusion of strategically orientedfindings in audit reports. Of those responses only a few could be said to reflectelements of theoretical or empirical strategic human resource management (SHRM)findings supported by the literature[1]. Examination of the responses suggests thatalthough IA may self-report high levels of commitment to the risk-managing

Figure 1.Matching IA and HR tocreate value in Hyland andVerreault (2003)

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philosophy, the actual audit process in the HRM context may revert to a compliancefocus. This disconnect suggests a problem with the diffusion of the risk managingparadigm throughout the audit process, and reveals a need to communicate to auditorsthe nature and types of strategic models and results of empirical work in SHRM thatmight encourage reference to strategic risk specific to HRM in audit planning sessions,audit program design, audit execution and reporting of results. Researchers have amajor role to play in the process of adapting the specialized knowledge of strategic riskattaching to a particular type of audit client such as HRM.

McNamee and Selim (1999, p. 19) point out two weaknesses of the current riskparadigm:

One is that internal auditors focus too much on measuring risk factors instead of theunderlying risk – different results can occur when the nature of risk changes and the internalauditor continues to use the same factors. The second weakness in risk assessment byinternal auditors is that planning is where the focus on risk usually ends. Once the internalaudit is planned (or the group of audits for the annual plan are chosen), the focus is switchedto the system of internal control. In current internal audit practice, controls, not risks, aretested, evaluated and reported to management.

Familiarity with the current risk profile of HRM developed primarily over the pastdecade may not yet be included in IA’s risk universe for HRM and, even if the risks arerecognized in a general sense, the actual audit process under-emphasizes that strategicrisk.

Human resource management functionsLike IA, HR is striving for relevance. For IA, the drive is to adopt and extend the riskmanagement paradigm, for HRM the paradigm shift is to become a strategic partner.For HR to achieve the status of strategic partner, the function must be acutely aware ofthe firm’s strategic objectives and align human capital and practices to help in meetingthose objectives (strategic fit). Additionally, HR must be aware of approaches to humancapital management and measurement that are proving effective in enhancingelements of firm performance. In the past, human resource management, known as“personnel administration” was compliance-focused and lacked strategic orientation.However, many organizations now develop and use human resource practices as asource of competitive advantage. We refer to this approach as “strategic humanresource management” or SHRM. Those HRM functions that have not transitioned tothe strategic view, we classify as non-strategic. HRM is under pressure from corporatemanagement to demonstrate value-added beyond the “smile and file” human relationsand compliance missions (Stewart, 1996; Sparrow, 1998).

Management also looks at outsourcing as a way to increase the strategic focus ofHRM through offloading compliance functions. IA must recognize the possibility thatHRM as a non core process might be a candidate for outsourcing (e.g. Linder andSawyer, 2003; Stroh and Treehuboff, 2003; Woodall and Gourlay, 2002; Belout et al.,2001; Cook, 1999), or the need to properly deploy technology to allow HRM to increaseattention to strategic goals (Jossi, 2001).

Human capital and competition: a macro viewThe creation of market economies in eastern Europe, the emergence of marketeconomies in India and China, the decline in worldwide tariff levels, and plunging

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communication and transaction costs have led to highly competitive world markets inmost sectors. Companies must focus on the productivity of human capital to thrive(Porter, 1998). We might think of a competitive economy’s “creative destruction”(Schumpeter, 1950) as a motivator for adoption of innovative HRM practices, as thosefirm’s adopting new ways of doing things with respect to such a critical resource ashuman capital might have what has been called the “human capital edge” (Pfau andKay, 2002). Supply and demand of skilled human capital must be considered in anyrisk assessment. A report titled Workforce 2020, (Judy and D’Amico, 1997) predicts ashortage of skilled labor in the USA. Major European economies face similar, evengraver, risks.

Strategic advantages of human capital practices: theory developmentHistorically, human resource management (formerly known as personnelmanagement) consisted largely of recordkeeping and maintenance activities. Thepersonnel function was considered an area of business that needed to be done, butwhich added little value to the organization in terms of productivity or profitability.Most of the early research on personnel management focused on issues affectingindividuals, such as employee testing and training (Ferris et al., 1999). The evolutionfrom personnel management to human resource management was more than simply achange in name. Rather, it represented a conceptual change from thinking of employeesin an organization as personnel (perhaps a cost to be minimized), to resources thatbring value to the organization. However, it was not until a broader perspective, knownas strategic human resource management (SHRM), developed in the late 1980s andearly 1990s that human resource management began to gain credibility as a potentialsource of competitive advantage. SHRM looks beyond individual implications ofhuman resource management issues and attempts to align human resourcemanagement activities with the strategic goals of the organization (Butler et al., 1991).

SHRM developed from scholars’ interest in examining the relationship betweenHRM practices and organization performance (Bowen and Ostroff, 2004) and fromtheoretical arguments that an organization’s human resources can be a source ofsustainable competitive advantage for the organization (e.g. Wright and McMahon,1992). There is general agreement among scholars that SHRM involves designing andimplementing internally consistent policies and practices that enable an organization’shuman resources to contribute to the achievement of business objectives; however, amore precise definition has yet to be reached (Huselid et al., 1997).

Building on theoretical arguments in favor of SHRM, research attempting todemonstrate the relationship between human resources practices and organizationalperformance emerged in the late 1980s and early 1990s (e.g. Delaney et al., 1989;Huselid, 1995; MacDuffie, 1995). Based on these studies, scholars began to compareapproaches to SHRM both conceptually and empirically. Two main approachesdeveloped initially (Youndt et al., 1996). Subsequent work expanded the number ofapproaches to three by making additional distinctions in the categorizations ofprevious work (Chadwick and Cappelli, 1999; Ferris et al., 1999). Most recently, theperspectives for studying the relationship between HRM and organizationalperformance have again been reduced to two as the body of research has narrowedin on two logical approaches which have found support in the literature. We describethe “systems approach” and the “strategic approach” and the evolution of these

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perspectives. These approaches are complementary and co-exist in organizations. Theeffective implementation of both SHRM approaches represents a formidablecompetitive advantage for the firm.

The systems approach focused initially on the relationship between individualHRM practices and organizational performance and later transitioned into anexamination of a set of HRM practices and their relationship as a group withorganizational performance (Bowen and Ostroff, 2004). This approach was identifiedby earlier scholars as the “universalistic” approach because it asserts that certain “bestpractices” will be advantageous to all organizations. Early research on “best practices”examined the effect of individual HRM practices, such as job design or promotioncriteria, on an organization’s turnover and productivity levels. However, subsequentresearch found that the return on groups of HRM practices that work with each other ina complementary fashion is greater than the effect of such practices used individually,and far superior to mismatching HRM practices that are contradictory. For example,the effect of using valid selection procedures should be greater if the organization usesperformance appraisals and incentive compensation programs that reward goodperformance (Huselid, 1995). If compensation programs based on seniority arecombined with performance appraisals and incentive compensation, their positiveeffects on performance should be lessened. According to the systems approach, whenHRM practices are aligned in a complementary fashion, an “internal fit” (Baird andMeshoulam, 1988) develops that leads to improved financial performance. Suchcomplementary HRM practices are known as high performance work systems.Huselid’s (1995) seminal work in this area sparked further thinking about how humanresources practices can be leveraged to improve organizational performance. In a studyof 968 publicly-held US organizations, he found that a one standard deviation increasein human resources “best practices” was related to a $7,868 profit increase and a$33,250 increase in the market value of the organization per employee. We present theHRM system as the horizontal alignment in Figure 2.

Figure 2.The two dimensions of

effective HRM policies andpractices

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The strategic approach, as suggested by Bowen and Ostroff (2004), has three differentmeanings in the literature. One meaning is the “fit” between HRM practices andorganizational strategy. This perspective also considers the horizontal alignment ofHRM practices, such that that the practices “fit” with each other to support thebusiness strategy (Bowen and Ostroff, 2004). A second meaning of the strategicapproach is based on contextual factors, such as organization size or industry.According to this contingency perspective, the effectiveness of HRM practices onincreasing organization performance depends in part on contextual factors associatedwith the organization. For example, Youndt et al. (1996) studied 97 plants from varioussegments of the metal-working industry finding that the combined effects ofmanufacturing strategies and sets of HRM practices on operational performance werepositive and statistically significant. The interactive effects of management strategyand HRM practices suggest the importance of a vertical fit between HRM practices andstrategic or contextual factors. A third meaning of the strategic approach concerns thecomplexity of a complete set of HRM practices, which are difficult for competitors toimitate. The resource based view of organizations (Barney, 1991) suggests thatorganizations can achieve competitive advantage by using a set of HRM practices thataffect employee effort, attitudes, and behaviors, and thus are difficult for competitors toimitate (Bowen and Ostroff, 2004). We recognize that the evolution of thought onSHRM is continuing and that the approaches to studying SHRM may further progress;however, for our purposes, we have used the most recent conceptualization of which weare aware, which is that there are two principal approaches in the SHRM literature tostudying the relationship between HRM and organizational performance: the systemsapproach and the strategic approach (Bowen and Ostroff, 2004). (See Figure 1 – thevertical dimension is strategic fit.)

The literature review below emphasizes the systems approach for several reasons.First, the findings are more universal. Second, an in-depth review of key studies in thesystems area does not allow for in depth consideration of the strategic approach due tospace considerations. Third, we believe that the findings from the systems approachare strong enough in their own right to make a convincing case that auditors shouldincorporate consideration of strategic risk in the HRM audit process.

Key SHRM practicesPfeffer (1994, 1998) described and distilled HRM best practices to a list of sevenstrategic areas as follows:

(1) Job security.

(2) Selective hiring of new personnel.

(3) Self-managed teams and decentralization of decision making as the basicprinciples of organizational design.

(4) Comparatively high compensation contingent on organizational performance.

(5) Extensive training.

(6) Reduced status distinctions and barriers, including dress, language, officearrangements, and wage differences across levels.

(7) Extensive sharing of financial and performance information throughout theorganization.

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These seven best practices should drive higher levels of performance in theorganizations that effectively use them. Other researchers have specifically noted thebenefits of complementary HR practices – the HR system cited above (Kandel andLazear, 1992; Holmstrom and Milgrom, 1994). Pfeffer’s list is a valid starting point, butwe note that other researchers and theory builders may present different lists or weightitems differently.

Empirical evidence linking HRM practices to firm performanceA cross-sectional study of publicly held firms in the USAAs reported above, Huselid (1995) conducted a cross sectional study of publicly heldfirms and found strong support for the effects of certain HRM practices on thereduction of turnover and the enhancement of revenue. Huselid’s study wascross-sectional; therefore, it left indeterminate the direction of influence between HRMpractices and firm performance. Did high performance work systems drive firmperformance of did high performing firms invest in high performance work systems?Finally, the survey contained only one respondent from each firm, making theestimation of response variance difficult if not impossible. However, the finding thatmajor positive financial outcomes were associated with implementation of certain HRpractices was striking. Internal auditors should be cognizant of Huselid’s findings inthe context of the general development of strategic HR thinking summarized byPfeffer, and the consistent implementation of a bundle of consistent practices.

A repeated large-scale cross-sectional studyPfau and Kay (2002) reported on the results of a series of surveys undertaken byWatson Wyatt Worldwide (WW). In 1999, WW undertook a large cross-sectional studyof over 400 US and Canadian firms and computed a human capital index (HCI) score.The firm found strong positive correlations between firm performance and a group of30 variables associated with SHRM. The initial survey also found some negativecorrelations between certain traditional HRM practices and firm performance. WWconducted a European HCI survey in 2000 and conducted another survey in 2001 thatincluded over 500 North American companies. The firm merged the European surveyand the 2001 North American Survey. In order to address the direction of influenceissue, the firm computed correlations between the first HCI survey and the mergedresults of the European and second North American administrations of the instrument.WW claimed clear evidence that in fact superior HRM practices are not only associatedwith but are lead indicators of increased shareholder value. The correlations betweenHRM practices and subsequent firm performance (0.41) were much greater than thosebetween firm performance and subsequent HCI scores (0.19). The principal indicatorsof shareholder value used were market value, three and five year TRS, and Tobin’sQ[2].

The HCI possesses the following positive attributes:. The HCI differentiates among firms and the differences are significant. The low

performing group averaged a 21 percent five year return. The medium scoringgroup averaged a 39 percent five year return, and the high performing groupaveraged a 64 percent five year return.

. The findings generally agree with prior theory and other empirical work. Thegeneral factors are similar to those cited by Pfeffer (1998) and Huselid (1995).

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. Some practices destroy value. The survey identified practices that had majornegative impacts on financial performance, but that may at first glance beviewed as positive initiatives.

. The results are cross cultural. The surveys include US, Canadian, and Europeanfirms.

. The repeated survey analysis allowed for the testing of the direction of effects.SHRM practices were a leading indicator of improved performance.

. There is sufficient detail in the survey questions to serve as a foundation for thedesign of an IA strategic risk management program.

See Panel A of Table I for a list of each of the major factors and their contribution tofirm value. Note that the sum of the positive practices is 47 percent. However, the indexentitled “Prudent use of resources” indicates a major negative impact from certain wellrespected HR initiatives that have a cumulative negative impact on value creation ofapproximately 34 percent. Each major factor is supported by a more detailed index thatlists the impact of each index item on value creation. Panel B presents detail for the“rewards and accountability index” while Panel C lists the components of the “Prudentuse of resources” index. Consider, for example, the possible audit approach of an IAfunction without knowledge of these survey findings. A hypothetical project toenhance communication (associated with a negative 7.7 percent effect on value creationas shown in Panel C of Table I) might never be questioned in the audit planning stagesand may be audited only to track compliance with budget and the goal of “enhancedcommunication.” Likely, no link would be attempted between the project and firm levelfinancial outcomes. We believe that prior knowledge of and training in the findings ofstrategic HRM might empower auditors to discuss such a project at the planningstages and to measure the success of such a project much differently. The surveysuggests that there are many such possible examples that may prompt IA to modifytraditional audit planning and execution in HRM audits.

A cross-sectional study of French industryIn a study of French employment records, d’Arcimoles (1997) found positive effects onfirm performance related to levels of training. Positive lagged correlations between thelevel of dismissals and return on capital were partially attributed to the sampleexcluding firms that were likely to go bankrupt. However, for healthy firms,employment reductions that might be a proxy for flexibility were associated withpositive returns. Most studies view turnover, especially voluntary turnover, as anegative human capital indicator (Huselid, 1995; Fitz-enz, 2000; Cascio, 2000; Bontisand Fitz-enz, 2002).

An in-depth study of US steel finishing linesIchniowski et al. (1997) conducted a highly detailed empirical study on US steelfinishing lines and later extended the study to a comparison of US and Japanese steellines (1999) using a process later labeled “insider econometrics” (Bartel et al., 2004). Thestudy investigated whether or not innovative HRM practices increase productivity.The authors found “consistent support for the conclusion that groups or clusters ofcomplementary human resource management (HRM) practices have large effects onproductivity, while changes in individual work practices have little or no effect on

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productivity” (Bartel et al., 2004, p. 291). Table II illustrates the HRM practicesinvestigated in the study.

The authors visited 45 out of 60 steel lines in the USA belonging to 17 differentcompanies. The sample included large companies with multiple lines, as well as smallcompanies. The study included 2,190 monthly observations of 36 of the steel finishinglines. The study controlled for 25 variables regarding lines (e.g. learning curve, width,type and design of capital equipment etc.) as well as structural, management, andpolicy-related variables. HRM policies were gathered from several organizational

Panel A. Overall index of HRM factors affecting market value

PracticeImpact on market value

(%)Total rewards and accountability 16.5Collegial, flexible workplace 9.0Recruiting and retention excellence 7.9Communications integrity 7.1Focused HR service technologies 6.5Prudent use of resources 233.9

Panel B. Total rewards and accountability index

FactorImpact on value creation

(%)Health benefits are important for recruiting and retention 2.8High percentage of company stock owned by employees 1.3Defined contribution and defined benefit plans, combined, important forrecruiting and retention 1.3High percentage of company stock owned by senior managers 1.2Company promotes most competent employees 1.1High percentage of employees participate in incentive/profit sharing plans 1.0Defined benefit plan important for recruiting and retention 0.9Employees have choice regarding benefits 0.9Defined contribution plan important for recruiting and retention 0.9Top performers receive better pay than average performers 0.8Company positions benefits above the market 0.7Company helps poor performers improve 0.7Company positions pay above the market 0.7Company terminates employees who continue to perform poorly 0.6Total impact of rewards and accountability 16.5

Panel C. Prudent use of resources index

FactorImpact on value creation

(%)Enhancing communication is a key goal in implementing HR servicetechnology 27.7Culture change is a key goal in implementing HR service technology 26.6Employees have opportunity to evaluate superiors 25.7Employees have access to training needed for career advancement 25.6Employees have opportunity to evaluate peers 24.9Training programs maintained even in difficult economic circumstances 23.4Total impact of prudent use of resources index 233.9

Source: Pfau and Kay (2002)

Table I.Watson-Wyatt humancapital index variables

– summary index

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levels, as well as from archival sources. The data were analyzed as a sample of fourclusters of HRM policies. Table III illustrates the four HRM systems and their componentpractices.

HRM system 1 implemented all SHRM practices while HRM system 4 representedthe traditional system containing no innovative practices. HRM system 1 incorporatedinnovative HRM practices in all HRM policy areas. Lines with this system have amulti-attribute incentive pay plan or a “pay-for-knowledge” incentive pay system;extensive screening of new workers; off-line training in technical skills and teamproblem solving; high levels of employee involvement in multiple problem solving

HRM variablename Mean Variable description

Incentive payProfit sharing 0.700 Is there a company profit-sharing plan covering the line workers?Line incentives 0.186 Are operators covered by a “non-traditional” incentive pay plan

which applies across shifts of workers and which is sensitive toquality as well as quantity aspects of output?

Recruitment andselectionHigh screening 0.085 Was an extensive selection procedure used to hire new workers,

including tests for personality traits needed for cooperative teamenvironments and efforts to set clear expectations about requiredwork behaviors of the new workers?

TeamworkHigh participation 0.237 Are a majority of operators involved informal or informal work

teams or other related problem-solving activities?Multiple teams 0.130 Do operators participate in more than one problem-solving team?Formal teampractice

0.335 Are operators organized into formal work teams either on the line orfor the purposes of problem-solving activities according to anestablished policy with at least some operators involved in teamactivities?

Employmentsecurity

0.228 Has the company committed to a goal of long-term employmentsecurity and offered employees a pledge of employment security?

Flexible jobassignmentJob rotation 0.079 Do operators rotate across jobs or tasks on the line?Skills trainingHigh train 0.134 Have all operators on the line received off-the-job training?Low train 0.208 Have at least some operators received off-the-job training?CommunicationInformationsharing

0.566 Are operators and union representatives, if any, provided withfinancial information on a regular basis?

Meet workers 0.508 Do line managers meet off-line with operators to discuss issues ofconcern, including issues related to performance and quality?

Meet union 0.224 Do union representatives and managers meet often to discussconcerns and cooperate in finding solutions to issues?

Labor relationsUnion 0.917 Is the line a unionized operation?Low grievance 0.499 Is the grievance-filing rate less than 12 per year?

Source: Ichniowski et al. (1997)

Table II.Definitions of HRMvariables

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teams; job duties covering a wide range of tasks with workers often rotating acrossjobs; regular information sharing between workers and management; and an implicitemployment security pledge. Please note the high level of agreement of thecharacteristics of the HRM systems with those cited earlier. The authors developedcriteria for the four HRM systems as a result of prior theory and empirical work.

Characteristics of System 4 included close supervision by foremen; strict work rulesand narrow job responsibilities; incentive pay based on quantity, but not quality, ofoutput; no work teams; no practice of managers sharing financial information ormeeting regularly offline with workers; no screening; and no off-line or other formaltraining.

Tests based on longitudinal data of those changing HRM systems showed positiveeffects from introducing innovative HRM practices, thus suggesting a cause-effectsequence. In terms of productivity, the most conservative estimate of the productivitydifferential for HRM System 1 was 6.7 percent. Using cost data from one small-scaleline, a conservative estimate of the effect of a 1 percent increase in uptime on revenueswas $30,000 less $2,100 for the cost of HRM policy implementation or $27,900 permonth. For a 6.7 percent increase in uptime the revenue gain net of HRM incrementalcosts was $186,930. After adjusting for various costs of implementation andgeneralizing, the authors estimated a $1,171,800 annual increase in operating profits.This does not count the subsequent increases in output quality that occurred after theline changed its HRM system. HRM System 1 positively affected product qualitymeasured by prime yield rates that considerably exceeded the yields of lines with otherHRM systems.

The authors concluded that “monthly panel data on productivity and HRMpractices in a homogeneous sample of production lines, show that innovative HRM

Practices in seven HRMpolicy areas HRM System 1 HRM System 2 HRM System 3 HRM System 4

Incentive payLine incentives 1.00 0.31 0.00 0.00Recruiting and selectionHigh screening 1.00 0.15 0.00 0.00TeamworkHigh participation 1.00 0.85 0.10 0.00Multiple teams 1.00 0.62 0.00 0.00Formal team practice 1.00 1.00 1.00 0.00Employment securityEmployment security 1.00 0.23 0.48 0.00Flexible job assignment 0.00Job rotation 1.00 0.15 0.03Skills trainingHigh train 1.00 0.69 0.00 0.00Low train 1.00 0.92 0.07 0.00CommunicationInformation sharing 1.00 0.54 0.62 0.00Meet workers 1.00 0.77 0.72 0.00

Source: Ichniowski et al. (1997)

Table III.Specific HRM practices

within four HRM systemcategories

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practices raise worker productivity. Moreover, systems of innovative HRM practiceshave large effects on production workers’ performance, while changes in individualemployment have little or no effect” (Ichniowski and Shaw, 1997).

A study of North American business units in a food service companyWright et al. (2003) conducted a study of 50 autonomous business units of a foodservice company with US and Canadian operations. The study specifically addressedthe problem of single respondent surveys for which Huselid’s (1995) study wascriticized by using the business unit as the level of analysis and using multiplerespondents within units. The study also implemented a research design that usedlagged financial performance data and organizational outcomes, thus allowing forinsight into casual links that cross-sectional surveys do not permit. Their resultsshowed that HR practices were strongly related to organizational commitment andboth dimensions were strong predictors of operational performance measures used toevaluate the business units. This result supports the Pfau and Kay (2002) surveyresults discussed above in terms of the direction of the effects of implementing SHRMpractices. Both HR practices and employee commitment were positively correlatedwith reduced expenses and increased operating profit.

A longitudinal study of US manufacturers challenging the HPWS-performance linkCappelli and Neumark (2001) conducted a longitudinal study that included data priorto the adoption of HPWS by US firms. The research design aimed at controlling forheterogeneity in cause that was not possible in other studies. Their findings challengethe link between such practices and robust positive firm level outcomes. The authorsfocused on what they determined to be the most common subset of HPWS acrossstudies – the extent of employee involvement and its link to improved organizationalperformance. Their choice was also conditioned on the early studies of Japanesecompanies whose most important virtue was claimed to be worker empowerment.Their dependent variables were sales per worker, total labor costs per worker, andlabor efficiency (the ratio of the first two measures). The authors concluded thatpolicies transferring power to employees result in higher compensation costs, higherproductivity, and have no effect on labor efficiency.

A Danish study of the HRM-innovation linkLaursen and Foss (2003) examined HRM systems using a database of 1,900 privatelyowned Danish firms that spanned both manufacturing and non-manufacturingcompanies. Several important contributions emerge from that study. First, HRMpractices are shown to be supportive of enhanced levels of innovation. (Innovation maybe seen as a leading indicator of firm success whereas financial performance may beseen as a lagging indicator.) Second, the authors used principal component analysis toactually derive the HRM practices that were associated with enhanced levels ofinnovation rather than specifying them. Recall that Ichniowski et al. (1997) specifiedthe HRM system components based on prior work. Third, the large dataset is across-section of an entire economy. Fourth, the economy is set in the EU, whereas mostof the HRM studies focus on the USA.

The authors found that two different HRM systems were suggestive of superiorlevels of product innovation:

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(1) System 1 HRM practices were: interdisciplinary workgroups; quality circles;systems for collection of employee proposals; planned job rotation; delegation ofresponsibility; integration of functions; and performance related pay.

(2) System 2 included only two factors both relating to training: internal trainingand external training.

In general sectors more closely related to science and technology and/or morespecialized firms were more likely to be innovators.

A cross-sectional survey in a low management discretion economyDen Hartog and Verburg (2004) conducted a cross-sectional survey of 175organizations from various sectors in the Netherlands. The study gathered datafrom HR professionals, executives, and core employees. The study contributes to ourunderstanding by providing results from an additional country setting that might becharacterized as low in management discretion, and also included results from severalgroups within each organization thus somewhat muting the single source varianceproblem. The study’s measurement instruments focused on items identified by Huselid(1995) as belonging to a cluster composing a high performance work system. Theauthors identified a set of practices they labeled “Employee skill and direction”consisting of strict selection, an emphasis on employee development, and the presenceof a strong philosophy linked to a mission statement and HR strategy. The identifiedbundle was positively associated with “willingness to go beyond contract” andnegatively associated with absenteeism. Turnover levels were not associated with thehigh performance practices, but instead were negatively associated with performanceevaluation and information sharing. (We would classify both of these additionalelements as elements of a high performance system, although not necessarily loadingon the same factor as the authors’ identified bundle. See the section describing the WWsurveys.) The authors also noted that even in the highly regulated Dutch environment,enough discretion existed to positively influence organizational culture throughselective work practices. Questions were raised by the authors regarding thecost-benefit of expensive HR practices and the potential differential affects of suchpractices on firm performance and employee welfare.

Intellectual capital ROI: a causal mapBontis and Fitz-enz (2002) present a model of human capital as a part of intellectualcapital. Intellectual capital also included structural capital (knowledge existing apartfrom employee knowledge often in the form of databases or file cabinets) and relationalcapital (knowledge resting on relationships with entities outside the firm such as thosewith suppliers or customers). The authors gathered both qualitative and quantitativedata from a sample of 25 large companies in the financial services industry. Theyproposed a conceptual model of human capital valuation as a cause of human capitaleffectiveness. The main inputs to human capital valuation were human capitalinvestment (a positive) and human capital depletion (a negative). Human capitaldepletion was primarily a function of voluntary turnover. See Figure 3 for their finalfitted model.

The fitted model shows both correlations between constructs (printed on the causalarrows) and percentage of model variation explained by each dependent variable(printed as R 2 under each dependent variable). Although coverage of each relationship

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is beyond the scope of the study, we will look at several important relationships.Managerial leadership has highly significant correlations with retention of key people(0.506) and value alignment (0.751). The second major correlate of retention of keypeople was employee satisfaction (0.442). The antecedents of human capitaleffectiveness were training (0.530) and employee satisfaction (0.358). The primaryantecedents of business performance in the model were knowledge generation (0.327)and employee commitment (0.439). The primary factors that tended to decrease humancapital depletion were the level of knowledge sharing (20.233) and the level ofbusiness performance (20.372).

The human capital causal map is a powerful look at the possible order andmagnitude of relationships that drove multiple aspects of firm performance for thesample studied. Notwithstanding the questions, the causal map extends ourunderstanding of results back to the processes that give rise to the results andspecifically includes elements of strategic fit and HRM practices.

A recent literature review and evaluationRoos et al. (2004) reviewed the research on the HRM-performance link and concludedthat while the links between HR practices and firm financial performance are notdisputed by researchers, more detailed work needs to be accomplished. The authorspropose a model based on intellectual capital (IC) involving rigorous measurement inorder to better understand causal mechanisms linking practices and performance. Weexpect additional contributions from the IC models to be forthcoming and to confirmthe overall findings of prior research, but perhaps with additional insights regardingcausation and enabling mechanisms. The Bontis and Fitz-enz (2002) study was notincluded in the review, but that study seems to fulfill the recommendations made bythe authors.

Figure 3.A causal map of factorsaffecting human capital inBontis and Fitz-enz (2002)

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Summary of the literature surveyWe find generally strong agreement among the works cited including the theoreticalwork of Pfeffer (1994, 1998); the cross-sectional survey work of Huselid (1995); Pfauand Kay’s (2002) surveys that included multiple industries from the USA, Canada andEurope; the “insider econometric analysis” of US steel finishing lines of Ichniowski etal. (1997), the extensive cross-sectional study of innovation in Danish firms by Laursenand Foss (2003), and the development of a causal map of intellectual capital ROI(Bontis and Fitz-enz 2002). We also note the relatively weak positive effects found byCapelli and Neumark (2001). The effects of national culture and intra firm differencesare likely to moderate and further explain the dynamics of HPWS adoption and impact,and current work in the application of intellectual capital models will further explainlinkages between practices and performance. Theory development, cross-sectionalstudies, field studies, and the specification of finance specific measurement models asdeveloped by Becker et al. (2001); Fitz-enz (2000); and Cascio (2000) are strong enoughin theoretical agreement, magnitude of empirically observed financial impacts, andrelevance to the IA risk assessment paradigm to suggest that IA must learn tounderstand, develop, and execute audit models that seek to understand and evaluatethe firm HRM practices and HRM programs against the strategic objectives of the firmand extant HRM best practice.

Discussion and recommendationsThis paper was motivated by what we perceived in a prior study as a mismatchbetween a strong overall self-assessment of IA functions as reflecting a risk-managingparadigm and the relative inability of respondents to cite actual strategic findings inHRM audits. The assessment of the strategic outlook of HR, as judged by IArespondents, was also higher than we may suspect based on the overall pace and levelof transformation in the HR function supported by published academic studies andpractitioner’s articles. We believe that it is likely that the relatively high rankings arebiased upward due to self-response bias and a lack of specification of strategic risk inthe context of HRM audits. We propose a client-centric approach to risk managementthat explicitly requires training in the strategic risks of the particular client. Thestrategic risks of clients will differ. Only through knowledge of the client specific valuedrivers can the general risk paradigm be integrated into the execution of each auditstep. HRM and IA need to identify firm strategy, show links between human capitalpractices and firm strategy, and measure progress over time. Only the developmentand implementation of HRM audits focusing on strategic risk as understood throughknowledge of firm specific strategies, HRM research, and best practice will enable IA toextend the risk managing paradigm to the center of audit practice from the peripheryof audit theory.

We suggest the following as promising research ideas for those interested in theissues raised in this paper:

. Development of a model strategic HRM audit based on the existing researchfindings and measurement models.

. Application of the strategic HRM model to the HRM practices of IA itself byexamining the acquisition, development, training and deployment of internalauditors based on cross sectional study and/or case studies.

. Development of case studies of IA functions focusing on strategic aspects ofHRM audits to determine “best practice”.

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. Conducting cross sectional studies of existing HRM audit programs to develop asort of “strategic index” of existing IA audit programs.

. Performing organizational interventions to discuss and teach the findings in theSHRM literature, thus acting as change agents or idea champions in thedevelopment of effective HRM client centric audit programs.

. Conducting a comparative study of audit practice with respect to HRM indifferent economies.

Notes

1. We recognize that CAE’s definition of the terms “strategic” and “risk managing” in relationto HRM may differ from that developed in the literature. Therefore, we asked two questionsthat allowed us to probe into the respondents’ definitions of these terms by having themprovide examples from actual audits of the HRM function. First, we asked for a specificexample of an audit finding included in the audit report for the HRM function that recognizesa strategic focus in HRM (e.g. the audit report notes that HRM determined its trainingcurriculum based on corporate strategic objectives and measured training outcomes inrelation to those objectives). Only 35 percent of the respondents provided an example, withthe remainder leaving the space blank or saying that they have not yet had a finding theycould share. The second question asked for a specific example of an audit finding included inthe HRM audit report that reflects the audit organization’s strategic focus (e.g. the internalaudit report makes a finding that absenteeism rates exceed benchmarked targets resulting inlower productivity and delayed shipments). Only 22 percent of the respondents provided anexample in response to this question. See Hyland and Verreault (2003) for additional details.

2. Pfau and Kay (2002) also integrated a series of surveys from employees of US companies todetermine the attitudes of employees and the links between employee attitudes and firmperformance. Among their findings, companies with high employee commitment deliveredTRS of 112 percent over the 1996-1998 period versus 76 percent for those firms with lowemployee commitment.

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