Employment Cost Model in 3 Steps, or How to make the CFO your Best Friend
written by Irina Miller
People are our organisations’ most valuable resource. At this point in history, when technology is replicable and markets are volatile, some researchers believe that a capable and engaged workforce is the most important component for any company’s success. People are also one of the most expensive resources, particularly good people. For most businesses Employment Costs constitute between 50% – 90% of their total Operational Expenses (or OpEx). While it is such a critical spend for any organisation, I find that in New Zealand HR seldom gets involved in controlling or influencing it. We need to get better at that. HR needs to befriend the Finance team and work together on spending this enormous amount of money in the best possible way – paying good people for doing the right job. How do you achieve this?. If you haven’t already, start by understanding your organisation’s cost structure: how big is your annual total OpEx and what part of it is your employment cost? This is the first step in befriending your CFO. They care a lot about OpEx and welcome anyone in the organisation taking interest in it.
While Employment Cost is usually the biggest part of Operational Expenses, it is also often the most unpredictable one. Another thing you need to know about your CFO: they don’t like surprises.
Finance departments know exactly how much they are going to pay people in the next pay run; but unfortunately they struggle to reliably predict how much the combined annual salary bill is going to be next financial year. Current forecasting models often include a recount of the current employees on payroll, assumptions around open vacancies and a “wish” list of new hires for the year ahead. Sometimes contingent workforce is taken into account. In practice, not enough conversations are held around the vacancy “wish” list and the contingent workforce during the forecasting process and too often original assumptions change dramatically over the course of the year – due to external and internal factors, like customer preferences, competitor changes, market conditions, organisational politics, and so on.
Finance would really like a reliable model to help predict Employment Costs. Fortunately, this is where remuneration professionals can offer valuable input.
Below I offer a high level overview of the process you need to follow to build your Employment Cost model – and it has only three steps. As you will see, each step is a project on its own, but it gives you a clear conceptual roadmap of how to get your organisation’s largest expense in check.
Step One – tidy up your organisational design
Whether you organise your workforce by individual jobs, job families or levels – establish how many full-time equivalent (FTE) employees are required in each category. Be prepared for it to change with the needs of the business, but every increase or decrease of FTE, as well as the creation or deletion of roles should be supported by a solid business rationale.
Step Two – implement your remuneration framework
A lot goes into creating a remuneration framework, but we won’t discuss it here. For the purpose of employment cost modelling, the most important remuneration framework outputs are your market comparators and positioning, adjusted for your current practice.
Step Three – create the employment cost model
A simplified version of your Employment Cost data model will look something like this:
|Level (if any)||Role (if any)||Job Family (if any)||Business Function||Number of FTE in the role/level||Market midpoint|
|11*||Business analyst||Analytics||Markets and Insights||5||$110,000|
The number of rows in the model can be anywhere from a handful (if you’re building it on levels alone) to 1,000 or more unique job titles. Either could work for organisation-wide employment cost modelling. The former will provide simplicity while the latter – greater precision. From experience, I can tell you that in order to enable additional insights (e.g. organisational efficiencies analysis, workforce design), levels alone are likely to be insufficient, while too many unique jobs present a challenge from statistical analysis point of view. Usually a combination of levels and job families provides the most balanced dataset.
Now you can adjust the model for current practice where it is different from the market (where the difference is material and across a large number of employees). For example, where you know you tend to pay a group of your employees over the market – use a PIR (Position in Range) higher than 100%. Based on your organisational strategy, you should also adjust for anticipated changes in areas where your employee numbers are expected to increase or decrease.
In a nutshell this is your model. And your CFO is now your best friend.
If you want to refine the model further, you can introduce multiple levers depending on your industry and organisational strategy. For example, projected sales numbers may tell you whether you need to increase or decrease the number of your sales representatives; seasonal cycles may dictate the size of your contingent workforce, and so on. I would recommend starting with a simplistic “just-enough” model with minimum levers and then refining it once it’s embedded.
What about all the on-going organisational changes?
Yes, in most businesses they happen all the time. In most businesses, however, neither Finance nor HR have clear visibility or control over them. Also there is seldom a centralised view of the organisational design, which leads to any changes being silo’ed and poorly thought through. This often leads to escalation of employment costs. Then drastic and crude measures are implemented to curb them quickly (think employment and salary freezes and reductions in staff). With the simplified Employment Cost model I offer above, Finance and HR (as well as business and people analysts) can put their efforts into tracking, understanding and hopefully controlling organisational changes in real time. We also get Finance and HR to continuously talk to each other, ideally you organise a panel with representatives from both teams that review every organisational change business case. Visibility and governance is improved and your executives get a better handle on the current and future shape and cost of your workforce.
Isn’t it risky to base the model on the remuneration framework rather than actual payroll?
No, it usually isn’t. Particularly if your remuneration framework is practical and fit-for-purpose. Let’s say you forecast your employment costs based on 100% PIR to market midpoint, which is where your current average PIR sits. Now let’s imagine the worst case scenario, where all hiring managers, recruitment partners and HR BPs lose their senses and begin replacing all vacancies at 120% PIR. Scary thought, right? Let’s also imagine, you are so busy with other projects you don’t review the recruitment stats for an entire 12 month period. With an average turnover of 15%, you are still only 3% off your original employment cost forecast. In practice, most employment cost predictions are further off-track than this and the most common causes are “under-the-radar” new roles, job level inflation and additional headcount. All of these usually come as a surprise to your finance department at the end of a reporting period. We already established earlier – finance departments don’t like surprises.
In conclusion – tread with care
There is nothing I enjoy more than simplifying complex matters in order to bring wider groups of people on the journey and into a conversation. People analytics in general, and employment costs in particular are certainly examples of those highly complicated topics. I have to say, however, that while the model is rather simple, the implementation is likely to be hard. It would require cross-functional collaboration, stellar technical knowledge in your respective fields, as well as openness to building new capabilities and designing new processes. Sometimes it may also require a cultural shift, building or re-building trust and learning new ways of working. At the end of the day, however, it is one of those changes that simplify things for others, brings clarity to your organisation, and repays the effort many times over. Be brave, give it a shot and prepare to be amazed by the outcome.
*Disclaimer: the article is intended for discussion purposes only. I recommend businesses seek guidance and advice in setting up employment cost models and remuneration frameworks. All figures, including banding, salaries, PIR, and other aggregates referred in the article are for example purposes only.