Cost Based Approaches to Human Resource Accounting

There are several approaches for the valuation of human resources. The monetary approaches to measurement of human assets are broadly based either upon cost or economic value. The cost approaches involve computation of the cost of human resources to the organization. The cost are capitalized and amortized over the useful life of the asset. Some important cost based approaches to Human Resource Accounting (HRA) are:

1. Historical Cost Model:

In Historical Cost method, the basic contributing factors for developing the human resource of the organization has been equated to the actual cost incurred. In this approach, the actual costs of recruiting, selecting hiring, training, placing and developing the employees of an organization are capitalized and amortized over the expected useful life of the asset concerned. If the asset is liquidated prematurely, losses are recorded, and if an asset has a longer life than estimates, revisions are made in the amortization schedule.

Historical cost approach relies primarily on accounting techniques which have been in common use for many years. It is easy to develop and operate these systems. Management also has little difficulty in interpreting the meaning and the information supplied by cost based systems since the underlying concepts are consistent with those of the conventional accounting data. It simply involves an extension of the concept of proper matching of costs with revenue. Historical cost of human resources is treated very much like the cost of fixed assets. The same principles of capitalization and amortization are applied.

The main advantage of this method is that

  • It is quite simple to understand and can be easily worked out.
  • It satisfies the traditional accounting concept of relating cost revenue.
  • It provides a basis for evaluating the company’s returns on investment in human resources.

This approach has the following limitations:

  • It takes into account only a part of the employees acquisition cost and ignores the aggregate value of their potential services.
  • It is not easy or it may not be possible to estimate the number of year over which the capitalized expenditure is to be amortized.
  • Because of the above problem, it will be difficult to determine a precise rate of amortization. A question may arise as to whether it should constant, increasing or decreasing.
  • One fact to be considered is that gaining experience economic value of human resources increase. But under this method the capital cost decreases, with amortization. The question arises as to how the difference could be reconciled.

2. Replacement Cost Model:

The approach was propounded first by Rensis Likert and was further developed by Eric G. Flamholtz. This is mainly based on the concept of Replacement cost. This is a measure the cost to replace a firm’s human resource. Rensis Likert had suggested determination of the value of total human organization on the basis of the assumption that a new similar organization has to be created from scratch. He says “Suppose that tomorrow, your firm had all of its present facilities but no personnel except the Chairman and he had to rebuild the human organization back to its present effectiveness. How much would t cost? All costs would be included which are involved in the recruiting, hiring, training the developing the replacement to the present level of proficiency and familiarity with the organization. This should serve a the basis of valuation of human resources of the organization from time to time”.

This approach incorporates the current value of the company’s human resources. It takes into account the fluctuations of the job market and the general rise in price level. Replacement costs have the advantage of being present oriented. This method is regard as as good surrogate for the economic value of the asset in the sense that market considerations are essential in reaching a final figure. Such a final figure is also generally intended to be conceptually equivalent to a notion of a person’s economic value.

A disadvantage of replacement cost is that it may not always be possible to obtain such a measure for a particular employee. It is difficult to fit identical replacement of the existing human resources in actual practice. Replacement cost does not necessarily reflect the knowledge, competence and loyalties concerning an organization that an individual can build over time. Further, the “managers asked to estimate the cost of completely replacing their human organization may have difficulty doing so, and different managers may arrive at quite different estimates”.

3. Opportunity Cost Model:

To meet the deficiencies of the Replacement cost, Hekimain and Jones have suggested the use of Opportunity Cost Concept. For capital equipment and assets Joel Dean has defines Opportunity Cost as “The most profitable alternative use … that is foregone by putting it to present use.” Under this method the value of an employee in his alternative use is determines that value is taken as the basis for estimating. If employees can be hired early eternally there is no opportunity cost for them. Hekimian and Jones have suggested a competitive bidding process for the scarce employee in a organization. Under opportunity cost method, the investment center managers will bid for the scare employee they to recruit. These ‘scare’ employees come from within the firm and include only those who are the subjects of recruitment request made by an investment center manager. In other words, employees not considered ‘scare’ are not included in the human asset base of the organization.

In opportunity cost concept, the divisional of investment center manager may bid for the services of the various personnel here quires. This bid price is then included in the investment base. The maximum bid price may go to the extent of the capitalized value of the extra profits likely to be generated by the ability and competence of the executive.

Hekimain and Jones believe that opportunity cost approach provides for more optimal allocation of personnel and sets the quantitative base for planning, evaluating and developing the human assets of the firm.

However, opportunity cost approach has narrowed down the concept of opportunity cost by restricting in to the next best use of the employees within the same organization. The main drawbacks of this method is:

  • The method does not show the true cost of human resources in an organization because it excludes from its purview the employees who are not being bid by other departments of investment centers.
  • The method provides only a partial solutions as the employees of the type that can easily be hired from outside are not assets under this approach.
  • To determine the bid price for an employee, a Manager must make a judgmental estimate of that employee’s value. Hence a low degree of objectivity can be expected form the opportunity cost.

4. Standard Cost Model:

To avoid complication of calculation under the replacement cost, standard cost or recruiting, hiring, training and developing per grade of employees are developed and established and made up-to-date every year. The standard cost so arrived at for all human beings are treated as value of human resources for accounting purposes. In case of new entrants the total standard costs would be increased by standard cost relating to that entrant.

5. Current Purchasing Power Model:

Under current purchasing power method, instead of taking the replacement cost to capitalize, the capitalized historic cost of investment in human resources is converted is converted into current purchasing power of money with the help of index numbers. If there is an increase in the index number, it will result in a corresponding increase in the value of human resources.

The standard cost method and the current purchasing power method also suffers from all drawbacks of the replacement cost except they are simpler calculation.

Source: Scribd.com (MBA –H4020 Human Resource Accounting)

About Abey Francis

Abey Francis is the founder of MBAKnol - A Blog about Management Theories and Practices - and he's always happy to share his passion for innovative management practices. You can found him on Google+ and Facebook. If you’d like to reach him, send him an email to: [email protected]

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