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MAJ 20,5

Evidence for increasing the focus on strategic risk in HRM audits

Daniel A. Verreault
John H. Sykes College of Business, University of Tampa, Tampa, Florida, USA, and

524

MaryAnne Hyland
School 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 specic to HRM audits. Design/methodology/approach Prior research that served as impetus for this paper is discussed. The ndings of other studies are presented to make a case for the business impact of strategic human resource management practices. Findings Studies on the competitive environment of rms, theoretical development in HRM, empirical work on the link between HRM practice and rm performance, and emerging models based on intellectual capital, suggest that there are compelling reasons for internal audit to devote substantial resources to the evaluation of strategic risk in HRM audits. Research limitations/implications The literature is still developing. The literature presented here is not an exhaustive list and does not include all ndings, but rather what are perceived to be the most important ndings. Practical implications Both high performance work systems and strategic t should guide internal audit in planning, designing audit programs, and executing strategic audits of human resources consistent with the risk management paradigm. Originality/value This paper bridges a gap between the human resource management literature and the internal auditing literature. Keywords Internal auditing, Risk management, Human resource management Paper type Literature review

Managerial Auditing Journal Vol. 20 No. 5, 2005 pp. 524-543 q Emerald Group Publishing Limited 0268-6902 DOI 10.1108/02686900510598876

Introduction The purpose of this paper is to cite evidence that there are important issues relevant to the specication and investigation of strategic risk in HRM audits that may be under-emphasized in much of current audit practice. Consistent with the increasing importance attached to management of a rms intangibles and emerging models of intellectual capital drivers, we believe that excellence in human resource practices greatly increases the potential for organizational success. We list six reasons for internal auditors to develop expertise in the assessment of human capital management, and for audit researchers to develop more understanding of how such expertise can be encouraged, accomplished, and measured:
The authors gratefully acknowledge the monetary support and data collection assistance of the Institute of Internal Auditors Research Foundation.

(1) Compensation expense is approximately 15 percent of an average rms operating expenses (Bontis and Fitz-enz, 2002). The amount is certainly material. Internal audit (IA) must be keenly aware that leveraging human assets is even more important than returns on fungible capital. It is human capital that is scarce and less easily duplicated in a knowledge-based economy and it is human capital that acquires, manages, and drives returns on the rms tangible assets. (2) Research shows that the variation in enterprise performance tied to the management of human resources could be substantial. An increasing body of literature and research addresses the importance of various sets of work practices on organizational performance (Lawler, 1992; Pfeffer, 1994, 1998; Huselid, 1995; Delaney and Huselid, 1996; Ichniowski et al., 1997, Ichniowski and Shaw, 1999, 2003; Pfau and Kay, 2002; Laursen and Foss, 2003; Bontis and Fitz-enz, 2002). (3) Elements of human capital management are central to the successful implementation of most other management initiatives and the achieving of the rms strategic goals. The importance of human resources as rm assets was appreciated by the accounting profession before the development of most current management initiatives (Flamholtz, 1985). Balanced Scorecard (Kaplan and Norton, 1996) models contain measurements related to employees. See Phillips and Stone (2000) and Becker et al. (2001) for fully developed HR scorecards that seamlessly link to well-accepted nancial performance measures. Valuation models (Copeland et al., 2000, Stewart III, 1991) recognize that enhanced performance of human capital is a key contributor to rm value. Stewart and Copeland recommend capitalizing some element of training and development costs as a signaling device for management and as a way 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 rigorous measurement have the most potential to reveal causal links between HR practices and rm performance. Fitz-enz (2000) presented a model of intellectual capital that is tightly integrated with nancial measures that may be calculated and tracked by internal auditors. Bontis and Fitz-enz (2002) derived a causal map of factors that enhance or weaken intellectual capital. IAs consideration of strategic risk in HRM audits could be strengthened by the development of an intellectual capital management and development framework. (5) A focus on human capital practices provides a strategic lens through which internal audit (IA) functions may view the human resource management (HRM) function. Knowledge of current theory and practice related to human capital will 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 increased scope and import, and audit reports linked to rm performance and strategy. (6) Analysis of human capital practices ts closely with a rigorous and coordinated approach to assessing and responding to all risks that affect the achievement of an organizations strategic and nancial objectives. This includes both upside and downside risks (Miccolis et al., 2001, p. xxii).

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Potential disconnect between the risk-managing paradigm and actual risk assessments The motivation for this paper is an apparent disconnect between the conceptual strength of the IA risk managing paradigm and the specic outputs of that process in the form of audit ndings in HRM audits. Hyland and Verreault (2003) proposed a model illustrating the value creating potential of the IA-HRM pairing. Additionally, survey results from 161 IA respondents described their self-assessment of their own units level of risk managing philosophy and their assessment of the extent to which their own rms HRM function exhibited a strategic outlook. See Figure 1 for the model. IA respondents generally ranked themselves high in adopting a risk managing audit philosophy and assessed their rms HRM functions as moderately high in strategic outlook. Sixty-nine percent of the usable responses were in this value creating quadrant. The motivating quadrant, which combined a risk managing approach to internal audit with a non-strategic approach to HRM t 25 percent of the usable responses. The cost minimizing and limiting quadrants received 4 percent and 1 percent of responses respectively. A total of 94 percent of IA functions self-classied their units as risk managing in their audit approach. Based on these positive overall self-assessments we expected that specic strategic HRM ndings would be relatively commonplace. IA respondents were then asked to cite audit ndings that might be classied as strategic. Analysis of responses indicated that the ability to actually cite any concrete nding relating to strategic goals was extremely limited. Respondents were asked to provide examples of rst, an audit nding that reected the consideration of strategic risk in IAs audit process and second, an audit nding that recognized a strategic action that had been implemented by HRM. Only 35 percent and 22 percent respectively of respondents provided any answers to the two specic questions concerning the inclusion of strategically oriented ndings in audit reports. Of those responses only a few could be said to reect elements of theoretical or empirical strategic human resource management (SHRM) ndings supported by the literature[1]. Examination of the responses suggests that although IA may self-report high levels of commitment to the risk-managing

Figure 1. Matching IA and HR to create value in Hyland and Verreault (2003)

philosophy, the actual audit process in the HRM context may revert to a compliance focus. This disconnect suggests a problem with the diffusion of the risk managing paradigm throughout the audit process, and reveals a need to communicate to auditors the nature and types of strategic models and results of empirical work in SHRM that might encourage reference to strategic risk specic to HRM in audit planning sessions, audit program design, audit execution and reporting of results. Researchers have a major role to play in the process of adapting the specialized knowledge of strategic risk attaching to a particular type of audit client such as HRM. McNamee and Selim (1999, p. 19) point out two weaknesses of the current risk paradigm:
One is that internal auditors focus too much on measuring risk factors instead of the underlying risk different results can occur when the nature of risk changes and the internal auditor continues to use the same factors. The second weakness in risk assessment by internal auditors is that planning is where the focus on risk usually ends. Once the internal audit is planned (or the group of audits for the annual plan are chosen), the focus is switched to the system of internal control. In current internal audit practice, controls, not risks, are tested, evaluated and reported to management.

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Familiarity with the current risk prole of HRM developed primarily over the past decade may not yet be included in IAs risk universe for HRM and, even if the risks are recognized in a general sense, the actual audit process under-emphasizes that strategic risk. Human resource management functions Like IA, HR is striving for relevance. For IA, the drive is to adopt and extend the risk management 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 of the rms strategic objectives and align human capital and practices to help in meeting those objectives (strategic t). Additionally, HR must be aware of approaches to human capital management and measurement that are proving effective in enhancing elements of rm 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 a source of competitive advantage. We refer to this approach as strategic human resource management or SHRM. Those HRM functions that have not transitioned to the strategic view, we classify as non-strategic. HRM is under pressure from corporate management to demonstrate value-added beyond the smile and le human relations and compliance missions (Stewart, 1996; Sparrow, 1998). Management also looks at outsourcing as a way to increase the strategic focus of HRM through ofoading compliance functions. IA must recognize the possibility that HRM as a non core process might be a candidate for outsourcing (e.g. Linder and Sawyer, 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 increase attention to strategic goals (Jossi, 2001). Human capital and competition: a macro view The creation of market economies in eastern Europe, the emergence of market economies 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 in most sectors. Companies must focus on the productivity of human capital to thrive (Porter, 1998). We might think of a competitive economys creative destruction (Schumpeter, 1950) as a motivator for adoption of innovative HRM practices, as those rms adopting new ways of doing things with respect to such a critical resource as human capital might have what has been called the human capital edge (Pfau and Kay, 2002). Supply and demand of skilled human capital must be considered in any risk assessment. A report titled Workforce 2020, (Judy and DAmico, 1997) predicts a shortage of skilled labor in the USA. Major European economies face similar, even graver, risks. Strategic advantages of human capital practices: theory development Historically, human resource management (formerly known as personnel management) consisted largely of recordkeeping and maintenance activities. The personnel function was considered an area of business that needed to be done, but which added little value to the organization in terms of productivity or protability. Most of the early research on personnel management focused on issues affecting individuals, such as employee testing and training (Ferris et al., 1999). The evolution from personnel management to human resource management was more than simply a change in name. Rather, it represented a conceptual change from thinking of employees in an organization as personnel (perhaps a cost to be minimized), to resources that bring value to the organization. However, it was not until a broader perspective, known as strategic human resource management (SHRM), developed in the late 1980s and early 1990s that human resource management began to gain credibility as a potential source of competitive advantage. SHRM looks beyond individual implications of human resource management issues and attempts to align human resource management activities with the strategic goals of the organization (Butler et al., 1991). SHRM developed from scholars interest in examining the relationship between HRM practices and organization performance (Bowen and Ostroff, 2004) and from theoretical arguments that an organizations human resources can be a source of sustainable competitive advantage for the organization (e.g. Wright and McMahon, 1992). There is general agreement among scholars that SHRM involves designing and implementing internally consistent policies and practices that enable an organizations human resources to contribute to the achievement of business objectives; however, a more precise denition has yet to be reached (Huselid et al., 1997). Building on theoretical arguments in favor of SHRM, research attempting to demonstrate the relationship between human resources practices and organizational performance emerged in the late 1980s and early 1990s (e.g. Delaney et al., 1989; Huselid, 1995; MacDufe, 1995). Based on these studies, scholars began to compare approaches to SHRM both conceptually and empirically. Two main approaches developed initially (Youndt et al., 1996). Subsequent work expanded the number of approaches to three by making additional distinctions in the categorizations of previous work (Chadwick and Cappelli, 1999; Ferris et al., 1999). Most recently, the perspectives for studying the relationship between HRM and organizational performance have again been reduced to two as the body of research has narrowed in on two logical approaches which have found support in the literature. We describe the systems approach and the strategic approach and the evolution of these

perspectives. These approaches are complementary and co-exist in organizations. The effective implementation of both SHRM approaches represents a formidable competitive advantage for the rm. The systems approach focused initially on the relationship between individual HRM practices and organizational performance and later transitioned into an examination of a set of HRM practices and their relationship as a group with organizational performance (Bowen and Ostroff, 2004). This approach was identied by earlier scholars as the universalistic approach because it asserts that certain best practices will be advantageous to all organizations. Early research on best practices examined the effect of individual HRM practices, such as job design or promotion criteria, on an organizations turnover and productivity levels. However, subsequent research found that the return on groups of HRM practices that work with each other in a 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 uses performance appraisals and incentive compensation programs that reward good performance (Huselid, 1995). If compensation programs based on seniority are combined with performance appraisals and incentive compensation, their positive effects on performance should be lessened. According to the systems approach, when HRM practices are aligned in a complementary fashion, an internal t (Baird and Meshoulam, 1988) develops that leads to improved nancial performance. Such complementary HRM practices are known as high performance work systems. Huselids (1995) seminal work in this area sparked further thinking about how human resources practices can be leveraged to improve organizational performance. In a study of 968 publicly-held US organizations, he found that a one standard deviation increase in human resources best practices was related to a $7,868 prot increase and a $33,250 increase in the market value of the organization per employee. We present the HRM system as the horizontal alignment in Figure 2.

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Figure 2. The two dimensions of effective HRM policies and practices

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The strategic approach, as suggested by Bowen and Ostroff (2004), has three different meanings in the literature. One meaning is the t between HRM practices and organizational strategy. This perspective also considers the horizontal alignment of HRM practices, such that that the practices t with each other to support the business strategy (Bowen and Ostroff, 2004). A second meaning of the strategic approach is based on contextual factors, such as organization size or industry. According to this contingency perspective, the effectiveness of HRM practices on increasing organization performance depends in part on contextual factors associated with the organization. For example, Youndt et al. (1996) studied 97 plants from various segments of the metal-working industry nding that the combined effects of manufacturing strategies and sets of HRM practices on operational performance were positive and statistically signicant. The interactive effects of management strategy and HRM practices suggest the importance of a vertical t between HRM practices and strategic or contextual factors. A third meaning of the strategic approach concerns the complexity of a complete set of HRM practices, which are difcult for competitors to imitate. The resource based view of organizations (Barney, 1991) suggests that organizations can achieve competitive advantage by using a set of HRM practices that affect employee effort, attitudes, and behaviors, and thus are difcult for competitors to imitate (Bowen and Ostroff, 2004). We recognize that the evolution of thought on SHRM 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 we are aware, which is that there are two principal approaches in the SHRM literature to studying the relationship between HRM and organizational performance: the systems approach and the strategic approach (Bowen and Ostroff, 2004). (See Figure 1 the vertical dimension is strategic t.) The literature review below emphasizes the systems approach for several reasons. First, the ndings are more universal. Second, an in-depth review of key studies in the systems area does not allow for in depth consideration of the strategic approach due to space considerations. Third, we believe that the ndings from the systems approach are strong enough in their own right to make a convincing case that auditors should incorporate consideration of strategic risk in the HRM audit process. Key SHRM practices Pfeffer (1994, 1998) described and distilled HRM best practices to a list of seven strategic areas as follows: (1) Job security. (2) Selective hiring of new personnel. (3) Self-managed teams and decentralization of decision making as the basic principles of organizational design. (4) Comparatively high compensation contingent on organizational performance. (5) Extensive training. (6) Reduced status distinctions and barriers, including dress, language, ofce arrangements, and wage differences across levels. (7) Extensive sharing of nancial and performance information throughout the organization.

These seven best practices should drive higher levels of performance in the organizations that effectively use them. Other researchers have specically noted the benets of complementary HR practices the HR system cited above (Kandel and Lazear, 1992; Holmstrom and Milgrom, 1994). Pfeffers list is a valid starting point, but we note that other researchers and theory builders may present different lists or weight items differently. Empirical evidence linking HRM practices to rm performance A cross-sectional study of publicly held rms in the USA As reported above, Huselid (1995) conducted a cross sectional study of publicly held rms and found strong support for the effects of certain HRM practices on the reduction of turnover and the enhancement of revenue. Huselids study was cross-sectional; therefore, it left indeterminate the direction of inuence between HRM practices and rm performance. Did high performance work systems drive rm performance of did high performing rms invest in high performance work systems? Finally, the survey contained only one respondent from each rm, making the estimation of response variance difcult if not impossible. However, the nding that major positive nancial outcomes were associated with implementation of certain HR practices was striking. Internal auditors should be cognizant of Huselids ndings in the context of the general development of strategic HR thinking summarized by Pfeffer, and the consistent implementation of a bundle of consistent practices. A repeated large-scale cross-sectional study Pfau and Kay (2002) reported on the results of a series of surveys undertaken by Watson Wyatt Worldwide (WW). In 1999, WW undertook a large cross-sectional study of over 400 US and Canadian rms and computed a human capital index (HCI) score. The rm found strong positive correlations between rm performance and a group of 30 variables associated with SHRM. The initial survey also found some negative correlations between certain traditional HRM practices and rm performance. WW conducted a European HCI survey in 2000 and conducted another survey in 2001 that included over 500 North American companies. The rm merged the European survey and the 2001 North American Survey. In order to address the direction of inuence issue, the rm computed correlations between the rst HCI survey and the merged results of the European and second North American administrations of the instrument. WW claimed clear evidence that in fact superior HRM practices are not only associated with but are lead indicators of increased shareholder value. The correlations between HRM practices and subsequent rm performance (0.41) were much greater than those between rm performance and subsequent HCI scores (0.19). The principal indicators of shareholder value used were market value, three and ve year TRS, and Tobins Q[2]. The HCI possesses the following positive attributes: . The HCI differentiates among rms and the differences are signicant. The low performing group averaged a 21 percent ve year return. The medium scoring group averaged a 39 percent ve year return, and the high performing group averaged a 64 percent ve year return. . The ndings generally agree with prior theory and other empirical work. The general factors are similar to those cited by Pfeffer (1998) and Huselid (1995).

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Some practices destroy value. The survey identied practices that had major negative impacts on nancial performance, but that may at rst glance be viewed as positive initiatives. The results are cross cultural. The surveys include US, Canadian, and European rms. The repeated survey analysis allowed for the testing of the direction of effects. SHRM practices were a leading indicator of improved performance. There is sufcient detail in the survey questions to serve as a foundation for the design 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 to rm value. Note that the sum of the positive practices is 47 percent. However, the index entitled Prudent use of resources indicates a major negative impact from certain well respected HR initiatives that have a cumulative negative impact on value creation of approximately 34 percent. Each major factor is supported by a more detailed index that lists 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 Prudent use of resources index. Consider, for example, the possible audit approach of an IA function without knowledge of these survey ndings. A hypothetical project to enhance communication (associated with a negative 7.7 percent effect on value creation as shown in Panel C of Table I) might never be questioned in the audit planning stages and may be audited only to track compliance with budget and the goal of enhanced communication. Likely, no link would be attempted between the project and rm level nancial outcomes. We believe that prior knowledge of and training in the ndings of strategic HRM might empower auditors to discuss such a project at the planning stages and to measure the success of such a project much differently. The survey suggests that there are many such possible examples that may prompt IA to modify traditional audit planning and execution in HRM audits. A cross-sectional study of French industry In a study of French employment records, dArcimoles (1997) found positive effects on rm performance related to levels of training. Positive lagged correlations between the level of dismissals and return on capital were partially attributed to the sample excluding rms that were likely to go bankrupt. However, for healthy rms, employment reductions that might be a proxy for exibility were associated with positive returns. Most studies view turnover, especially voluntary turnover, as a negative human capital indicator (Huselid, 1995; Fitz-enz, 2000; Cascio, 2000; Bontis and Fitz-enz, 2002). An in-depth study of US steel nishing lines Ichniowski et al. (1997) conducted a highly detailed empirical study on US steel nishing lines and later extended the study to a comparison of US and Japanese steel lines (1999) using a process later labeled insider econometrics (Bartel et al., 2004). The study investigated whether or not innovative HRM practices increase productivity. The authors found consistent support for the conclusion that groups or clusters of complementary human resource management (HRM) practices have large effects on productivity, while changes in individual work practices have little or no effect on

Panel A. Overall index of HRM factors affecting market value Impact on market value Practice (%) Total rewards and accountability 16.5 Collegial, exible workplace 9.0 Recruiting and retention excellence 7.9 Communications integrity 7.1 Focused HR service technologies 6.5 Prudent use of resources 2 33.9 Panel B. Total rewards and accountability index Factor Health benets are important for recruiting and retention High percentage of company stock owned by employees Dened contribution and dened benet plans, combined, important for recruiting and retention High percentage of company stock owned by senior managers Company promotes most competent employees High percentage of employees participate in incentive/prot sharing plans Dened benet plan important for recruiting and retention Employees have choice regarding benets Dened contribution plan important for recruiting and retention Top performers receive better pay than average performers Company positions benets above the market Company helps poor performers improve Company positions pay above the market Company terminates employees who continue to perform poorly Total impact of rewards and accountability Panel C. Prudent use of resources index Factor Enhancing communication is a key goal in implementing HR service technology Culture change is a key goal in implementing HR service technology Employees have opportunity to evaluate superiors Employees have access to training needed for career advancement Employees have opportunity to evaluate peers Training programs maintained even in difcult economic circumstances Total impact of prudent use of resources index Source: Pfau and Kay (2002) Impact on value creation (%) 2 7.7 2 6.6 2 5.7 2 5.6 2 4.9 2 3.4 2 33.9 Impact on value creation (%) 2.8 1.3 1.3 1.2 1.1 1.0 0.9 0.9 0.9 0.8 0.7 0.7 0.7 0.6 16.5

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Table I. Watson-Wyatt human capital index variables summary index

productivity (Bartel et al., 2004, p. 291). Table II illustrates the HRM practices investigated in the study. The authors visited 45 out of 60 steel lines in the USA belonging to 17 different companies. The sample included large companies with multiple lines, as well as small companies. The study included 2,190 monthly observations of 36 of the steel nishing lines. 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, and policy-related variables. HRM policies were gathered from several organizational

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HRM variable name Incentive pay Prot sharing Line incentives

Mean 0.700 0.186

Variable description Is there a company prot-sharing plan covering the line workers? Are operators covered by a non-traditional incentive pay plan which applies across shifts of workers and which is sensitive to quality as well as quantity aspects of output? Was an extensive selection procedure used to hire new workers, including tests for personality traits needed for cooperative team environments and efforts to set clear expectations about required work behaviors of the new workers? Are a majority of operators involved informal or informal work teams or other related problem-solving activities? Do operators participate in more than one problem-solving team? Are operators organized into formal work teams either on the line or for the purposes of problem-solving activities according to an established policy with at least some operators involved in team activities? Has the company committed to a goal of long-term employment security and offered employees a pledge of employment security? Do operators rotate across jobs or tasks on the line? Have all operators on the line received off-the-job training? Have at least some operators received off-the-job training? Are operators and union representatives, if any, provided with nancial information on a regular basis? Do line managers meet off-line with operators to discuss issues of concern, including issues related to performance and quality? Do union representatives and managers meet often to discuss concerns and cooperate in nding solutions to issues? Is the line a unionized operation? Is the grievance-ling rate less than 12 per year?

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Recruitment and selection High screening 0.085

Teamwork High participation Multiple teams Formal team practice Employment security Flexible job assignment Job rotation Skills training High train Low train Communication Information sharing Meet workers Meet union Labor relations Union Low grievance

0.237 0.130 0.335

0.228

0.079 0.134 0.208 0.566 0.508 0.224 0.917 0.499

Table II. Denitions of HRM variables

Source: Ichniowski et al. (1997)

levels, as well as from archival sources. The data were analyzed as a sample of four clusters of HRM policies. Table III illustrates the four HRM systems and their component practices. HRM system 1 implemented all SHRM practices while HRM system 4 represented the traditional system containing no innovative practices. HRM system 1 incorporated innovative HRM practices in all HRM policy areas. Lines with this system have a multi-attribute incentive pay plan or a pay-for-knowledge incentive pay system; extensive screening of new workers; off-line training in technical skills and team problem solving; high levels of employee involvement in multiple problem solving

Practices in seven HRM policy areas Incentive pay Line incentives Recruiting and selection High screening Teamwork High participation Multiple teams Formal team practice Employment security Employment security Flexible job assignment Job rotation Skills training High train Low train Communication Information sharing Meet workers

HRM System 1 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00

HRM System 2 0.31 0.15 0.85 0.62 1.00 0.23 0.15 0.69 0.92 0.54 0.77

HRM System 3 0.00 0.00 0.10 0.00 1.00 0.48 0.03 0.00 0.07 0.62 0.72

HRM System 4 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

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Source: Ichniowski et al. (1997)

Table III. Specic HRM practices within four HRM system categories

teams; job duties covering a wide range of tasks with workers often rotating across jobs; regular information sharing between workers and management; and an implicit employment security pledge. Please note the high level of agreement of the characteristics of the HRM systems with those cited earlier. The authors developed criteria 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 rules and narrow job responsibilities; incentive pay based on quantity, but not quality, of output; no work teams; no practice of managers sharing nancial information or meeting regularly ofine with workers; no screening; and no off-line or other formal training. Tests based on longitudinal data of those changing HRM systems showed positive effects from introducing innovative HRM practices, thus suggesting a cause-effect sequence. In terms of productivity, the most conservative estimate of the productivity differential for HRM System 1 was 6.7 percent. Using cost data from one small-scale line, a conservative estimate of the effect of a 1 percent increase in uptime on revenues was $30,000 less $2,100 for the cost of HRM policy implementation or $27,900 per month. For a 6.7 percent increase in uptime the revenue gain net of HRM incremental costs was $186,930. After adjusting for various costs of implementation and generalizing, the authors estimated a $1,171,800 annual increase in operating prots. This does not count the subsequent increases in output quality that occurred after the line changed its HRM system. HRM System 1 positively affected product quality measured by prime yield rates that considerably exceeded the yields of lines with other HRM systems. The authors concluded that monthly panel data on productivity and HRM practices in a homogeneous sample of production lines, show that innovative HRM

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practices raise worker productivity. Moreover, systems of innovative HRM practices have large effects on production workers performance, while changes in individual employment have little or no effect (Ichniowski and Shaw, 1997). A study of North American business units in a food service company Wright et al. (2003) conducted a study of 50 autonomous business units of a food service company with US and Canadian operations. The study specically addressed the problem of single respondent surveys for which Huselids (1995) study was criticized by using the business unit as the level of analysis and using multiple respondents within units. The study also implemented a research design that used lagged nancial performance data and organizational outcomes, thus allowing for insight into casual links that cross-sectional surveys do not permit. Their results showed that HR practices were strongly related to organizational commitment and both dimensions were strong predictors of operational performance measures used to evaluate the business units. This result supports the Pfau and Kay (2002) survey results discussed above in terms of the direction of the effects of implementing SHRM practices. Both HR practices and employee commitment were positively correlated with reduced expenses and increased operating prot. A longitudinal study of US manufacturers challenging the HPWS-performance link Cappelli and Neumark (2001) conducted a longitudinal study that included data prior to the adoption of HPWS by US rms. The research design aimed at controlling for heterogeneity in cause that was not possible in other studies. Their ndings challenge the link between such practices and robust positive rm level outcomes. The authors focused on what they determined to be the most common subset of HPWS across studies the extent of employee involvement and its link to improved organizational performance. Their choice was also conditioned on the early studies of Japanese companies whose most important virtue was claimed to be worker empowerment. Their dependent variables were sales per worker, total labor costs per worker, and labor efciency (the ratio of the rst two measures). The authors concluded that policies transferring power to employees result in higher compensation costs, higher productivity, and have no effect on labor efciency. A Danish study of the HRM-innovation link Laursen and Foss (2003) examined HRM systems using a database of 1,900 privately owned Danish rms that spanned both manufacturing and non-manufacturing companies. Several important contributions emerge from that study. First, HRM practices are shown to be supportive of enhanced levels of innovation. (Innovation may be seen as a leading indicator of rm success whereas nancial performance may be seen as a lagging indicator.) Second, the authors used principal component analysis to actually derive the HRM practices that were associated with enhanced levels of innovation rather than specifying them. Recall that Ichniowski et al. (1997) specied the HRM system components based on prior work. Third, the large dataset is a cross-section of an entire economy. Fourth, the economy is set in the EU, whereas most of the HRM studies focus on the USA. The authors found that two different HRM systems were suggestive of superior levels 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 of responsibility; integration of functions; and performance related pay. (2) System 2 included only two factors both relating to training: internal training and external training. In general sectors more closely related to science and technology and/or more specialized rms were more likely to be innovators. A cross-sectional survey in a low management discretion economy Den Hartog and Verburg (2004) conducted a cross-sectional survey of 175 organizations from various sectors in the Netherlands. The study gathered data from HR professionals, executives, and core employees. The study contributes to our understanding by providing results from an additional country setting that might be characterized as low in management discretion, and also included results from several groups within each organization thus somewhat muting the single source variance problem. The studys measurement instruments focused on items identied by Huselid (1995) as belonging to a cluster composing a high performance work system. The authors identied a set of practices they labeled Employee skill and direction consisting of strict selection, an emphasis on employee development, and the presence of a strong philosophy linked to a mission statement and HR strategy. The identied bundle was positively associated with willingness to go beyond contract and negatively associated with absenteeism. Turnover levels were not associated with the high performance practices, but instead were negatively associated with performance evaluation and information sharing. (We would classify both of these additional elements as elements of a high performance system, although not necessarily loading on the same factor as the authors identied bundle. See the section describing the WW surveys.) The authors also noted that even in the highly regulated Dutch environment, enough discretion existed to positively inuence organizational culture through selective work practices. Questions were raised by the authors regarding the cost-benet of expensive HR practices and the potential differential affects of such practices on rm performance and employee welfare. Intellectual capital ROI: a causal map Bontis and Fitz-enz (2002) present a model of human capital as a part of intellectual capital. Intellectual capital also included structural capital (knowledge existing apart from employee knowledge often in the form of databases or le cabinets) and relational capital (knowledge resting on relationships with entities outside the rm such as those with suppliers or customers). The authors gathered both qualitative and quantitative data from a sample of 25 large companies in the nancial services industry. They proposed a conceptual model of human capital valuation as a cause of human capital effectiveness. The main inputs to human capital valuation were human capital investment (a positive) and human capital depletion (a negative). Human capital depletion was primarily a function of voluntary turnover. See Figure 3 for their nal tted model. The tted model shows both correlations between constructs (printed on the causal arrows) 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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Figure 3. A causal map of factors affecting human capital in Bontis and Fitz-enz (2002)

is beyond the scope of the study, we will look at several important relationships. Managerial leadership has highly signicant correlations with retention of key people (0.506) and value alignment (0.751). The second major correlate of retention of key people was employee satisfaction (0.442). The antecedents of human capital effectiveness were training (0.530) and employee satisfaction (0.358). The primary antecedents of business performance in the model were knowledge generation (0.327) and employee commitment (0.439). The primary factors that tended to decrease human capital depletion were the level of knowledge sharing (2 0.233) and the level of business performance (2 0.372). The human capital causal map is a powerful look at the possible order and magnitude of relationships that drove multiple aspects of rm performance for the sample studied. Notwithstanding the questions, the causal map extends our understanding of results back to the processes that give rise to the results and specically includes elements of strategic t and HRM practices. A recent literature review and evaluation Roos et al. (2004) reviewed the research on the HRM-performance link and concluded that while the links between HR practices and rm nancial performance are not disputed by researchers, more detailed work needs to be accomplished. The authors propose a model based on intellectual capital (IC) involving rigorous measurement in order to better understand causal mechanisms linking practices and performance. We expect additional contributions from the IC models to be forthcoming and to conrm the overall ndings of prior research, but perhaps with additional insights regarding causation and enabling mechanisms. The Bontis and Fitz-enz (2002) study was not included in the review, but that study seems to fulll the recommendations made by the authors.

Summary of the literature survey We nd generally strong agreement among the works cited including the theoretical work of Pfeffer (1994, 1998); the cross-sectional survey work of Huselid (1995); Pfau and Kays (2002) surveys that included multiple industries from the USA, Canada and Europe; the insider econometric analysis of US steel nishing lines of Ichniowski et al. (1997), the extensive cross-sectional study of innovation in Danish rms by Laursen and 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 by Capelli and Neumark (2001). The effects of national culture and intra rm differences are 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 explain linkages between practices and performance. Theory development, cross-sectional studies, eld studies, and the specication of nance specic measurement models as developed by Becker et al. (2001); Fitz-enz (2000); and Cascio (2000) are strong enough in theoretical agreement, magnitude of empirically observed nancial impacts, and relevance to the IA risk assessment paradigm to suggest that IA must learn to understand, develop, and execute audit models that seek to understand and evaluate the rm HRM practices and HRM programs against the strategic objectives of the rm and extant HRM best practice. Discussion and recommendations This paper was motivated by what we perceived in a prior study as a mismatch between a strong overall self-assessment of IA functions as reecting a risk-managing paradigm and the relative inability of respondents to cite actual strategic ndings in HRM audits. The assessment of the strategic outlook of HR, as judged by IA respondents, was also higher than we may suspect based on the overall pace and level of transformation in the HR function supported by published academic studies and practitioners articles. We believe that it is likely that the relatively high rankings are biased upward due to self-response bias and a lack of specication of strategic risk in the context of HRM audits. We propose a client-centric approach to risk management that explicitly requires training in the strategic risks of the particular client. The strategic risks of clients will differ. Only through knowledge of the client specic value drivers can the general risk paradigm be integrated into the execution of each audit step. HRM and IA need to identify rm strategy, show links between human capital practices and rm strategy, and measure progress over time. Only the development and implementation of HRM audits focusing on strategic risk as understood through knowledge of rm specic strategies, HRM research, and best practice will enable IA to extend the risk managing paradigm to the center of audit practice from the periphery of audit theory. We suggest the following as promising research ideas for those interested in the issues raised in this paper: . Development of a model strategic HRM audit based on the existing research ndings and measurement models. . Application of the strategic HRM model to the HRM practices of IA itself by examining the acquisition, development, training and deployment of internal auditors based on cross sectional study and/or case studies. . Development of case studies of IA functions focusing on strategic aspects of HRM audits to determine best practice.

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Conducting cross sectional studies of existing HRM audit programs to develop a sort of strategic index of existing IA audit programs. Performing organizational interventions to discuss and teach the ndings in the SHRM literature, thus acting as change agents or idea champions in the development of effective HRM client centric audit programs. Conducting a comparative study of audit practice with respect to HRM in different economies.

Notes 1. We recognize that CAEs denition of the terms strategic and risk managing in relation to HRM may differ from that developed in the literature. Therefore, we asked two questions that allowed us to probe into the respondents denitions of these terms by having them provide examples from actual audits of the HRM function. First, we asked for a specic example of an audit nding included in the audit report for the HRM function that recognizes a strategic focus in HRM (e.g. the audit report notes that HRM determined its training curriculum based on corporate strategic objectives and measured training outcomes in relation to those objectives). Only 35 percent of the respondents provided an example, with the remainder leaving the space blank or saying that they have not yet had a nding they could share. The second question asked for a specic example of an audit nding included in the HRM audit report that reects the audit organizations strategic focus (e.g. the internal audit report makes a nding that absenteeism rates exceed benchmarked targets resulting in lower productivity and delayed shipments). Only 22 percent of the respondents provided an example 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 to determine the attitudes of employees and the links between employee attitudes and rm performance. Among their ndings, companies with high employee commitment delivered TRS of 112 percent over the 1996-1998 period versus 76 percent for those rms with low employee commitment. References Baird, L. and Meshoulam, I. (1988), Managing two ts of strategic human resource management, Academy of Management Review, Vol. 13, pp. 116-28. Barney, J. (1991), Firm resources and sustained competitive advantage, Journal of Management, Vol. 17, pp. 99-120. Bartel, A., Ichniowski, C. and Shaw, K. (2004), Using insider econometrics to study productivity, The American Economic Review, Vol. 94 No. 2, pp. 217-23. Becker, B.E., Huselid, M. and Ulrich, D. (2001), The HR Scorecard: Linking People, Strategy, and Performance, Harvard Business School Press, Boston, MA. Belout, A., Dolan, S.L. and Saba, T. (2001), Trends and emerging practices in human resource management: the Canadian scene, International Journal of Manpower, Vol. 22 No. 3, pp. 207-15. Bontis, N. and Fitz-enz, J. (2002), Intellectual capital ROI: a causal map of human capital antecedents and consequents, Journal of Intellectual Capital, Vol. 3 No. 3, pp. 223-47. Bowen, D.E. and Ostroff, C. (2004), Understanding HRM-rm linkages: the role of the strength of the HRM system, Academy of Management Review, Vol. 29, pp. 203-21. Butler, J.E., Ferris, G.R. and Napier, N.K. (1991), Strategy and Human Resource Management, South-Western, Cincinnati, OH.

Capelli, P. and Neumark, D. (2001), Do high-performance work practices improve establishment level outcomes?, Industrial and Labor Relations Review, Vol. 54 No. 4, pp. 737-75. Cascio, W.F. (2000), Costing Human Resources: The Financial Impact of Behavior in Organizations, South-Western, Cincinnati, OH. Chadwick, C. and Cappelli, P. (1999), Alternatives to generic strategy typologies in strategic human resource management, in Wright, P., Dyer, L., Boudreau, J. and Milkovich, G. (Eds), Research in Personnel and Human Resource Management, Supplement 4, JAI Press, Greenwich, CT. Cook, M.F. (1999), Outsourcing Human Resource Functions, AMACOM, New York, NY. Copeland, T., Koller, T. and Murrin, J. (2000), Valuation: Measuring and Managing the Value of Companies, John Wiley & Sons, New York, NY. dArcimoles, C. (1997), Human resource policies and company performance: a quantitative approach using longitudinal data, Organizational Studies, Vol. 18 No. 5, pp. 857-74. Delaney, J. and Huselid, M. (1996), The impact of human resource management practices on perceptions of organizational performance, Academy of Management Journal, Vol. 39 No. 4, pp. 949-69. Delaney, J., Lewin, D. and Ichniowski, C. (1989), Human Resource Policies and Practices in American Firms, US Government Printing Ofce, Washington, DC. Den Hartog, D.N. and Verburg, R.M. (2004), High performance work systems, organizational culture and rm effectiveness, Human Resource Management Journal, Vol. 14, pp. 55-78. Ferris, G., Hochwarter, G., Buckley, W., Harrell-Cook, M. and Frink, D. (1999), Human resources management: some new directions, Journal of Management, Vol. 25 No. 3, pp. 385-415. Fitz-enz, J. (2000), The ROI of Human Capital, AMACOM, New York, NY. Flamholtz, E. (1985), Human Resource Accounting, 2nd ed., Jossey-Bass, San Francisco, CA. Hand, J. and Lev, B. (Eds) (2003), Intangible Assets: Values, Measures, and Risks, Oxford University Press, Oxford, UK. Holstrom, B. and Milgrom, P. (1994), The rm as an incentive system, American Economic Review, Vol. 84, pp. 972-91. Hurwitz, J., Lines, S., Mongomery, B. and Schmidt, J. (2002), The linkage between management practices, intangibles performance and stock returns, Journal of Intellectual Capital, Vol. 3 No. 1, pp. 51-61. Huselid, M. (1995), The impact of human resource management practices on turnover, productivity, and corporate nancial performance, Academy of Management Journal, Vol. 38, pp. 635-72. Huselid, M., Jackson, S. and Schuler, R. (1997), Technical and strategic human resource management effectiveness as determinants of rm performance, Academy of Management Journal, Vol. 40 No. 1, pp. 171-88. Hyland, M.M. and Verreault, D.A. (2003), Developing a strategic internal audit-human resource management relationship: a model and survey, Managerial Auditing Journal, Vol. 18 No. 6, pp. 465-77. Ichniowski, C. and Shaw, K. (1999), The effects of human resource management practices on economic performance: an international comparison of US and Japanese plants, Management Science, Vol. 45 No. 5, pp. 704-21. Ichniowski, C. and Shaw, K. (2003), Beyond incentive pay: insiders estimates of the value of complementary human resource management practices, The Journal of Economic Perspectives, Vol. 17 No. 1, pp. 155-80.

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Wright, P., Gardner, T. and Moynihan, L. (2003), The impact of HR practices on the performance of business units, Human Resource Management Journal, Vol. 13 No. 3, pp. 21-36. Youndt, M., Snell, S., Dean, J. and Lepak, D. (1996), Human resource management, manufacturing strategy, and rm performance, Academy of Management Journal, Vol. 39, pp. 836-66. Further reading Currie, G. and Procter, S. (2001), Exploring the relationship between HR and middle managers, Human Resource Management Journal, Vol. 11 No. 3, pp. 53-69. DeFeo, J. and Barnard, W. (2004), Juran Institutes Six Sigma Breakthrough and Beyond, McGraw-Hill, New York, NY. Gupta, P. (2004), Six Sigma Business Scorecard, McGraw-Hill, New York, NY. Hamel, G. and Prahalad, C.K. (1994), Competing for the Future, Harvard Business School Press, Boston, MA. Harrell-Cook, G. and Ferris, G.R. (1997), Competing pressures for human resource investment, Human Resource Management Review, Vol. 7 No. 3, pp. 317-40. Harrington, H.J. (1991), Business Process Improvement: The Breakthrough Strategy for Total Quality, Productivity, and Competitiveness, McGraw-Hill, New York, NY. Hitt, M.A., Bierman, L., Katsuhiko, S. and Kochhar, R. (2001), Direct and moderating effects of human capital on strategy and performance in professional service rms: a resource-based perspective, Academy of Management Journal, Vol. 44 No. 1, pp. 13-28. Huselid, M. and Becker, B. (1996), Methodological issues in cross-sectional and panel estimates of the human resource-rm performance link, Industrial Relations, Vol. 35, pp. 400-22. Ichniowski, C., Kochan, T., Levin, D., Olson, C. and Strauss, G. (1996), What works at work? Overview and assessment, Industrial Relations, Vol. 35 No. 3, pp. 299-333. Jackson, S. and Schuler, R. (1995), Understanding human resource management in the context of organizations and their environments, Annual Review of Psychology, Vol. 46, pp. 237-64. Klingner, D. (1993), Reinventing public personnel administration as strategic human resource management, Personnel Management, Vol. 22 No. 4, pp. 565-79. Leonard, B. (2002), GM drives HR to the next level, HR Magazine, Vol. 47 No. 3, pp. 46-50. Mohrman, S.A. and Lawler, E.E. (1999), The new human resources management: creating the strategic business partnership, in Schuler, R.S. and Jackson, S.E. (Eds), Strategic Human Resource Management, Blackwell Publishers, Oxford, pp. 433-48. Pelham, D. (2002), Is it time to outsource HR?, Training, Vol. 39 No. 4, pp. 50-2. Schuler, R. (1992), Strategic human resource management: linking people with the needs of the business, Organizational Dynamics, Vol. 21 No. 1, pp. 18-32. Schuler, R.S. and Jackson, S.E. (Eds) (1999), Strategic Human Resource Management, Blackwell, Oxford, UK. Ulrich, D.O. (1997), Measuring human resources: an overview of practice and a prescription for results, Human Resource Management, Vol. 36 No. 3, pp. 303-20. Varma, A., Beatty, R., Schneir, C.E. and Ulrich, D.O. (1999), High performance work systems: exciting discovery or passing fad?, Human Resource Planning, Vol. 22 No. 1, pp. 26-37. Watson, G.H. (1993), Strategic Benchmarking, John Wiley & Sons, New York, NY. Wright, P., McMahan, G. and McWilliams, A. (1994), Human resources and sustained competitive advantage: a resource-based perspective, The International Journal of Human Resource Management, Vol. 5, pp. 301-26.

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