Why You Shouldn't Rely on Turnover Cost Estimates

Contributor:  Haig R. Nalbantian
Posted:  07/09/2012  12:00:00 AM EDT
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Even in times of high unemployment, HR and other business leaders often seek to benchmark turnover costs against standard “rule of thumb” estimates. However, such estimates can be misleading because of the way in which they are calculated. Most calculations simply roll up the hard and soft costs of replacing departing employees, which overlooks the many possible positive effects of turnover. Standard cost estimates also tend to disregard the significant variation in negative impact across organizations and workforce segments within organizations. This article describes the costs and potential benefits of turnover, uses case studies to demonstrate variations in impact, and discusses how employers can appropriately assess the impact of turnover in their own workforces.

Role of turnover in workforce management

One of the most common questions posed by HR and other business leaders concerns the cost of turnover. The question remains pertinent even in these times of high unemployment, since some sectors are still experiencing high turnover, especially among high-skilled talent. Companies are paying top dollar to get top talent, so trying to keep those employees is a high priority.

Frequently cited estimates of the cost of turnover vary considerably. Estimates range from 0.3 to 2.0 or more times salary, depending on whether employees are hourly or salaried and on the level and complexity of positions in question. The breadth of that range alone should make employers wary about relying on such rules of thumb. But the very idea of some general rule of thumb is problematic. Indeed, these estimates are as close to worthless as any commonly reported HR “benchmark” because they implicitly assume that all turnover is negative. As a result, these assessments typically calculate total turnover cost by simply adding up the various hard and soft costs incurred in recruiting, screening, hiring, on-boarding, training and developing replacements, along with best-guess estimates of productivity lost from operational downtime.

This approach neglects the various potential positive effects of turnover that may actually produce significant productivity gains for organizations, thereby reducing real labor cost. The benefits of turnover can take a variety of forms:

  • Turnover may help weed out poor performers, allowing their replacement by higher performers. 
  • Turnover can correct for that classic labor market inefficiency: employees poorly matched to jobs and organizations. These mismatches occur all too often due to incomplete and asymmetric information in labor transactions.
  • Turnover may open up slots for up-and-coming talent who are competing to move up in the career hierarchy, thereby motivating them to perform better and remain with the organization. This may be particularly important in the low- or no-growth environments that many organizations in developed economies are facing today.
  • Higher turnover may enable an organization to transform or “remodel” its workforce to accommodate new business requirements. In today’s fast-paced economy, rapid changes in business and operational environments may significantly alter what’s required in and from an organization’s workforce. Without turnover, achieving these talent changes may be too hard or take too long to achieve, imperiling the required business transformation.
  • At a more macro level, certain kinds of turnover can end up stimulating greater and faster innovation. The movement of talent across organizations may allow ideas and know-how to circulate more readily within a sector or discipline as new groupings of talent are forged – much like a natural experiment in creativity and innovation. Innovation-driven companies are sometimes far more dependent than they realize on the circulation of employees across competitors.

In view of these potential positive outcomes, some organizations face the problem of too little – not too much – turnover.

Two case studies help demonstrate how traditionally determined “costs” of turnover can be outweighed by its positive impact on workforce productivity. Rule-of-thumb estimates would not only overstate the true turnover costs to each organization, but also misidentify the underlying workforce problem each employer faced.

Low turnover impedes business transformation.
Take the example of a large, global technology company faced with dramatic changes in its business, as new competition emerged in Asia and new technologies quickly and radically changed the very nature of product offerings. The company’s leaders recognized the need for a new business design to operate effectively in this new competitive landscape. They quickly engineered that transformation, moving to reorganize their business, establishing new units to develop and deliver products and services reflecting the new technologies.

The success of these business changes demanded significant changes in the company’s mix of workforce skills, knowledge and capabilities, as well as some new employee behaviors. Transformation of the workforce, however, wasn’t happening for a rather simple reason: A premium reward package and stellar employment brand had made this organization a “best place to work.” Turnover was next to nonexistent, particularly among low performers and those who didn’t have the requisite skills and knowledge to support the new business. The company had become a best place to work – but for the wrong kind of people.

In this case, the very reward practices and culture that had made the company successful for a very long time had become an impediment to its successful transformation. These practices were blocking market signals about changes in the value of different segments of the company’s workforce and preventing natural adjustments, via turnover and new hires, to its human capital assets. This failure was putting the company’s survival in peril. Changes in these practices were necessary to help stimulate higher levels of natural attrition, which was preferable to involuntary reductions in force, with all the unintended outcomes and reputational damage that would result. Too little turnover had become a bad thing for this company and extremely costly – something that would never show up in standard cost-of-turnover estimates.

Assessing the performance of high-turnover populations.
Another example of how misleading cost-of-turnover estimates can be is found by comparing turnover patterns at two regional banks:

Bank A had the higher overall turnover rate and was rightly concerned about it. Bank B had lower overall turnover and thought it had no problem. However, comparing the turnover patterns at these banks leaves it unclear who had the bigger and most costly problem. Bank A’s turnover was concentrated among lower performers in customer-facing jobs – the very jobs that likely had the most impact on customer retention and growth in market share. Bank B had the same turnover rates among its higher performers and its low performers, so it was losing too much of the talent necessary to success.

In effect, Bank A didn’t actually have a turnover problem but a selection problem: The bank was bringing in people not well matched to their jobs and their work environment. Under these circumstances, a high level of “quick quits” – employees leaving within six months of hire – was actually beneficial, allowing the organization to cut its losses, so to speak. The last thing this bank needed to do was get better at keeping low performers. Instead, Bank A needed to focus on improving its recruitment, selection and on-boarding processes.

Labor costs vary for different types of human capital

Unlike simple cost estimates, detailed statistical analyses of the running record of an organization’s own workforce and performance data can directly measure the impact of turnover on workforce productivity and other business performance measures. Our work performing these analyses over the years has shown that the actual costs vary dramatically across organizations (even in the same industry), depending on a host of “contextual factors” within each organization. (For an exposition of the analytical techniques described here, see Nalbantian, H, Guzzo, R, Kieffer, D, and Doherty, J. Play to Your Strengths: Managing Your Internal Labor Markets for Lasting Competitive Advantage (New York: McGraw Hill, 2004). pp. 103–118.)

The most important factor influencing the impact of turnover is the relative value of institutional versus general knowledge/capability, or what economists call firm-specific versus general human capital:

Institutional or firm-specific.
The value of firm-specific human capital accrues from the long-term association between employer and employee. It reflects the special knowledge and capability that can only come from working with the same people, customers, technologies, capabilities over time. Such value is embedded in the relationship and cannot be transported across markets. It can be considered the investment component of labor cost.

In contrast, general human capital reflects the capability and know-how that resides in individual employees – their knowledge, ability, creativity, energy and health, whether intrinsic attributes or acquired through education and experience. General human capital comes and goes with the individual employee and has a well-determined market price.

Properly assessing the cost of turnover requires knowing the extent to which organizations depend on firm-specific versus general human capital to create value.

Firm-specific human capital.
Some organizations derive most value from firm-specific human capital, including the regional bank in the following illustration.

Statistical modeling of this bank’s branch and regional performance – including net income, customer retention, growth and market share – determined that the single biggest human capital predictor of improvements in these measures was the average tenure in front-line jobs. Every one-year increase in average employee tenure in the branches was worth $40 million.

Organizations like this bank are very vulnerable to turnover; they need to “build” – not “buy” – their workforces. In this context, turnover is costly to productivity: When employees leave, firm-specific human capital is eroded and cannot be bought back. The resulting productivity losses create turnover costs beyond the direct expenses of recruitment, hiring and on-boarding, among others.

General human capital.
Organizations that rely on general human capital to generate value depend, first and foremost, on the intrinsic quality and capabilities of the people employed to drive value. For these organizations, the arrival of new blood and new ideas from the outside is what most stimulates performance.

Take the example of a large insurance company whose leaders insisted their business was all about relationships: Building enduring bonds between clients and client-relationship managers (CRMs) was essential to business success, top business and HR leaders said. What did the evidence say? Statistical modeling found no connection between the tenure of CRMs and core measures of performance and growth tracked by the business. Turnover among CRMs had no impact; in fact, service teams that included more up-and-coming junior talent and recent hires actually performed better. Maybe clients did enjoy their long-standing relationships with individual CRMs, but the evidence indicated that their loyalty to the firm was not affected if and when their contacts left. The real business affiliation was with the firm, not the CRM a client knew.

Intra-organization variations.
Whether firm-specific or general human capital is most important to business value is not uniform within an organization and can depend on the part of the workforce concerned. For example, statistical modeling conducted for another regional bank found turnover among front-line jobs was extremely damaging, as with the other bank noted above. However, in this organization, turnover of managers and other full-time senior employees had little productivity impact. In fact, higher turnover in these positions actually improved results for some productivity and customer value measures. Apparently, firm-specific human capital in this bank was critical mostly in jobs with high and regular customer contact; in managerial jobs, general human capital mattered more and therefore was less affected by turnover.

In this case, those simple rules of thumb that invariably indicate turnover among managers is more costly than turnover among front-line, customer-facing employees would be dead wrong.

Organizations that generate more value from general than firm-specific human capital can acquire the talent they need when they need it by going directly to the market and meeting the market price. Usually, these employers can quickly replace what they lose with little or no loss in productivity.

In this environment, turnover will be significantly less costly and might even bring appreciable gains in productivity due to better matching of employees to jobs and organizations. After all, matching people to jobs is a primary purpose of labor markets. If turnover were always costly as most rule-of-thumb estimates suggest, labor markets would have little productive role beyond filling entry-level positions – the very raison d’etre for labor markets would disappear.

In practice, most organizations require some mix of firm-specific and general human capital. The choice is seldom an all-or-nothing proposition. As for how that mix affects turnover costs, only empirical analysis can properly answer a fundamentally empirical question.

Effective assessment of turnover costs (and benefits)

As the examples in this article illustrate, an organization seeking to understand the impact of turnover should carefully assess its own workforce rather than rely on rule-of-thumb estimates. More precise quantitative estimates of actual turnover costs can be developed using statistical modeling methods, as discussed above. Well-designed, controlled statistical modeling can help an organization determine the value of investing to optimize turnover.

A more subjective but still useful approach is to undertake a disciplined, qualitative assessment, reviewing some of the key contextual factors that will significantly influence turnover costs. Relevant factors include the buy/build balance; the homogeneity of work, work processes and productive activity within job families; the extent of reliance on team production; the stability of workforce requirements over time; the speed of technological change; the importance of product and/or process innovation; and the organization’s workforce profile, among other things. A well-designed, carefully executed qualitative assessment like this can help an organization understand how to adjust rule-of-thumb estimates to account for its own realities and avoid a serious and costly miscalculation.

Haig R. Nalbantian Contributor:   Haig R. Nalbantian

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