“Best Practices” is a common business term used in almost every management meeting. But, are best practices actually best for your company? As corporate America has evolved, more and more emphasis has been placed on Return-On-Investment or ROI. The burden of ROI proof initially fell to the operations side of most companies, but now even hard-to-quantify business areas like Human Resources and Risk Management are asked to prove the value of their stated best practices.
At the heart of every good Human Resources or Risk Management hiring strategy is employment background screening. Employment background screening is widely recognized as a necessary process that is designed to keep out undesirable candidates, but it also represents a significant expense. The question then is this: How much actual dollar value does a background screening program deliver? Demonstrating a real-world payoff for a strategic background screening program that is based on common sense and best practices is the goal of this paper.
First, though, we will review the major areas in which companies are adversely affected by hiring the wrong employees…hires that many times can be prevented with the implementation of a quality employment background screening program. This will allow us to establish the “waste bank” of dollars from which the screening program will draw its returns.
The major areas we will discuss are:
Turnover is defined as the ratio of the number of workers that have to be replaced in a given time period to the average total number of workers employed during the same period.
The Bureau of Labor Statistics estimates that for 2004 the annual average total employment for the United States was approximately 138 million workers, with a total separations (turnover) rate of 38.7%, resulting in 53.4 million position turnovers. The Employment Policy Foundation of Washington, D.C. has calculated the average national cost of turnover, across all positions, at $13,355 per worker, or approximately 25% of the average cost of salary plus benefits. That puts the total loss to the American economy due to employee turnover at $713 billion for 2004, or 6.1% of the Gross Domestic Product (GDP) of $11.734 trillion.
Although the average turnover rate for a U.S. company is 38.7%, the range varies widely depending upon the industry and employment level. For example, the Aberdeen Group states the following annual turnover rates for hourly workers:
In addition, the cost estimate of turnover at 25% of salary plus benefits by the Employment Policy Foundation is the most conservative such estimate. The Saratoga Institute estimates the cost of turnover at 150% of annual compensation for salaried workers, while Dr. Bradford Smart suggests that the cost for senior executive turnover is as high as 2,400% in his book Topgrading.
The Employment Policy Foundation estimates that for a firm with 40,000 employees, the difference between a 15% turnover rate and a 25% turnover rate is over $50 million annually. The difference between a 15% turnover rate and a 40% turnover rate is over $130 million annually.
Occupational fraud consists of asset misappropriations, corruption schemes, and fraudulent statements. Regardless of the employee’s level within the organization, or the sophistication of the plot, occupational fraud can always be thought of as a form of theft.
According to the Association of Certified Fraud Examiners’ 2002 Report to the Nation on Occupational Fraud and Abuse, about 6% of U.S. revenues are lost annually to occupational fraud. Based upon this estimate, in 2004 the economy suffered a loss of $704 billion that can be directly attributed to employee fraud.
The United States Department of Commerce reports that 30% of all business failures result from theft or embezzlement.
Catastrophic events include workplace violence, sexual harassment, and accidents that occur due to falsified qualifications or alcohol/drug use. Compounding these events are the resultant law suits and negligent hiring litigation that nearly always follow on.
The Workplace Violence Research Institute estimates the annual cost of workplace violence at $36 billion, while the Substance Abuse and Mental Health Services Administration (SAMHSA) says that alcohol and drug abuse costs U.S. businesses about $81 billion each year; totaling $117 billion/year. While reliable estimates are not available regarding the costs of sexual harassment and falsified qualifications, it can easily be surmised that their contribution pushes the total cost of catastrophic events in the workplace costs the U.S. economy more than $150 billion each year, or about 1.3% of the GDP.
Proforma Screening Solutions’ historical data shows that 10% of all job applicants have reportable criminal records. Liability Consultants, Inc. reports that employers lose over 70% of negligent hiring cases, with the average settlement being over $1.6 million.
THE BIG PICTURE
When taken in totality, the business losses that can be reduced by background screening - including turnover, theft/fraud, and catastrophic events (and their resultant legal losses) - add up to over $1.5 trillion annually. When this data is compared against total business revenues (GDP) and applied to an “average” company, we can see that 13.4% of all revenues go into our “waste bank”. This figure provides ample room for improvement, with the starting point being the introduction of a strategic background screening program implemented by a highly qualified provider.
According to the US Small Business Administration, for every dollar an employer invests in employment screening, the return on investment ranges from $5-16, resulting from improved productivity, reduced absenteeism, lower turnover – and decreased employer liability.
The following model is based upon the work and formulas derived by Charles Handler, Ph.D. and Steven Hunt, Ph.D. This model captures and quantifies the various components that cost companies money by hiring the wrong employees. Included in these calculations are the cost of employee turnover and the costs of catastrophic hires – employees who engage in theft, violence, sexual harassment, etc.
These costs, and the estimates regarding how much a strategic background screening program can reduce them, are then compared to the actual costs of operating a background screening program to arrive at an estimated Return On Investment.
We begin by examining the formula definitions, with detailed descriptions of the components and the logic used in determining the values used for each component. Next, we will introduce the formulas themselves. Finally, we will calculate and examine the results using the most substantiated data available based upon a fictional average sized company of 10,000 employees.
The number of employees hired per year due to growth and turnover. We are using a mid-size company with 10,000 current employees and 500 annual hires due to growth as our basis. Given the average annual turnover rate of 38.7%, the total annual hires…and thus the number used for N, is 500 + (10,500 x 38.7%) or 4,564 (4,064 due to turnover).
Direct Losses from Catastrophic Hire (DLCH):
This is the average loss incurred due to hiring an employee who engages in theft, violence, lawsuits, or other counterproductive behaviors. It should include legal and security fees incurred as a result of counterproductive behavior. We have very conservatively set this value at $26,710, or half of the estimated $53,420 value of salary plus benefits based upon the Employment Policy Foundation’s estimates. Actual costs would most likely be much higher.
Percentage of Catastrophic Hires Avoided (HA):
This indicates the percentage of candidates screened out through background checks who would have engaged in employee theft, violence, or legal actions had they been hired. Industry statistics suggest that around 10% of background verifications uncover something substantially negative about candidates. If we estimate that half of these candidates would in fact engage in counterproductive behavior, this value can be set at 5% of hires (N), or 228 hires.
Assessment Cost (C):
How much the use of assessment tools will increase the costs of evaluating candidates. The cost of background check packages ranges from $10 - $200 depending upon position and responsibilities. We will use $60 per background check for this exercise.
Annual Turnover Rate (TR):
The percentage of the workforce that currently leave each year due to turnover. This number is set at 38.7% based upon Bureau of Labor Statistics estimates.
Average Time to Fill (TF):
The average number of weeks required to fill a vacant position. This number is set at 5.3 weeks based upon the 2006 Society of Human Resource Professionals (SHRM) average time to fill metric of 37 days for all same-industry hires.
Value of Performance (VP):
This is an estimate of the annual revenue generated by the employee. This is commonly set at 2.5x employee salary (plus benefits) according to SHRM guidelines. We are using an average salary (plus benefits) of $53,420 based upon Employment Policy Foundation data. The result is a figure of $133,550 that is then divided by 52 and multiplied by the number of weeks it takes to fill the position.
Hiring Cost (HC):
The average internal business costs associated with hiring an employee. These costs include time spent by recruiters and managers sourcing and screening candidates, time and costs spent training new hires, as well as any other on-boarding costs such as relocation or orientation. SHRM studies place average hiring costs at $2,546 for hourly employees and $6,943 for salaried employees. We have set the value at $4,745 as an average.
Selection Ratio (SR):
This is the number of candidates you typically assess before making a hiring decision. It is typically somewhere between 3 and 10. We have set this number at 5.0.
Reduction in Turnover (rx t):
The decrease in turnover that will result from the use of a strategically designed and implemented background screening program implemented by a quality provider. When designed properly, these tools can reduce turnover by 50% or more. Nissan North America was able to reduce its annual turnover rate from 91% to 10% over the course of 4 years by utilizing better screening and assessment strategies. We are using a conservative 25% for this exercise, which would reduce annual hires by 1,016 based upon the currently assumed 38.7% turnover rate.
Value Provided by Reducing Turnover
One goal of a strategic background screening program is to help increase employee retention. This formula estimates the financial value of using background screening and assessment tools to reduce turnover.
Value of Reduced Turnover = (N*TR) * (((TF*VP)/52) + HC) * rx t
Value Provided by Avoiding Catastrophic Hires
Although good employees can be a company's greatest asset, the wrong employees can be a company's largest liability. Certain assessment tools such as drug screens and background checks reduce the risks of hiring employees who may engage in counterproductive activities such as theft, violence, or sabotage. For this model, Employee Fraud is combined with Catastrophic Events to calculate values for avoiding Catastrophic Hires.
Value of Avoiding Catastrophic Hires = (N * DLCH * HA)
Return on Investment
The net value of a solid hiring program that involves stringent background screening and assessments is determined by adding the value of avoiding catastrophic hires with the value of reducing turnover and subtracting the total program cost (number of hires x program cost x selection ratio).
Net Value = (Value of Avoiding Catastrophic Hires + Value of Reduced Turnover) – (N*C*SR)
ROI = (Net Value / Total Program Cost) * 100
Estimated ROI from strategically designed and expertly implemented employment background screening program based upon the formulas derived Charles Handler, Ph.D. and Steven Hunt, Ph.D.
The calculated results, when applied to our figurative company, indicate:
Upon examination, it becomes evident that background screening is not only necessary as part of a best practices approach to hiring, but, it also delivers real value to the company’s bottom line. There are scarce few business expenses that can generate the type of ROI that background screening can. Fewer still that are as necessary to preserve the safety of employees while protecting the public image of your company.