the real option

7/30/2019 The Real Option

1/32

PLEASE SCROLL DOWN FOR ARTICLE

This article was downloaded by: [Indian Institute of Management (T&F Special) Consortium]

On: 14 March 2011

Access details: Access Details: [subscription number 934501804]

Publisher Routledge

Informa Ltd Registered in England and Wales Registered Number: 1072954 Registered office: Mortimer House, 37-

41 Mortimer Street, London W1T 3JH, UK

Publication details, including instructions for authors and subscription information:http://www.informaworld.com/smpp/title~content=t713702518

Sanghamitra Sanyala; P. K. Settaa Human Resource Group, Indian Institute of Management Calcutta, Calcutta, India

Online publication date: 27 January 2011

Sanyal, Sanghamitra and Sett, P. K.(2011) 'Applying real options theory to HRM: an empirical study ofIT software firms in India', The International Journal of Human Resource Management, 22: 1, 72 102

10.1080/09585192.2011.538969

http://dx.doi.org/10.1080/09585192.2011.538969

Full terms and conditions of use: http://www.informaworld.com/terms-and-conditions-of-access.pdf

This article may be used for research, teaching and private study purposes. Any substantial orsystematic reproduction, re-distribution, re-selling, loan or sub-licensing, systematic supply ordistribution in any form to anyone is expressly forbidden.

The publisher does not give any warranty express or implied or make any representation that the contentswill be complete or accurate or up to date. The accuracy of any instructions, formulae and drug dosesshould be independently verified with primary sources. The publisher shall not be liable for any loss,actions, claims, proceedings, demand or costs or damages whatsoever or howsoever caused arising directlyor indirectly in connection with or arising out of the use of this material.
http://www.informaworld.com/smpp/title~content=t713702518http://dx.doi.org/10.1080/09585192.2011.538969http://www.informaworld.com/terms-and-conditions-of-access.pdfhttp://www.informaworld.com/terms-and-conditions-of-access.pdfhttp://dx.doi.org/10.1080/09585192.2011.538969http://www.informaworld.com/smpp/title~content=t713702518


2/32

Applying real options theory to HRM: an empirical study

of IT software firms in India

Sanghamitra Sanyal and P.K. Sett*

Human Resource Group, Indian Institute of Management Calcutta, Calcutta, India

Environmental uncertainties can impact the market value of a firms human assets bothpositively and negatively, and make return on human assets uncertain over time.However, the strategic human resource management (SHRM) literature has so far focusedalmost exclusively only on the upside value of human assets of a firm. Real options theorycan provide the process heuristics as well as the economic logic for guiding investments inhuman assets to create sustainable market value for firms operating in uncertainenvironments. In spite of the growth in popularity of the real options approach, nomeaningful progress, however, has been made towards application of this approach toHRM. This study, using data from 108 IT software development firms in India, seeksto address this gap and make three important contributions to the SHRM literature:(1) operationalise the concept ofHR options by identifying the HR practices that possessoption value; (2) investigate how use of HR options affects firm-level performance; and(3) develop and test a causal model that links the various types of HR options that firmsuse to exploit uncertainties faced by them with the firm-level operational and financialoutcomes. The results support the central hypothesis of the article that use of HR optionsby firms operating in uncertain environments would have positive impact on theiroperational and financial performance. Significant differences were observed in the natureof linkages between different types of HR options used to address different types ofuncertainties, and the operational and financial performance of the firm.

Keywords: environmental dynamism; firm performance; HR options; real optionstheory; strategic HRM

Introduction

Like in the case of other firm assets, environmental uncertainties can make return on

investments in human assets uncertain, leaving room for both downside losses and upside

gains. However, the strategic human resources management (SHRM) literature has so far

considered almost exclusively only the upside value of human assets of a firm. Disregarding

the uncertainties surrounding the human assets is likely to lead to overvaluation of suchassets and to underestimation of the role of investments in human assets in creating market

value for the firm (Bhattacharya and Wright 2005). Like any other strategic investments

made under uncertainty, investments in human assets can be designed and managed to

protect the firms human assets from downside risks (e.g. obsolescence) and to exploit

upside opportunities created by uncertainties (e.g. development of new products).

Real options theory that deals with managing investments in real (physical and human)

assets under uncertainty, offers enormous potential for guiding investments in human

assets for creating sustainable market value for firms operating in uncertain environments.

ISSN 0958-5192 print/ISSN 1466-4399 online

q 2011 Taylor & Francis

DOI: 10.1080/09585192.2011.538969

http://www.informaworld.com

*Corresponding author. Email: [email protected]

The International Journal of Human Resource Management,

Vol. 22, No. 1, January 2011, 72102


3/32

It is well recognised that in todays globalised markets, one of the sources of sustainable

competitive advantage resides in non-tradable, difficult to imitate, firm-specific human

resources comprising the skills, experience, judgement, behavioural repertoires and social

network of employees (Hitt, Keats and Demarie 1998; Miller and Lee 2001; Sirmon, Hitt

and Ireland 2007). However, because markets for such firm-specific, partly intangibleassets either do not exist or are thin, the greatest challenge the managers face today is how to

evaluate the alternatives and make an optimum choice to invest in such resources that would

maximise the long-term market value of the firm (Teece 2007).

Investments in building organisational capabilities under uncertainty are irreversible in

nature. Firms cannot easily adjust the organisational capabilities to the emergence of

market opportunities. Therefore, the firms that have made investments in capabilities

appropriate to these opportunities are likely to gain advantage over those who have made

sub-optimum choices (Kogut and Kulatilaka 2001).

Non-existent or thin markets for such intangible assets create the opportunities for

strategic managers to achieve resource heterogeneity that can be a source of sustainable

competitive advantage for the firm (Helfat et al. 2007; Teece 2007). Complementarily, the

absence of an indication of market value of such resources may lead to improper choice

and inappropriate use and deployment of such resources. Real options approach can help

to discover market value and avoid inappropriate deployment of such resources.

To achieve sustainable superior performance in a dynamic environment, it is not

enough for a firm to possess valuable resources, it must also be capable of continuously

renewing, reconfiguring and redeploying such resources with changes in environmental

needs (Teece, Pisano and Shuen 1997; Brush and Artz 1999; Barney 2001; Kraatz and

Zajac 2001; Aragon-Correa and Sharma 2003; Chan, Shafer and Snape 2004; Sirmon et al.

2007). Return on an investment can be amplified by the recognition of the synergistic

value of, and/or by investments in, co-specialised or complementary assets (Helfat et al.2007; Teece 2007). In such a scenario, resource investments and unfolding strategic

options created by such investments are to be regarded as two related elements in a single

chain of events (Bowman and Hurry 1993). Real options theory can provide the process

heuristic for understanding the cognitive and the economic logic of sequential resource

investment choices that firms make in managing their human resources.

However, in spite of the growth in popularity of the real options approach to value a

firms strategic investment decisions under uncertainty, no meaningful progress has been

made towards application of this approach to investments in human assets. Bhattacharya

and Wright (2005) made a beginning in this direction by proposing a broad conceptual

framework that identifies the generic types of uncertainties that impinge on human assetsand the related option-like investments that firms can make to exploit those uncertainties.

No empirical work has been reported so far on this framework.

Using data from 108 IT software development firms in India, this study seeks to

address this gap and make three important contributions to the existing SHRM literature.

First, it elaborates, refines and operationalises the concept of HR options that should

facilitate further research. Second, it extends the framework of Bhattacharya and Wright

(2005) by postulating and empirically investigating how use of HR options affects firm

performance. Finally, it develops and tests a hypothesised causal model that links the

various types of HR options, and the firm-level operational and financial outcomes.

In the past, there have been a number of studies on IT-related firms in India. Budhwar,

Pawan, Luthar and Bhatnagar (2006a) and Budhwar, Pawan, Varma, Singh and Dhar

(2006b) studied the HR systems of Indian business process outsourcing centres and call

centres. Raman, Budhwar and Balasubramanian (2007) analysed the people management

The International Journal of Human Resource Management 73


4/32

issues in Indian knowledge process outsourcing centres. Impact of people management

practices on organisational performance of IT software firms was investigated by Paul and

Anantharaman (2003). But none of these studies investigated whether and how investments

in HR assets enable the IT software firms in India to gainfully exploit environmental

uncertainties, which is the central concern of this article.

Theory and hypotheses

Real options

An option is the right, without any obligation, to act in a particular way in the future. Options

are valuable when there is uncertainty (Amram and Kulatilaka 1999). Most ubiquitous form

of options is a financial option which is a contract written to create right to purchase (or sell)

a publicly traded financial asset (e.g. stocks, bonds and currency) at a pre-determined price,

by or on a certain date, without any obligation to buy (or sell). Option holder creates this

discretionary right in his favour by paying a price (option premium), which is his option

investment, to the seller.

Fundamental idea is to make a specific but limited investment commitment that creates

future decision rights (McGrath, Ferrier and Mendelow 2004). For example, the holder of

a financial option on company stocks can decide, at his discretion, whether or not to buy

the stocks depending upon the actual price prevailing at the appointed time in the future.

If the stocks are being traded at a price lower than the price mentioned in the contract, he

does not exercise the option and loses only the money he paid to buy the option. On the

other hand, the potential gain he can make under favourable market conditions is

unlimited. The value of an option investment under uncertainty is derived from this kinked

pay off which is asymmetric in favour of upside gains.

Firms invest in physical and human assets which are an act of incurring an immediatecost in the expectations of creating future revenue streams. Most of these investments in

such real assets share three important characteristics in varying degrees: (1) irreversibility

(initial cost cannot be partly or fully recovered should you change your mind),

(2) uncertainty (over the future rewards from the investment) and (3) timing (you can

postpone action to get uncertainty resolved at least partially) [Dixit and Pindyck 1994].

These three characteristics interact to determine the optimality of the investment decisions

taken by the firm.

Firms can gain from stochastic variations in environmental conditions, in regard to

such investments, if they can keep their options open for their future actions that they may

take after some of the current uncertainties are resolved. Real options are specificinvestments in physical and human assets of the firm that provide the opportunity to

respond to future contingent events in a flexible manner (Kogut and Kulatilaka 2001). In a

narrow sense, the real options approach is the extension of financial option theory to

options on real (non-financial) assets (Amram and Kulatilaka 1999). Application of the

financial option pricing model (Black and Scholes 1973) helps to determine the market

value of investments in physical and human assets and to bring the discipline of free

market in choosing between the available alternatives. However, the strategic implications

of real options approach are much broader as discussed subsequently.

Not all firm investments in real assets may have the option value. Real options are

up-front investments that allow management to capitalise on favourable opportunities and

mitigate downside risks by proactively managing uncertainty over time in a flexible

manner rather than by trying to avoid uncertainty (Kester 1984; Kogut 1991; Leiblein

2003). What distinguishes options from other firm resources is that resources with option

S. Sanyal and P.K. Sett74


5/32

value generate choices (e.g. dual-fuel power generator; multi-skilled workforce) and

allow preferential access to future opportunities (e.g. investments in development of new

technology, products or markets; acquiring sole selling rights in an emerging market)

[Bowman and Hurry 1993, p. 762].

Real options literature identifies different classes of real options that firms can use toaddress the various types of uncertainties they face (Trigeorgis 2001). Options to defer,

stage or abandon are typically resorted to in cases involving large investments under

uncertainty. Flexibility options, to alter scale of operations or switch process inputs or

outputs, are built into the initial design (e.g. flexible manufacturing system, recruitment of

multi-skilled workforce) when uncertainties in factor- and/or product-markets are

anticipated. Discretionary investments in research and development, and development of

new skills that can spawn future growth by exploiting future opportunities thrown up by

environmental uncertainties are regarded as growth and learning options (Myers 1977).

However, real-life projects are often more complex in that they involve a collection of

multiple interacting options (Trigeorgis 2001). The presence of subsequent options can

increase the value of effective underlying asset for earlier options, whereas exercise of

prior real options may alter (e.g. expand or contract) the underlying asset itself, and hence

the value of subsequent options on it (Trigeorgis 1993).

Many scholars in management literature have seen strategy through the option lens as a

process of organisational resource-investment choices or options (Myers 1977, 1984; Kogut

1991; Bowman and Hurry 1993). From an emergent perspective (Mintzberg 1978), a strategy

emerges through the sequential striking of this option chain. The process involves both the

cognitive process of sequential recognition of shadow options and a series of economic

decision making involving sequential investments; each conferring preferential access to the

next option in the chain (Bowman and Hurry 1993, p. 762). This broader application of real

options theory as a heuristic for strategy is of particular relevance for the subsequentdiscussion on managing human assets under uncertainty by investing in HR options.

Human resources and environmental uncertainties

Bhattacharya and Wright (2005) analyse the uncertainties faced by a firms human assets

by: (1) type and (2) source of uncertainty. They identify three types: uncertainties of

(1) return, (2) volume and combination and (3) costs. They argue that the sources of these

uncertainties maybe (1) the market, (2) the firm itself or (3) the individual employees.

Exogenous changes such as technological developments, product and process innovations,

shift in consumer preferences, competitor moves and so on may affect the market value of a

firms human capital as these changes can make some of the current products, processes andhuman skills obsolete. Such market changes may call for a change in firm strategy, or even

in the absence of such triggers, a firm may suo moto decide to change its current strategy to

be able to exploit market opportunities better. Change in firm strategy often calls for

deployment of a different configuration of human assets which, in turn, may affect the value

of current human resources. Finally, human resource is a unique resource in that it is

owned by the individual employees, not the firm. So, individual as well as collective will of

the employees (e.g. to leave the company, not to put in extra effort, not to use discretionary

judgement) may affect both the size and the quality of the human assets of a firm.

Uncertainties of return

Uncertainties in demand and supply in both product and labour markets may affect a

firms human assets, and in turn, its business. Fluctuations in demand for the firms



6/32

existing product affect the quantity while market demand for new, or improved or

substitute products which need different production processes may affect both the

quantity and the type of human capital needed to be deployed by the firm. These

changes can make some of the existing resources redundant (in terms of skills and/or

number) and call for new skills and competencies. Increasing demand for a new skillwhich is in short supply raises its market price, creating uncertainties of return

irrespective of whether the firm can meet such demands through internal or external

labour market.

Within the firm, the product market strategy determines the configuration of skills

needed to implement the strategy. The change in demandsupply profile of skills due to

change in strategy impacts the value of firms human resources much in the same way as the

external market forces do. With change in strategy, if the firm is unable to effect concomitant

change in its skill profile, by exercising numerical and/or functional adjustments of its

workforce, then its economic returns on human capital, and even on overall investments,

could be adversely affected.

At the employee level, the value of a firms current human assets may be seriously

impaired if the employees do not quickly pick up the new competencies required in the

changed scenario due to their lack of learning abilities, motivation or their unwillingness

to pick up new skills. Similarly, voluntary turnover of employees possessing strategic

skills depletes the firms valuable human capital base. Labour market competition or job

dissatisfaction may cause such turnover. Another insidious way the value of the firms

human assets may get eroded is due to uncertain and declining employee productivity

arising out of gradual disengagement of the employees with the strategic goals of the firm.

Declining employee productivity may happen at both individual and collective levels,

requiring appropriately different HR interventions.

Uncertainties of volume and combination

When a firm offers a portfolio of products that requires different production processes and

correspondingly different configurations of skills, it is exposed to uncertainties of both

volume and combination (product mix) of demands. A single product firm is exposed only

to the risk of uncertainties of volume of demand. Uncertainties of volume have

significance only for the number of people of a given skill engaged on production of a

product; it has no effect on the skill composition. The firm may face surplus/shortage of

persons with a given skill at a given location, or division, or unit of the firm. In contrast,

uncertainties of combination that implies market demands shifting in terms of product-mixcalls for changing the skill-mix of people engaged in production of such product

portfolios.

Uncertainties of volume and combination may arise also from a firms endogenous

actions like technological upgradation and changes in product offerings to exploit

market opportunities or to improve profitability. Like in the case of market changes,

firm-induced changes also call for numerical and functional flexibilities of human

resources of the firm.

Employees themselves can create uncertainties of volume and combination of skills

supply available to the firm at any given point in time by way of fluctuating levels of

absenteeism due to whatever reasons, sudden exodus of a large number persons belonging

to a particular skill category and so on. Also, they can thwart a firms efforts to reconfigure

the volume and combination of its human resources by refusing to upgrade or learn new

skills, resisting redeployment across jobs, units or locations and so on.



7/32

Uncertainties of costs

Uncertainties of costs arise when a firms input costs (e.g. employment costs) are high and

fixed but its revenues are volatile. Volatilities in revenue can be a chain reaction of

volatilities in product market demand, economic downturn, intensified product market

competition and so on. At firm level, high debt:equity ratio, large sunk cost accompaniedby unutilised capacity of fixed assets, etc. tend to make the firms cost structure inherently

rigid. Similarly, hiring a large permanent workforce and paying them fixed salaries above

the market rate and offering them liberal fringe benefits (including post-retirement

benefits) may also make the firms cost structure rigid and uncompetitive, particularly if

the firm is not able to extract above average economic returns (e.g. higher employee

productivity) from such investments. Rigid cost structure makes the profitability of the

firm highly vulnerable to even relatively small increases in input costs like the periodic

salary increases of permanent workforce. Employees also can cause uncertainties of costs

in ways like not contributing commensurate with high salary compensation and/or

excessive (intended/unintended) use of liberal fringe benefits.

HR options

Bhattacharya and Wright (2005, p. 938) define HR options as investments in the human

capital pool of an organisation that provides the capability to respond to future contingent

events. This definition clearly posits HR options as a sub-set of real options. A firms

investment in HR options is made through HR practices that can build a human resource

capability, comprising skills and behavioural repertoires of employees, to flexibly respond to

future uncertain events (Wright and Snell 1998; Bhattacharya and Wright 2005). This means,

not all HR practices have option value. Many HR practices (e.g. recruitment tests for

technical skills, training on existing skills) that do not address the issue of management ofuncertainty do not possess any option characteristics and hence, do not qualify as HR options.

Dynamic, resource-based view of firms contends that sustainability of competitive

advantage depends not only on the nature of resource bundles at any one point in time but

also on a firms ability to renew, reallocate, rejuvenate and redefine its resources in a manner

that coaligns with the contingent needs of the changing environment (Brush and Artz 1999;

Aragon-Correa and Sharma 2003; Chan et al. 2004). The firm needs to possess

organisational ambidexterity that is defined as an organisations ability to be aligned and

efficient in its management of todays business demands while simultaneously being

adaptive to changes in the environment (Raisch and Birkinshaw 2008, p. 378). It is required

to maintain a dynamic fit between its supply of human capital and its changing strategicimperatives.

HR practices represent firm capabilities that create value for the firm by developing

enabling human skills and behaviour. However, not all HR practices contribute to the

capacity to constantly renew, resynthesise and reconfigure the human asset base of an

organisation. On the basis of evidences from organisational and HRM literatures, Ketkar

and Sett (2009) identify a certain class of HR practices, which they call ambidextrous HR

system, that can induce necessary transformations in employee skills and behaviours

contingent on environmental changes and, thus, create the context for organisational

ambidexterity (Gibson and Birkinshaw 2004). These HR practices and processes possess

option value (Kogut and Kulatilaka 2001) and bestow dynamic capabilities (Teece et al.

1997) to the firm to deal with future contingent events. Like other investments under

uncertainty, a firm must choose among the alternative capabilities to invest in based upon

their potential market values. The optimal choice is the one that permits the firm to make



8/32

the best response to market opportunities and threats (Kogut and Kulatilaka 2001). By

inducing flexibilities for future action, these HR options limit downside risk and create

opportunities for upside gains (Bhattacharya and Wright 2005).

In the following sub-sections, we discuss the possible range of HR options that a firm

can invest in to exploit the uncertainties facing its human assets.

HR options and uncertainties of return

As discussed earlier, uncertainties of return may arise from obsolescence of existing skills

and demand for new or improved skills as well as due to high employee turnover and

decline in employee productivity. The former sub-set of uncertainties hampers growth of

the firm in new areas of business in the absence of learning capabilities of its employees.

We call the related set of HR options that a firm can create as growth and learning

options. The latter sub-set tends to affect a firms return from its existing lines of business

and calls for a different category of HR options which we call turnover and productivity

options. We discuss these two sets of HR options consecutively in the followingsub-sections.

Growth and learning HR options

If a firm can avoid skill obsolescence through continuous skill upgradation as well as by

learning new skills, it is capable of not only avoiding erosion in value of its human assets

but also creating new capabilities that may help the firm to expand into completely new

areas of business. A host of HR practices when properly designed and implemented with

right focus can address these issues.

Employee selection that emphasises cognitive skills and learning abilities rather

than narrow functional skills required by current jobs has been found to be associatedwith adaptable employee skills and behaviours (Wright, Smart and McMahan 1995;

Youndt, Snell, Dean and Lepak 1996; Stevens and Campion 1999). Comprehensive training

programmes that put premium on development of new skills and learning abilities have

been found to enhance organisational flexibility by building broader repertoires of

skills and behaviours possessed by the employees (Arthur 1994; Youndt et al. 1996;

Guthrie 2001; Collins and Clark 2003; Fulmer, Gerhart and Scott 2003; Collins and

Smith 2006).

Development-oriented employee performance management systems that value and

reward not only current performance but also discretionary behaviours, new skill

acquisition, adaptability or development of competencies required for the future have beenfound to be effective in fostering learning and motivating employees to acquire new skills

and behaviours (Collins and Clark 2003; Bowen and Ostroff 2004; Chan et al. 2004).

Career development policies that encourage growth of firm-specific skills and behavioural

repertoires, and put premium on acquisition of such skills by the employees can act as a

prime mover in continuous capability renewal and development process (Collins and

Smith 2006). Skill-based pay helped in multi-skilling of employees (Delaney and Huselid

1996; Murray and Gerhart 1998; Guthrie 2001; Shaw, Gupta and Delery 2001). Open

communication systems facilitate internal change initiatives by enhancing adaptability of

skills and behaviours of employees (Chan et al. 2004).

We call the class of HR options represented by the HR practices described above as

growth and learning HR options. We posit that firms that face risks of skill obsolescence

and higher demands for new skills are likely to invest in a greater number of growth and

learning HR options.



9/32

Turnover and productivity HR options

Employee turnover is caused by both exogenous (e.g. better job offer) and endogenous

(e.g. job dissatisfaction) reasons, whereas loss of productivity is principally attributable to

employee dissatisfaction and alienation. Sources of employee dissatisfaction cover the

entire spectrum of HR policies of a firm because employee dissatisfaction can arise out ofperceived unfairness of any HR policy.

Above average pay has been found to be associated with higher employee

productivity and lower turnover rate (Arthur 1994; Becker and Huselid 1998; Shaw,

Delery and Gupta 1998; Way 2002). In economics literature, efficiency wage theory-

based arguments have linked higher pay with both higher employee efficiency and lower

intention to quit (Shapiro and Stiglitz 1984; Krueger and Summers 1987). Similarly,

higher employee benefits have also been associated with lower turnover (Arthur 1994;

Shaw et al. 1998).

Financial incentive plans like group-based performance pay has been found to lead to

both higher productivity and longer retention (Huselid 1995; MacDuffie 1995; Ichniowski,Shaw and Prennushi 1997; Becker and Huselid 1998; Guthrie 2001; Paul and

Anantharaman 2003; Collins and Smith 2006). Economics literature also report group-

based performance pay to be effective in aligning the task goals of the individuals with

those of the organisation (Blasi, Kruse, Sesil, Kroumova and Carberry 2000).

Career growth opportunities within the organisation, and merit- and performance-

based promotions lead not only to higher efficiency but also higher employee motivation

and retention (Huselid 1995; Becker and Huselid 1998; Guthrie 2001; Paul and

Anantharaman 2003).

Open communication systems combined with participatory work practices not only

enable the employees to understand the competitive context of the firm but also motivate

them to engage in organisational processes that create competitive advantage (Chan et al.2004; Jansen, Van Den Bosch and Volberda 2005). Employee participatory practices such

as quality circles and team-based work design have been seen to contribute towards higher

productivity and retention (Arthur 1994; Ichniowski et al. 1997; Guthrie 2001; Way 2002;

Paul and Anantharaman 2003). HR practices aimed at increasing employee involvement

such as job enrichment, self-managed teams and quality circles promote employee

empowerment that releases motivation, initiative and flexibility required from employees

to respond to dynamic competitive environment (Adler, Goldoftas and Levine 1999;

Wall, Cordery and Clegg 2002; Cordero, Walsh and Kirchhoff 2005).

Existence of effective employee voice systems such as information sharing, grievance

redressal system or suggestion scheme have been found to be associated with higheremployee morale, productivity and lower turnover rate (Arthur 1994; Huselid 1995;

MacDuffie 1995; Ichniowski et al. 1997; Becker and Huselid 1998; Shaw et al. 1998;

Guthrie 2001; Chan et al. 2004).

Evidences presented above illustrate the HR practices that firms can use as turnover

and productivity HR options to manage uncertainties of return emanating from employee

turnover and declining productivity. Firms that are exposed to risks of employee turnover

and loss of productivity are likely to invest more in turnover and productivity HR options.

HR options and uncertainties of volume and combination

Any HR practice that contributes towards numerical and/or functional flexibilities among

firm employees would be a potential candidate for acting as a HR option to manage

uncertainties of volume and combination.



10/32

Demands emanating out of sudden changes in scale of operation and/or product-mix

(requiring a change in skill-mix) may be met in a number of ways. Team-based working

may help to absorb such fluctuations through multi-tasking, internal reallocation of tasks

or by creating a context for team members picking up a wider repertoire of skills

(Ichniowski et al. 1997; Guthrie 2001). At organisational level, existence of adequate andscalable training facilities and institutional culture of forming task-based temporary

project teams can enable the organisation to manage such variations (Youndt et al. 1996;

Guthrie 2001; Collins and Clark 2003; Collins and Smith 2006). Similarly, practices such

as job rotation and periodic transfers of employees across departments, divisions or units

can help create numerical and functional flexibilities (MacDuffie 1995; Ichniowski et al.

1997; Allwood and Lee 2004; Collins and Smith 2006).

Practices such as employment of temporary or part-time workers to absorb temporary

increases in workload are being increasingly used by the firms (Foote and Folta 2002).

Creating a buffer through additional bench strength is very popular in Indian IT software

industry for meeting the fluctuations in workload.

From the above discussion, it is clear that under conditions of uncertainties of volume

and combination, the HR options that the firm uses relate to capabilities to vary scale of

operation, timing of investment in human resources (e.g. engagement of temporary

workforce) and to switch from one skill to another depending on the change in demand-

mix. We call this combined class of options as scale, timing and switching HR options. We

contend that firms facing significant uncertainties of volume and combination would use

scale, timing and switching HR options to manage them.

HR options and uncertainties of cost

HR practices of a firm as a whole may contribute towards lowering of operating costs bymanaging the firms human resources efficiently (Beer, Spector, Lawrence, Millis and

Walton 1985; Becker and Huselid 1998). Similarly, HR practices that help improve labour

productivity also help to reduce unit labour cost, but they should rather be treated as

productivity-related HR options. The point of consideration here is those specific HR

practices that directly contribute towards financial flexibility of the firm (Atkinson 1984).

Organisational and unit level performance-linked financial incentive plans, rather than

individual-level incentive plans, have been found to render employment costs more

flexible (Gerhart and Milkovich 1990, 1992). Bhattacharya and Wright (2005) also argue

that performance-based incentive plans at firm or unit level generate options to alter costs.

Similarly, firm level profit sharing and gain sharing plans have been found to be associatedwith improved financial performance of the firms (Schuster 1986; Gerhart and Milkovich

1990).

Competitive pressures on the firms to reduce controllable operating costs have led

many firms to adopt or change over to employee benefit schemes that are designed based

on the principle of defined contribution by (rather than defined benefit to) the employees.

Examples are health insurance scheme under which the employer pays only a fixed

premium and annuity-based retirement benefit scheme where the employer periodically

contributes only a fixed sum to a pension fund during the service life of the employee in

the organisation. The common objective underlying the two examples is avoidance of an

unlimited or open-ended, long-term financial commitment by the firm.

We call the class of HR options described above as HR options to make employment

cost variable. These options are likely to be exercised by firms that face considerable

uncertainties of costs.



11/32

HR options and firm performance

The contingency theory, contingent resource-based view and organisations and natural

environment literatures have all shown that managerial perceptions of the exogenous

business environment influence firm strategy which in turn has influence on firm

performance (Aragon-Correa and Sharma 2003; Fiol and OConnor 2003; Verdu-Jover,Llorens-Montes and Garcia-Morales 2006; Nadkarni and Narayanan 2007). As a heuristic

for strategy implementation, managers make a sense of the environmental threats and

opportunities, calibrate them with internal strengths and weaknesses of the firm, and then

engage in a decision process that involves resource investments or divestments whereby

they alter the resource base of their firm to coalign with the perceived demands of the new

environment (McGrath et al. 2004; Sirmon et al. 2007; Teece 2007).

Accordingly, we posit that firms whose human assets are exposed to significant degree

of uncertainties of various types would exercise corresponding types of HR options to

exploit those uncertainties, and the use of such HR options would have positive impact on

firm performance.A number of SHRM scholars have argued that the direct effect of firm HR system is

likely to be on HR outcomes which are the most proximal, and the effect should get

progressively attenuated on increasingly more distal operational and financial outcomes

(Dyer and Reeves 1995; Becker and Huselid 1998; Wright, Gardner and Moynihan 2003).

In strategy literature, Kaplan and Norton (1996, 2001) have also contended that the

strategy map or the causal chain of value creation by the firm starts with skilled, motivated

and empowered employees running the business processes that create and deliver

customer value which, in turn, enables the firm to appropriate stakeholder value by selling

its products and services. Thus, the financial performance lies at a distant end of a causal

chain (Guest, Michie, Conway and Sheehan-Quinn 2003).

We, therefore, argue that the effect of use of HR options on financial performancewould be mediated by operational performance of the firm, excepting in cases where such

options (e.g. HR options to vary employment costs) have a direct monetary impact.

A causal model

On the basis of the above discussions and for firms that are exposed to significant levels of

environmental uncertainties affecting their human assets, we hypothesise a mediated

causal model, as shown in Figure 1, that links the use of HR options of various types with

the operational and the financial outcomes at firm level.

The component hypotheses of the full causal model may be stated as follows:

Hypothesis 1: Effect of growth and learning-related HR options on firm financial

performance would be mediated by operational performance and

positive.

Hypothesis 2: Effect of turnover and productivity-related HR options on firm financial

performance would be mediated by operational performance and

positive.

Hypothesis 3: Effect of scale, timing and switching-related HR options on firm

financial performance would be mediated by operational performance

and positive.

Hypothesis 4: Effect of HR options to vary employment costs on firm financial

performance would be direct (i.e. not mediated by operational

performance) and positive.



12/32

Hypothesis 5: Effect of overall use of HR options on firm financial performance would

be positive.

Method

Sample and survey

A questionnaire-based survey was conducted on Indian IT software development firms

whose human assets are typically exposed to a diverse range of uncertainties. A single

industry design was consciously chosen as one of the study objectives was to validate and

operationalise the concept of HR options. It would have been a difficult and complex

exercise to achieve this objective in a multi-industry context, as firms in different

industries face different types and levels of uncertainties.

Out of about 600 firms enlisted in the NASSCOM database of IT software firms in

India, 505 firms that had a minimum of 50 regular employees and were in existence for at

least 3 years (as of April 2007) were targeted. The selection criteria were based on therationale that (1) firms with less than 50 employees were unlikely to have any formal HRM

system or function and (2) minimum 3 years of continuous operation was considered

necessary to capture the steady state effects of HR practices on firm performance (Wright,

Dunford and Snell 2001). To obtain an accurate assessment of (1) uncertainties faced by

the firms that may affect the future value of their human assets and (2) HR practices (HR

options) actually deployed by the firms to manage those uncertainties, it was decided to get

responses from both the head of operations and the head of HR in each responding firm.

An e-mail request for participation in the study along with a soft copy of the survey

questionnaire was sent to all 505 firms. Two reminder e-mails were sent after gaps of 15

and 30 days. Out of 505 firms targeted, 435 were located in six major cities. Personal visits

were made to these centres to collect data. For the remaining 70 odd firms located in other

towns, two copies of the printed survey questionnaire were also sent by post. Telephonic

contacts were also made to elicit response from the firms.

Growth & Learning

HR Options

Turnover & ProductivityHR Options

Scale, Timing & Switching

HR Options

HR Options to Vary

Employment Costs

Aggregate

Financial

Performance

Operational

Performance

Figure 1. Hypothesised causal model.



13/32

Complete filled-in questionnaires were received only from 116 firms. The response

rate (23%) compared well with that achieved in similar studies in India (Singh 2003) and

abroad (Bhattacharya, Gibson and Doty 2005). Out of 116 questionnaire responses

received, 111 were obtained in a face-to-face setting and 5 were sent by e-mail/post.

After testing for outliers, a final sample of 108 firms was used for further analysis.In the sample, 40 firms had between 50 and 99 permanent employees, 41 firms had

between 100 and 1000, while 27 firms had above 1000 permanent employees. The average

age of firms was 10 years. The respondents were all senior managers (CEOs/vice-

presidents) either from operations or HR. Their length of service in the IT industry varied

between 3 and 30 years. All the respondents had spent a minimum of 1 year in the present

company. There were only 31 female respondents.

For the purpose of data analyses, average score of the two responses received from

each company was used since t-test of differences in means and x2 test for independence

between the two sets of data (one from operating heads and the other from HR heads) did

not indicate any statistically significant differences.

Use of HR options by the firms measurement scale

The questionnaire that operationalised the construct of HR option and measured the extent

of use of HR options by a firm was developed in three phases. In Phase 1, an inventory of

items for the draft instrument was generated through review of the relevant literature (as

reported earlier), followed by personal interviews with seven senior managers working in

IT software companies and two academicians from business schools who were conversant

with the IT industry practices. The interviews were semi-structured. The concept of HR

options was broadly explained to the interviewees; the rest of the interview was open

ended and aimed at gathering information on the specific types of uncertainties faced by

the firms in IT software industry and the typical HR practices deployed by them to

preserve and/or enhance the value of HR assets. In Phase 2, a panel of 16 experienced

senior managers from IT software firms were requested to review the draft questionnaire

and indicate to what extent the items were valid in the context of the actual working of IT

software firms. On the basis of their feedback, suitable modifications were incorporated

into the draft. For instance, an item that indicated use of contingent/temporary workforce

of software engineers to adjust to changes in volume and combination was dropped

because the reviewers unanimously indicated that such a HR practice was never used

by the IT software firms in India. Finally, in Phase 3, the modified draft was pre-tested by

administering it on a sample of 17 managers drawn from the IT software industry.

The final survey questionnaire is incorporated as Appendix 1. It had a total of 43 itemscovering growth and learning (13 items), turnover and productivity (20 items), scale,

timing and switching (7 items) and HR options to vary employment costs (3 items).

Firm performance measures

IT software firms in India, excepting a very few large firms, are unlisted. It is extremely

difficult to get reliable archival data for such firms in the public domain. Accordingly, it

was decided to design the firm performance questionnaire in two parts. In the first part,

perceptual measures (on a 5-point Likert-type scale) were used to capture operational and

financial performance (Appendix 2). The corresponding scale items were chosen based on

a survey of the relevant research (Dyer and Reeves 1995; Delaney and Huselid 1996; Paul

and Anantharaman 2003; Ketkar and Sett 2009). The scale measuring improvements

in operating performance had 10 items covering cost, quality, efficiency, customer



14/32

satisfaction level achieved, etc. Financial performance scale had 5 items measuring

revenue growth, profitability, operating cost efficiency, market share growth and overall

financial performance, benchmarked against the industry average (used as mid-point of the

scale). The respondents were asked to indicate the perceived performance on the relevant

parameters averaged over the past 5 years (3 years for financial performance) so that thescales captured the equilibrium level effects of the HR practices (Wright et al. 2001;

Bhattacharya et al. 2005). The second part sought actual data on sales revenue, operating

profit and employment cost for the last 3 years (20032006). As only 4 firms out of 108

provided these data, it could not be used in data analyses.

Use of perceptual measures as valid representation of the firms objective performance

has been confirmed by a number of studies (Khatri 2000; Deanne, Den and Verburg 2004).

Due to the inherently intrusive nature of financial measures, a large number of SHRM

scholars have preferred to use less intrusive self-reported measures to assess the firm

performance including the firms financial and market performance (Powell 1995;

Delaney and Huselid 1996; Khatri 2000; Paul and Anantharaman 2003). Such self-

reported measures are particularly helpful in obtaining responses on items that are prone to

low or poor responses. They also help to tap and obtain fairly valid responses on critically

important operational performance measures such as those relating to product/service

quality, effectiveness of new product development process, firms ability to attract and

retain customers, and so on (Ketkar and Sett 2009).

Control variables

Two control variables were used: (1) size of the firm (natural log of number of regular

employees) and (2) age (natural log) of the establishment. We argue that a large firm

is likely to have more entrenched HR systems compared with smaller firms and this

inertia may interfere with their ability to introduce necessary changes in their HR system

(Guthrie 2001). Similarly, an organisation tends to grow resistance to change as it becomes

older (Michie and Sheehan-Quinn 2001).

Analyses

Validation of measurement scales

Two measurement scales were used in this study: (1) extent of use of different types of HR

options and (2) measurement of operational- and financial-performance of the firm. None

of the scales used in this study represented any single unified concept. For instance, a set of

diverse practices were grouped under growth and learning HR options because they allwere thought to be addressing a common goal (namely, stability of return) and not because

they shared any common conceptual underpinning. Similarly, the items in the firm

performance measurement scales related to distinct aspects of firm performance (e.g. cost,

quality, sales revenue and market share) and did not represent any unified construct.

A number of scholars (MacDuffie 1995; Youndt et al. 1996) have argued that where a

set of practices are grouped based on the common task they seek to accomplish, it is

unreasonable to expect any clear and meaningful factor to emerge in a factor analysis.

Since factor analysis assumes that the observed indicators are linear combinations of some

underlying factors, grouping of HR practices based upon factor loadings would be a faulty

and misleading exercise.

In such circumstances, the right methodological approach would be to first establish

the content validity of the scale by getting opinions of experts with sound domain

knowledge and then test for internal consistency of the scale items through reliability tests.



15/32

The common logic or the common goal (e.g. stability of return) that a set of HR practices

(e.g. growth and learning-related HR practices) intended to achieve is likely to endow

them with a systemic property that exerts a powerful pull towards internal consistency

within each bundle (MacDuffie 1995, p. 200).

Accordingly, the validation of the scales was done mainly through checks for contentvalidity and internal reliability. However, as a standard protocol, exploratory factor

analysis (EFA) was carried out in each case.

Testing of sub-hypotheses

Hypotheses 1 to 5 were tested using a three-step regression analysis (Baron and Kenny

1986) and the Sobels Test statistic (Sobel 1982) as explained later.

Testing of causal model

The hypothesised full causal model (Figure 1) was tested through structural equationmodelling (SEM) technique using AMOS 7.0, with the covariance/correlation matrix as

input. In order to verify whether the hypothesised model is the best representation of the

data, it was compared with nested models that were theoretically justifiable, apart from a

control model and a non-mediated model (Kelloway 1998).

Following the recommendations in the SEM literature, the following goodness-of-fit

indices were used in addition to the x2 test: (1) root mean square error of approximation

[RMSEA] (absolute fit index; recommended by Byrne 1998), (2) comparative fit index

[CFI] (relative fit index; recommended as the statistic of choice for SEM research by

Byrne 1998), and parsimony comparative fit index [PCFI]. The following cut-off values

were adopted: (1) RMSEA , 0.08 for good fit (Loehlin 2004); (2) CFI . 0.90 for good fit,

and 0.800.89 for adequate fit (Byrne 1998); and (3) PCFI $0.50 (Mulaik et al. 1989).

Results

Validation of measurement scales

Use of HR options

EFA with oblique rotation performed with 43 items revealed 12 factors with eigen values

more than 1 that accounted for 69.98% of total variance. However, combinations of items

of none of the factors that emerged were theoretically meaningful.

Test for scale reliability showed high reliability for the composite scale (Cronbachs

a 0.92). The three (out of four) constituent sub-scales, namely, growth and learning(13 items); turnover and productivity (20 items); and scale, timing and switching (7 items)

also exhibited high degree of reliability with values of Cronbachs alpha being 0.79, 0.88

and 0.73, respectively. The sub-scale on employment cost which had only three items

showed a low reliability score (Cronbach a 0.46).

Content validity of the scale was ensured through the validation process explained

earlier.

Firm performance

EFA indicated existence of two distinct factors; both with eigen value more than 1.

The first factor comprise all the five items of the financial performance sub-scale, the

second factor had 10 items associated with the sub-scale of operating performance.

The two factors explained a total variance of 58.8%. EFA, therefore, fully supported the



16/32

postulated factor structure of the scale. Because of the very objective nature of this scale,

no further validity tests were considered necessary.

The composite scale as well as the operational- and financial-performance sub-scales

exhibited high reliability with the values of Cronbachs alpha being 0.91, 0.90 and 0.87,

respectively.

Descriptive statistics

Table 1 presents means, standard deviations (SDs) and bivariate correlations among the

variables.

An examination of means indicate that the respondent firms made significant use of

HR options of different types. HR options to vary employment costs had the lowest mean

but the highest SD among the various types.

The four dimensions of HR options are significantly and positively correlated with one

another. Three out of four dimensions of HR options, namely, options relating to growth andlearning; turnover and productivity; and scale, timing and switching, all had strong positive

correlationswith the various dimensions of bothoperating- and financial-performance of the

firms. Use of option relating to variable employment cost had significant positive correlation

with operating cost efficiency, market share and overall firm performance but not with the

remaining dimensions of firm performance. On an overall basis, it canbe stated that the inter-

correlations between the variables of interest in the study followed the expected patterns.

Test of hypotheses: multiple regression analyses

For testing the mediated relationship as hypothesised under Hypotheses 1 to 5, a three-step

procedure was followed (Baron and Kenny 1986; Kenny, Kashy and Bolger 1998). First,the mediator (z) was regressed on the independent variable (x) [z b0 b1x ]; second,

dependent variable (y) was regressed on the independent variable (x) to calculate the direct

effect [y c0 c1x ] and, third, to calculate the indirect effect, dependent variable (y) was

regressed on the independent variable (x) by introducing the mediator variable (z) into the

equation [y a0 a1x a2z ]. Mediation is shown to exist if two conditions are fulfilled:

(1) standardised beta coefficients b1 and c1 are both significant and (2) a1 is either

non-significant or is less than c1 (non-significant a1 indicates full mediation; Baron and

Kenny 1986; Kenny et al. 1998). To estimate the strength of mediation, Sobels Test

statistic (Sobel 1982) was calculated for each mediated model.

Results given in Table 2 support the hypothesised linkages between HR options andfinancial performance. All mediations are partial which indicated that the related HR

options also had some significant direct effects on financial performance.

Test of full causal model

The hypothesised model showed good fit with data (x2 2690.37, df 1529, p , 0.001;

x2/df 1.76; RMSEA 0.08; CFI 0.64; PCFI 0.61) in spite of significant x

2 test

(Bentler 1990; Kelloway 1998). The x2 per degree of freedom was well within the

acceptable range (#3). RMSEA and PCFI both showed very good fit though the value of

CFI was lower than that required for adequate fit ($0.8). Thus, the measurement model

showed reasonably good fit. In the structural model, three out of five paths were strong and

significant (Figure 2). Paths from growth and learning, and turnover and productivity

related HR options to operational performance failed to be statistically significant.



17/32

Table1.

Descriptivestatisticsandzero-ordercorrelations.

M

SD

1

2

3

4

5

6

7

8

9

10

HRoptionsused

1.Grow

thandlearningoptions

5.22

0.70

1

2.Turnoverandproductivityoptions

5.38

0.71

0.64**

1

3.Scale

,timingandswitchingoptions

5.55

0.69

0.50**

0.55**

1

4.Optio

nstovaryemploymentcosts

4.39

1.05

0.30**

0.22*

20*

1

Firmperformance

5.Operatingperformance

4.08

0.64

0.35**

0.40**

0.34**

0.05

1

6.Sales

revenue

3.69

0.78

0.25**

0.42**

0.30**

0.11

0.35**

1

7.Profitability

3.65

0.82

0.36**

0.41**

0.34**

0.10

0.37**

0.73**

1

8.Operatingcostefficiency

3.57

0.76

0.32**

0.32**

0.38**

0.30**

0.26**

0.50**

0.50**

1

9.Mark

etshare

3.56

0.82

0.30**

0.37**

0.27**

0.19*

0.28**

0.57**

0.50**

0.38**

1

10.Overallfirmperformance

3.83

0.74

0.34**

0.41**

0.34**

0.25**

0.38**

0.69**

0.70**

0.50**

0.72**

1

Notes:N

108,*p,

0.05,**p,

0.01;one-tailedtest.



18/32

Table2.

Mediatedregression:HRoptions,operatingperformanceandaggregatefinancialperformance.

Hypothesis:IV

MV

DV

b1

c1

a1

Sobelstatistic

Remarks

H1:Grow

thandlearningoptionoperatio

nalperformance

financial

performance

0.35

***

0.32***

0.23*

2.23*

Partialmediation(a1

,

c1)

H2:Turn

overandproductivityoptionop

erationalperformance

financial

performance

0.42

***

0.41***

0.32***

1.98*

Partialmediation(a1

,

c1)

H3:Volu

meandcombinationoptionope

rationalperformance

financial

performance

0.34

***

0.39***

0.31***

2.08*

Partialmediation(a1

,

c1)

H4:Employmentcostoptionoperationalperformance

financial

performance

0.05

0.16

0.14

0.51

Nomediation

H5:OverallHRoptionindexoperationalperformance

financial

performance

0.50

***

0.38***

0.28**

1.89

Partialmediation(a1

,

c1)

Notes:N

108,*p,

0.05;**p,

0.01;***p,

0.001;one-tailedtest;a1,b1,c1

stan

dardisedregressioncoefficients;IV,independentvariables;MV,mediatingvariablesandDV,

dependent

variables.



19/32

On the basis of the evidence adduced during the testing of Hypotheses 1 to 5 that HR

options also have significant direct effects on financial performance as also the conceptual

rationale that investments in HR options should ultimately affect financial performance, the

hypothesised causal model was next compared with a nested model (Nested model 1) that

had three additional paths one each from growth and learning, turnover and productivity,

and scale, timing and switching HR options, respectively, to financial performance.

Nested Model 1 showed only moderate fit with data (x2 2850.26, df 1526,

p , 0.001; x2/df 1.86; RMSEA 0.09; CFI 0.59; PCFI 0.57). In the structural

model (Figure 3), path coefficients of paths linking turnover and productivity as well as

scale, timing and switching options with operational performance were significant only at

p # 0.10 level and those linking with financial performance were not statistically

significant. The path linking HR options to vary employment cost with financial

performance was significant only at p # 0.10 level.

Since both the measurement and structural models of the Nested model 1 did not

exhibit adequate fit with data and also the nested model had a larger x2 value than the

hypothesised model (which indicated a poorer fit), it was decided to test the hypothesised

model with a second nested model (Nested model 2) which was created by removing the

two paths in Nested model 1 that failed to achieve statistical significance. This

modification was theoretically plausible in as much as it implied that the effects of these

two HR options on aggregate financial performance were fully mediated by operational

performance of the firm.

Nested model 2 showed reasonably good fit with data (x2 2677.11, df 1528,

p , 0.001; x2/df 1.75; RMSEA 0.08; CFI 0.65; PCFI 0.62). The x2 per degreeof freedom was well within the acceptable range (#3). RMSEA and PCFI both showed

very good fit though the value of CFI was lower than that required for adequate fit ($0.8).

Growth & Learning

HR Options



HR Options

HR Options to Vary

Employment Costs

Aggregate

Financial

Performance

Operational

Performance

0.10

0.10

0.45

0.21*

0.52***

0.390.33

Figure 2. Hypothesised causal model: test results.Notes: Values in bold letters denote the standardised beta coefficients and values on the top rightcorner of each variable denote squared multiple correlations. Dotted double-arrows on the leftsignify inter-correlations between the variables. N 108;

p , 0.10; *p , 0.05; **p , 0.01 and

***p , 0.001; two-tailed test.



20/32

In the structural model (Figure 4), four out of six path coefficients were strong and

significant. Paths from growth and learning, and turnover and productivity related HR

options to operational performance failed to be statistically significant as in the case of

the hypothesised model. Interestingly, however, the direct path from growth and learning

HR option to aggregate financial performance emerged as strong and significant.

The control model (only direct paths from the two control variables to financial

performance) as also the non-mediated model (direct paths from the four HR components

0.16

0.02

0.39

0.19

0.22*

0.33**Growth & Learning

HR Options



HR Options

HR Options to Vary

Employment Costs

Aggregate

Financial

Performance

Operational

Performance

0.29*

0.23 0.30

0.12

Figure 3. Nested model 1.Notes: As in Notes of Figure 2.

0.14

0.45

0.30**

0.37

0.08

0.40**

0.42

0.10

Growth & Learning

HR Options

Turnover & Productivity

HR Options


HR Options

HR Options to Vary

Employment Costs

Aggregate

Financial

Performance

Operational

Performance

Figure 4. Nested model 2.Notes: As in Notes of Figure 2.



21/32

Table3.

Comparativeevaluationofthehypothesisedandnestedcausalmodels.

Model

x

2

(df)

x

2/df

Dx

2,

Ddf

RMSEA

C

FI

PCFI

Hypothes

isedmodel

2690.37***(152

9)

1.76

0.08

0

.64

0.61

Firstnestedmodel

2850.26***(152

6)

1.86

()159.89***.3(incomparisonwiththehypoth

esisedmodel.)

0.09

0

.59

0.57

Secondn

estedmodel

2677.11***(152

8)

1.75

(2)13.26***,1(incomparisonwiththehypothe

sisedmodel.)

0.08

0

.65

0.62

Notes:N

108;***p,

0.001;one-tailedtest.



22/32

to financial performance) showed poor fit with data and were, therefore, considered

non-viable.

Comparative evaluation of the hypothesised and the two nested models

The hypothesised model was compared with the nested models using the change in x2

test(Bentler and Bonett 1980; Thompson 2004) as also the three fit indices. The results are

presented in Table 3.

Nested model 1 had a significantly larger x2 value and inferior fit indices than the

hypothesised model. However, Nested model 2 showed better representation of the data

than the hypothesised model. The x2 value for Nested model 2 was significantly lower

(indicating better fit), and the other fit indices were favourably comparable with the

corresponding indices of the hypothesised model. Therefore, Nested model 2 (Figure 4)

emerged as the best-fit model. In Nested model 2, the four dimensions of HR options and

operational performance together explained 42% of variance in aggregated financial

performance against 33% of such variance explained in the hypothesised model.

Test for common method variance using Harmans test

Cross-sectional and self-reported data are susceptible to common method biases.

Following the procedure adopted by several scholars (Iverson and Maguire 2000), a post

hoc test was conducted using confirmatory factor analysis to test the hypothesis that a

single factor (common method) can account for all of the variance in the data. All items of

both the independent and the dependent variables were included in a single factor and the

fit indices were examined. The single factor model showed poor fit with the data

(x2 5270.88; df 2414; x2/df 2.18; RMSEA 0.08; CFI 0.37; PCFI 0.36)

with values of both CFI and PCFI being way below the acceptable range, and the value ofx2 being much higher than the hypothesised or nested models. Although this test does not

eliminate the possibility of method bias, it provides evidence that inter-item correlations

are not driven purely by method bias (Podsakoff, MacKenzie and Podsakoff 2003).

Discussion and conclusion

This study hopes to make two important contributions to the literature. First, it elaborates

and refines the conceptualisation of HR options made by Bhattacharya and Wright (2005)

and then operationalises it in terms of specific HR practices. Second, it empirically

investigates the linkage between use of HR options and the firms operational- and

financial-performance.

HR options

Bhattacharya and Wright (2005) developed only a general framework that linked different

types of environmental uncertainties likely to be faced by firms with a set of generic HR

practices that may mitigate the impact of a given type of uncertainty. We extensively

reviewed the literature to identify a more detailed and nuanced set of HR practices with

option value. For example, Bhattacharya and Wright (2005) have posited team-based

working only as a switching option. However, team-based work design which is an aspect

of the same practice has been associated with higher productivity and employee retention

(Arthur 1994; Ichniowski et al. 1997; Guthrie 2001; Way 2002; Paul and Anantharaman

2003).

Development of the draft questionnaire based on literature review was the first step

towards operationalisation. This was followed by the three-stage validation process with



23/32

the help of industry and academic experts to arrive at an industry (IT software)-specific list

of HR practices, which are considered by the firms in the IT industry as actually or

potentially useful for exploiting the uncertainties faced by their human assets.

It is pertinent to point out that operationalisation of HR options needs to be industry

specific as the profile of uncertainties vary across industries, and in some cases regulatory

framework and entrenched industry practices may rule out use of certain practices (e.g. use

of contingent workforce).

Each item of the 43-item questionnaire developed (Appendix 1) represented a specific

aspect of a HR practice that addressed one, or more than one, type(s) of uncertainties(Figure 5). For example, there were five items that could be captured under the rubric of

career planning and promotion as a HR practice. However, all the five items did not

address the same type of uncertainty. Three of the items (item nos. 8, 11 and 12 of the

questionnaire) related to that aspect of career planning and promotion policy that helped

the firm to develop and acquire superior and/or new skills and thereby address the

uncertainties of return. One item (item no. 14) that related to employee career growth plans

was presumed to help the firm in lowering voluntary employee turnover that was identified

to be a major threat faced by the Indian software firms. The fifth item (Item no. 42)

measured the extent to which the promotions were performance and merit based. This

element was aimed at countering the uncertainties due to loss of employee productivity by

providing incentives for superior performance.

Similarly, there were as many as seven items that belonged to the HR practice of

contingent financial rewards. Decision to incorporate these seven items was made based

Staffing & Related Practices

1. Recruitment & Selection [Items: 1,2] (A1)

2. Performance Appraisal System [5]A1, [24,25,28] (A3)

3. Career Planning & Promotion [8, 11, 12]A1, [14]A2, 42 (A3)

4. Training [3,4,7] (A1), [32] (B)

5. Job Rotation & Transfers [30, 39] (B)

6. Bench Strength Management [29] (B)

Employee Voice Systems

7. Employee Participation [17,18,20,21] (A2)

8. Grievance Handling/Attitude Survey/Exit Interview

[15, 19, 23] (A2)

9. Employee Communication [6] A1, [22] (A3)

Reward Systems

10. Competitive Pay [40, 41] (A2)

11. Contingent Financial Rewards [9, 10] A1, [13] A2, [26] A3,

[36, 37, 43] (C)

12. Defined Contribution based Retirement Plans [38] (C)

Work System

13. Job Design & Employee Empowerment [16] A2, [27] (A3)

14. Team Working [31, 33, 34, 35] (B)

Uncertainties of

Return due to:

# Turnover (A2)

# Productivity

(A3)

Uncertainties of

Volume &Combination (B)

Uncertainties of

Return due to:

# Skill Obsolescene

/ New Skills (A1)

# Uncertainties of

Costs (C)

Figure 5. Types of uncertainties and HR options: multiplexed linkages.Notes: Numbers within [ ] represent serial number of the item of the questionnaire (Appendix 1).Letter(s) within ( ) indicate the type of the uncertainties addressed by a given HR practice. As isevident, a number of HR practices address more than one type of uncertainties.



24/32

on the recognition that there can be a variety of parameters to which financial rewards can

be linked and that the architecture of the contingent payment system may vary from simple

to multi-parameter and multi-tier. Two items (item nos. 9 and 10) related to skill

development as the contingency parameter. Firms using skill-based pay and/or rewarding

acquisition of new skills by employees would rate high on these items. One item (item no.13) related to linking financial rewards to longer employee tenure and another (item no.

26) to improved productivity. Two items (item nos. 36 and 37) were supposed to measure

the extent of use of the contingent financial rewards directly to reduce labour cost per unit

of output. Item no. 43 used a progressive scale that rated the firms using a multi-parameter,

multi-tier architecture of contingent financial rewards higher on that scale.

HR options firm performance linkage

From the standpoint of both theory and practice, an obvious question is what, if any, is the

effect of HR options, which are the investments that the firms make on human assets, on

financial performance of the firms. A related question is how do HR options influence

financial performance.

The study shows that HR options definitely create value as they explain 37% and 42%

of the variance in operational- and financial-performance of the firms, respectively.

However, the process through which they affect financial performance depends on the type

of HR options being used.

Growth and learning HR options seem to influence the financial performance directly.

So does the HR options to vary employment costs. However, the effects of other two types

of HR options, namely, turnover and productivity, and scale, timing and switching, on

financial performance is indirect and mediated by operational performance of the firm.

The dynamics of product market competition in Indian software industry is driven bycontinuous development of superior products and services using the state of the art

technology. In such a scenario, market success such as growth in sales revenue,

profitability and market share are driven directly by the firms ability to continuously renew

and upgrade the skills of its employees. For instance, in an industry that is characterised by

constant technological improvement, customers would invariably prefer new and

innovative products that utilise the new technologies. Continuous development of such

new and innovative products, in turn, is dependent upon the firms ability to concomitantly

develop new employee skills. Only those firms which can offer such superior customer

value propositions are likely to register faster sales revenue growth and/or higher market

share, particularly in a rapidly expanding and technologically evolving market which isalso highly competitive. In such a market context, the nexus between development of

employee skill and superior financial performance is likely to be explicit and direct.

An examination of the five constituent items of the financial performance scale would

reveal that four out of the five items are related to superior financial performance by the

firm against market competition. On the other hand, the growth and learning HR options

sub-scale had 12 items all of which related to acquiring and development of new and

superior skills dictated by evolving market needs.

It is, therefore, not surprising to find that use of growth and learning HR options was

directly related to superior financial performance of IT software firms in India.

The above findings enrich the state of knowledge in the field in two important ways.

First, it provides empirical evidences in support of the conceptualisation made by

Bhattacharya and Wright (2005), and second, it also unravels how different types of HR

options are likely to affect firm performance at different (operational/financial) levels.



25/32

Implications for practice

The concept of HR options is both novel and powerful. It draws upon the accumulated

knowledge and experience in the fields of real options and financial options. It should force

the practicing managers to look at the discipline of HRM from a completely new

perspective. This new perspective is likely to deepen their knowledge about how they shouldmanage human resources so that they not only preserve but also enhance its future value, and

how the investments they make on human assets can create organisational capabilities that

help their firms to achieve sustainable competitive advantage in a dynamic environment.

In tangible terms, the inventory of HR practices that appear in the survey questionnaire

itself provides a direct guidance to the managers about the various types of HR practices or

various facets of a given HR practice, which have option value. Discerning managers

would also note that a firms insurance against environmental uncertainties lies in

choosing a series of such options as bundles as the uncertainties and the options are

connected through multiplexed linkages with a particular type of uncertainty being

addressed by a mutually reinforcing set of HR practices, and complementarily, a given HRpractice managing the effects of several types of uncertainties (see Figure 5).

However, the managers need to know that to get superior business results, investments

in HR options, like any other investments, must be founded upon a sound business strategy

that flows from a clear understanding of the business challenges. Without this

strategic intent, HR options would not lead to superior firm performance. There must be

a strategic fitbetween the strategy that the firm is pursuing and the battery of HR options that

the firm is investing in. Moreover, external fit with business strategy should be

complemented with internal fit(consistency) between the HR practices chosen to support

the strategy.

The concept of strategy map and its aligned concept of HR value chain should sensitise

the managers about the process through which HR options lead to financial and marketresults. As this study has shown, it is important to note that causal paths may differ with the

type of HR options in use. HR options relating to growth and learning, and variable

employment costs have been found, at least in this study, to have a direct link with

financial and market performance of the firm; whereas the effects of turnover and

productivity, and scale, timing and switching options on financial performance seem to be

mediated by operational performance.

This research brings to the fore how critical it is for the firms to invest in appropriate

HR options to achieve superior firm performance in a turbulent environment. By providing

a complete range of findings, from operationalisation of HR options to their relationships

with firm performance, this research hopes to empower the practicing managers with thenecessary concepts and tools to develop proper investment strategies for managing

the human assets of their firms.

Limitations of the study

The cross-sectional nature of the study is its major limitation. There is expected to be an

inevitable time lag between adoption of a HR practice and before its results start showing

up (Wright, Gardner, Moynihan and Allen 2005). This study does not take such temporal

factors into account. Future research based on panel data or cross-sectional studies

conducted in phases may lead to further refinements of the findings.

The scales used in this study contained in total of 69 items and the causal models tested

were quite complex. Though the results actually obtained were fairly satisfactory, the

SEM method for analysing such complex models and with so many indicators called for a



26/32

larger sample size than 108. We could not get responses from about 400 other firms in the

industry in spite of our best efforts.

Directions for future researchFuture studies may verify the findings of this study through replication as well as by

investigating the relationships in other industry contexts. Replication studies are needed

because in this study, some of the hypothesised linkages were either not supported or did

not come out as strongly as one would have expected.

This study tried to operationalise the concept of HR options and investigate their

effects on firm performance in respect of core group(s) of employees. Lepak and Snell

(2002) suggest that different employment modes (comprising different groups of

employees) are associated with different levels of human capital value and uniqueness

and, therefore, firms should use HR configurations (of practices) which are consistent with

the particular employment mode. Future studies should explore the role of HR optionswith respect to different groups of employees.

Another interesting area would be to study the multiplexed linkages between the

different types of uncertainties and the various combinations of elements of HR practices

(Figure 5). It is quite plausible that a specific bundle of elements from different HR

practices may be more effective in managing a particular type of uncertainty because of

the synergy they create through their complementarities. Effective bundle configurations

may again vary with the industry and/or type of strategy being pursued by a firm.

References

Adler, P., Goldoftas, B., and Levine, D. (1999), Flexibility Versus Efficiency? A Case Study ofModel Changeovers in the Toyota Production System, Organization Science, 10, 43 68.

Allwood, J.M., and Lee, W.L. (2004), The Impact of Job Rotation on Problem Solving Skills,International Journal of Production Research, 42, 5, 865881.

Amram, M., and Kulatilaka, N. (1999), Real Options: Managing Strategic Investment in anUncertain World, Boston, MA: Harvard Business School Press.

Aragon-Correa, J.A., and Sharma, S. (2003), A Contingent Resource Based View of ProactiveCorporate Environmental Strategy, Academy of Management Review, 28, 1, 71 88.

Arthur, J.B. (1994), Effects of Human Resource Systems on Manufacturing Performance andTurnover, Academy of Management Journal, 37, 3, 670687.

Atkinson, J. (1984), Manpower Strategies for Flexible Organizations, Personnel Management, 16,2831.

Barney, J. (2001), Is the Resource-Based View a Useful Perspective for Strategic ManagementResearch? Yes, Academy of Management Review, 26, 4156.

Baron, R.M., and Kenny, D.A. (1986), The Moderator-Mediator Variable Distinction in SocialPsychological Research, Journal of Personality and Social Psychology, 51, 6, 11731182.

Becker, B.E., and Huselid, M.A. (1998), High Performance Work Systems and Firm Performance:A Synthesis of Research and Managerial Implications, in Research in Personnel and Human

Resources Management(Vol. 16), ed. G.R. Ferris, Greenwich, CT: JAI Press, pp. 53101.Beer, M., Spector, B., Lawrence, P., Millis, D., and Walton, R. (1985), Human Resource

Management: A General Managers Perspective, New York: The Free Press.Bentler, P.M., and Bonett, D.G. (1980), Significance Tests and Goodness of Fit in the Analysis of

Covariance Structures, Psychological Bulletin, 88, 588606.Bentler, P.M. (1990), Fit Indexes, Lagrange Multipliers, Constraint Changes and Incomplete Data

in Structural Models, Multivariate Behavioral Research, 25, 2, 163172.Bhattacharya, M., Gibson, D., and Doty, D.H. (2005), The Effects of Flexibility in Employee Skills,

Employee Behaviors, and HR Practices on Firm Performance, Journal of Management, 31, 4,622640.



27/32

Bhattacharya, M., and Wright, P.M. (2005), Managing Human Assets in an Uncertain World:Applying Real Options Theory to HRM, International Journal of Human Resource

Management, 16, 6, 929948.Black, E., and Scholes, M. (1973), The Pricing of Options and Corporate Liabilities, Journal of

Political Economy, 81, 637659.

Blasi, J., Kruse, D., Sesil, J., Kroumova, M., and Carberry, E. (2000), Stock Options, CorporatePerformance and Organizational Change, Oakland, CA: The National Center for EmploymentOwnership.

Bowen, D.E., and Ostroff, C. (2004), Understanding HRM-Firm Performance Linkages: The Roleof the strength of the HRM System, Academy of Management Review, 29, 2, 203221.

Bowman, E.H., and Hurry, D. (1993), Strategy Through the Option Lens: An Integrated View ofResource Investments and the Incremental Choice Process, Academy of Management Review,18, 4, 760782.

Brush, T.H., and Artz, K.W. (1999), Toward a Contingent Resource-Based Theory: The Impactof Information Asymmetry on the Value of Capabilities in Veterinary Medicine,Strategic Management Journal, 20, 223250.

Budhwar, P.S., Luthar, H.,

the real option

Documents