By Mary F. Cook and Scott B. Gildner
2006, 236 pages, Paperback with CD-ROM
SHRMStore Item #: 61.15002
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Making an Outsourcing Decision
Understanding the strategic implications and practical steps that you should take when deciding to outsource is important. You should weigh the advantages against the risks carefully and thoughtfully, because outsourcing decisions usually represent a permanent change in strategy and have long-term implications. Careful analysis is required to ensure that the outsourcing strategy will meet your organization’s financial and business objectives and to confirm that the vendor marketplace can sustain or exceed current service levels. In addition, it is important to focus on the process of outsourcing and the timing of the change. Such a significant change in the way that a company does business should come in stages that can be planned, implemented, and managed successfully over time.
Understanding the Nature of the Decision
The first step in making the decision to outsource is to clearly identify the nature of the decision. In particular, are you making a basic, tactical “make versus buy” decision, or are you potentially pointing your organization in a new strategic direction from which you are unlikely to return. For example, the decision to hire an external recruiter to outsource some of your staffing requirements can be easily reversed, and such a decision can stand on its own merits. Conversely, outsourcing a more complex area such as defined benefit administration— particularly if it involves a conversion to a vendor’s proprietary systems platform—is a strategic decision that is likely to be maintained into perpetuity. So although the decision-making process follows the same steps, strategic outsourcing decisions deserve more care, due diligence, and management concurrence than do tactical outsourcing decisions.
Strategic outsourcing decisions—those decisions that change the delivery strategy of an organization—typically go through a preliminary analysis phase. This phase of considering outsourcing is often called a visioning phase. Usually a feasibility study is done at this point. The objectives of this phase are as follows:
- Identify the specific services that can be outsourced in support of the strategic objectives that have been established.
- Identify the systems and technological functionality that might be acquired through outsourcing.
- Identify the kind of cost savings or productivity improvements that would be required to support the decision to outsource the function.
- Begin to consider the effect that outsourcing would have on the organization and the change management that would need to be performed.
Although it is relatively easy to identify those noncore functions that can and perhaps should be outsourced in an academic sense, many organizations need to come to this conclusion as part of an overall educational process. Ideally, all transactional activities would be included in the analysis of the outsourcing alternative. The decision to retain specific activities that are potentially strategic for the organization can be made after the vendors’ capabilities have been taken into account, later in the process.
Visioning provides a useful framework for a broad segment of the HR functional leaders to openly discuss and analyze their processes in a creative environment. This visioning exercise can be a valuable first step in the outsourcing process.
Defining the Scope of Services for Consideration
The most important step in any outsourcing decision-making process is to clearly define the scope of the services that are being considered for outsourcing. Too often, organizations make the mistake of assuming that there is an industry standard definition of outsourcing for various services. However, the outsourcing marketplace for most HR services has developed to satisfy a wide variety of potential clients. Thus, the potential providers for any specific service will include software application developers; outsourcing providers for the small, middle, or large markets; co-sourcing organizations; third-party administrators; and consulting firms. To the extent that those organizations successfully address the needs of their specific target market, they will believe that they are in the general outsourcing marketplace for the services you require.
For example, it is not uncommon for companies to issue a request for proposal (RFP) for payroll services only to find that it is very difficult to compare services and prices, given the variation in the marketplace for defining in-scope versus out-of-scope services. But for small companies, payroll administration merely involves producing payroll checks and advices on a schedule, including determining and reporting tax and other deductions. However, larger companies may want their payroll administrator to perform customer service functions related to changes in tax elections, to administer garnishments, or even to provide data files to other organizations. So it is easy to see how misunderstandings can arise between purchasers and sellers of outsourced services.
To avoid this confusion -- or, worse yet, the establishment of a relationship that does not meet the needs of your organization -- you must take the time to develop a detailed set of requirements for the function you are interested in outsourcing.
Calculating Baseline Costs
The next step, after identifying your business requirements, is to calculate the baseline cost of administration prior to outsourcing. Although the ultimate decision to outsource may depend largely on nonfinancial factors, such as a desire to gain access to modern technology, all outsourcing decisions require an analysis of the effect of the decision on operating costs.
Capturing the current (i.e., baseline) cost of administration in such a way that it can be compared to the cost of outsourcing may prove more complex than originally envisioned. Every organization tracks its internal costs in a way that makes the most sense for that particular organization. Outsourcing organizations, however, tend to track their costs on a client-by-client basis so that they can assess the profitability of each assignment. Therefore, their model will be designed to specifically identify all of the costs related to the provision of administrative services. Your organization may not be a service organization. It may be a large manufacturing or retail organization that is more interested in tracking the cost of inventory or goods produced. Thus, the internal budgets for staff functions like human resources may not contain all of the costs associated with performing these services. Common examples of relevant cost items that may not be included in HR functional budgets include rent, management overhead, IT support costs, HR systems operating costs, HR staff contained in business operating budgets, depreciation on capital investments, and third-party agreement fees and expenses. But all of those relevant costs must be captured in order to compare the cost of outsourcing to the current cost of administration internally.
There is a trick to ensuring that you have captured all of your current internal administrative costs. You should set up an analysis of your current costs as if you were an outsourcing provider. Under this approach, you would build your analysis to include the following broad categories of costs:
Direct staff expenses. This category includes all of the costs associated with the functional staff that is directly involved in providing the services.
Operating expenses. This category includes all of the nonstaff expenses associated with providing the services.
External service providers. This category includes all of the third-party costs (if any) already associated with providing the services.
Indirect staff expenses. This category consists of additional staff costs that are contained in other functional budgets within your organization, such as the IT and legal budget or the budgets of various field locations.
Once baseline costs are developed, the next step is to compare them against market benchmark data. The purpose of this comparison is to get an idea -- before you approach the provider community -- of whether you are likely to be able to establish a positive business case for outsourcing. In addition, comparing your baseline costs against marketplace benchmarks can provide you with confirmation that you have, in fact, identified all of your costs. Otherwise, your numbers may look unusual relative to the benchmark data.
There are several ways to develop benchmark data for comparison purposes. First, you may want to contact peer organizations to see if they have analyzed their functional costs. Second, you may want to review published data through an Internet search. Third, you may want to approach associations or organizations that benchmark HR functions as one of their services. Or, finally, you can ask vendors to provide detailed cost information that is based on their experience with similar organizations seeking similar services.
Note that benchmark data, though a useful tool, require some careful validation before those data can be applied to your outsourcing decision-making process. In particular, most benchmark data include information taken from a wide variety of organizations without any attempt to segregate the data for comparability. Therefore, it is sometimes necessary to adjust the benchmark data, either explicitly or implicitly, before using them in a direct comparison against your baseline costs.
Three factors that have a significant effect on benchmark data are
- Size of the organization
- Complexity of the services provided
- Volume of activity of the services under consideration
Of those three, the first and last have the greatest effect on most HR activities. For example, the cost of administration for a firm with 100,000 employees, on a per employee basis, is likely to be 50 to 75 percent of the same cost for a firm with just 10,000 employees, and possibly less than half of the cost of a firm with 1,000 employees. Program complexity also affects the cost of HR administration, although less than is commonly assumed. Generally, complexity will increase the cost of administration by 5 to 15 percent relative to industry standard pricing for any consistent set of services and size of organization.
Finally, not all organizations must support the same volume of activity in various HR functions. For example, a retailer that has 100 percent annual turnover has different requirements for its recruiting and staffing function than does a high-technology organization that has 10 percent turnover and is primarily concerned about hiring the best software engineers.
For all of those reasons, it can be difficult to find benchmarking data that are specific enough for comparison against cost baselines. Increasingly, however, such information is becoming available as more organizations monetize the cost of their administration by outsourcing.
Identifying Strategic Alternatives
The next step in analyzing the feasibility of outsourcing is to identify the various strategic alternatives. At a minimum, you should analyze the following alternatives:
The status quo scenario. Keep delivery in its current state, with minimal investment in new or enhanced capabilities.
The sustainable scenario. As in the case of the status quo scenario, keep delivery in its current state, but allow for a reasonable amount of investment in new technology to provide market-competitive services to employees.
A co-sourcing scenario. For example, implement a new point solution, such as sourcing certain aspects of the services like call center support to an external organization.
The outsourcing scenario. Shift responsibility for the day-to-day management of the function under consideration to a third-party organization.
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