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How to Calculate and Maximize Outsourcing ROI
 

By Mikio Manuel   11/14/2007
Mark Henry, CEO of MasterMind Inc.

Here is a formula you can use to determine whether outsourcing an HR function is a good choice. Consider risk vs. reward and the cost of not using staff time more effectively, as well as cost of staff time, when calculating whether it's better to outsource.

The Starting Gate
Many years ago I was part of a 45-person Human Resources department located downtown in Washington, D.C. We had seven service centers across the country staffed by another 125 professionals. We employed consultants from time to time, mostly to help out with special projects, but the norm was to administer almost all of our HR programs in-house.

It may have been a Freudian slip or it may have been a projection of my thoughts or feelings onto the outside world. One day my colleague in the next cubicle picked up his phone and answered, just like we all did. But this time it sounded different. I'm pretty sure he said "Human Racehorses."

I asked him about it and he assured me that he did say "Human Resources", but from that day forward the event took on a life-and a meaning-all its own. I realized it was not unusual for five or six of my coworkers to put in a full eight-hour day on any given Saturday. One afternoon I had a chance to chat briefly with the department head and awkwardly asked when the pace finally slowed down around the office.

"October," she said.

Five years later I reminded her of this conversation. She smiled and said, "I never said what year."

The First Turn
More recently, I was scheduled to meet with an HR director from a different company to discuss the benefits of outsourcing. She walked into the meeting and immediately asked which of her people I recommend she fire if part of her HR operation were outsourced. Instead of responding directly, and remembering my experiences in D.C., I asked her a few questions:

  • How many good ideas and value-added projects do you have on file that you'd like to implement, some day?

  • How many on your staff stay late, come in early or give up all or part of their weekend to complete day-to-day tasks?

  • How much of your budget have you spent on consultants and outside experts to initiate special programs that your own people could have planned and implemented if they had the time?

  • How much more satisfied do you think your people would be if you outsourced the repetitive tasks and allowed your people to focus on the real, strategic initiatives?

By the end of the meeting she thanked me for my time and was pleased with the prospect of redeploying one of her best staffers to tackle a high profile, long overdue project with the potential to benefit employees at all levels in her organization.

Into the Stretch
Whether your Human Resources department is large or small, whether your organization is local or regional in scope or extends beyond national borders, you can probably relate to one or both of these anecdotes. So, how do you determine if outsourcing can make HR administration less challenging and more gratifying? How do you know if the answer is cost effective?

First, analyze typical HR activities on a risk vs. reward basis. In his book Jack: Straight from the Gut, Jack Welch shares his experience that outsourcing provides inherent value. He states, "…don't own a cafeteria: let a food company do it! Don't run a print shop: let a printing company do that. Understand where your real value added is and put your best people and resources behind that."

He continues, "…back rooms by definition will never be able to attract your best. We converted ours into someone else's front room and insisted on getting their best."

Take that advice a step further and evaluate the outsourcing decision-making process through quantified analysis by listing the typical activities that your department handles on a daily basis. Evaluate each on a risk vs. reward basis and determine the approximate cost of an outsourced solution (see the chart on risk vs. reward). To maximize your up-front return on investment, place your initial focus on the tasks that fall into the "high risk, low reward" quadrant or category.

For example, if benefits billing reconciliation is currently administered in-house as a manual process, consider the risks associated with handling such a highly regulated, potentially expensive process. Even if administered flawlessly by your staff, billing reconciliation will never help you retain employees or reduce your administrative costs. It might make sense for your department to determine the potential cost savings associated with outsourcing this function.

Outsourcing Is Pulling Ahead
A sample ROI calculator can help you build your case for strategic HR outsourcing by showing exactly how long it will take to achieve a 100 percent return on your initial investment. This sample identifies the monthly reconciliation of benefits bills as a target process. This same calculator can be extended by changing the data in a few cells to compile a complete picture of potential ROI available to your company through outsourcing.

The calculator will help determine approximately how much money you can save in the coming year by outsourcing monthly reconciliation of benefits bills. First, calculate how much benefits bill reconciliation currently costs your company annually.

To do this, first define the following variables:

NE = Number of Employees in your company (employees).
AS = the average Annual Salary of the individual(s) performing this task ($/year).
TS = the estimated Time Spent on the task each month (hours/month).
CO = the annualized Cost of Outsourced solution ($/year), based on estimates in the risk vs. reward chart.

Next, begin calculations by determining estimated Annual Benefits (AB) by multiplying the employee's(s') average annual salary (AS) by a factor of .35 as follows:

AB = (AS) * (.35)
AB = ($70,000/year) * (.35)
AB = $24,500/year

Average total compensation (TC) includes both average annual salary (AS) and estimated annual benefits (AB), or:

TC = (AS) + (AB)
TC = ($70,000/year) + ($24,500/year)
TC = $94,500/year

Assuming a 40-hour work week, the hourly rate of an employee (HR) is equal to total annual compensation (TC) divided by the number of work hours in a year:

HR = (TC) / (52 weeks/year) * (40 hours/week)
HR = ($94,500/year) / (52 weeks/year) * (40 hours/week)
HR = ($94,500/year) / (2080 hours/year)
HR = $45.43/hour

Total time spent annually (TT) is estimated hours spent per month (TS) times 12 months per year:

TT = (TS) * (12 months/year)
TT = (5 hours/month) * (12 months/year)
TT = (60 hours/year)

Finally, the total cost of labor per year to reconcile benefits billing in-house (LT) is the number of hours spent per year (TT) multiplied by the average hourly rate of the employees reconciling the bills (HR):

LT = (TT) * (HR)
LT = (60 hours/year) * ($45.43/hour)
LT = $2725.80/year

In addition to the cost of labor for flawless administration and reconciliation, we must also calculate the approximate cost due to errors. The estimated cost due to error rate (ER) can be found by multiplying the number of employees (NE) by the national average of $3,300 in annual employer costs of benefits per employee times a national average error rate of 3 percent as follows:

ER = (NE) * ($3,300.00/employee/year) * (3%)
ER = (300 employees) * ($3,300.00/employee/year) * (.03)
ER = ($990,000.00/year) * (.03)
ER = $29,700.00/year

With these two main components of the cost to reconcile benefits billings in-house, you can now figure your current annual total costs. Annual total cost of the task (AT) is the sum of the annual cost of labor for this task (LT) and the cost due to error rate (ER):

AT = (LT) + (ER)
AT = ($2725.80/year) + ($29,700.00/year)
AT = $32,425.80/year

At this point we've completed the majority of the algebra, and know our total costs to complete this task in-house.

If this function were outsourced it would take approximately one half of an hour per month of your staff's time to reconcile benefits billings. The annual cost of the task each year after outsourcing (TCO) is equal to the annual cost of the outsourced solution (CO) plus the annual outsourced cost of the task (OC). First, calculate the annual outsourced cost of the task (OC) by multiplying time spent on the task after outsourcing (TO) times the hourly rate for in-house labor (HR) for the entire year, below:

OC = (TO) * (HR) * (12 months/year)
OC = (.5 hours/month) * ($45.43/hour) * (12 months/year)
OC = ($22.72/month) * (12 months/year)
OC = $272.64/year

To determine the total costs due to outsourcing (TCO):

TCO = (CO) + (OC)
TCO = ($15,000/year) + ($272.64/year)
TCO = $15,272.64/year

It is now possible to see how much money is saved, each year, due to outsourcing benefits billings reconciliation (OS) by subtracting the annual total costs of outsourcing (TCO) from the annual total cost of this task in-house (AT), as follows:

OS = (AT) - (TCO)
OS = ($32,425.80/year) - ($15,272.64/year)
OS = ($17,153.16/year)

And finally to convince your CFO and senior business executives, the Return on Investment (ROI) equals your annual savings due to outsourcing (OS) divided by your annual total costs to accomplish the task after outsourcing (TCO), times 100 percent, or:

ROI = [(OS) / (TCO)] * 100%
ROI = [($17,153.16/year) / ($15,272.64/year)] * (100%)
ROI = [1.12] * (100%)
ROI = 112%

Now, to calculate the return on investment for any other in-house vs. outsourced task, simply modify the calculation according to the specific professional costs of your staff vs. the cost of outsourcing that function.

It's Down to the Wire
If your own calculations indicate that you should outsource some portion of your HR administration, the first thing to remember is that it is not appropriate to outsource every activity. Your own employees should continue to choose key new hires, review employee performance and handle strategic programs to retain your best talent. In other words, outsourcing everything may not make sense. Rather, outsource specific tasks according to your organizational needs.

When evaluating potential outsourcing partners be sure to consider each candidate on the following:

1. Financial Stability—you want to ensure that your outsourcing partner will be with you for the long term.

2. Service Record—Your ultimate partner will be more than simply a vendor, you must be able to rely on your outsourcer to address challenges and issues to your satisfaction in a timely manner, as they arise.

3. Cost—a key consideration, but not if the up-front savings come at the expense of long-term service and support or hidden charges down the road.

4. Technology Leadership—ensure that your potential partner will be able to accommodate your changing needs due to increased staff or expansion into other regions.

5. Disaster Recovery—the data that you entrust to an outsource partner is of the utmost importance. It should be safeguarded to ensure that it is available to you even if there is a technology malfunction, natural disaster or facility damage.

6. Quality of Implementation—your outsourcing partner should provide a consultant committed to the successful implementation of its solution.

7. Training—perhaps one of the most critical but often overlooked aspects of successfully converting to an outsourced solution.

And It's Outsourcers in the Winner's Circle
Armed with the above knowledge, you can determine:

  • What activities are most beneficial for your department to outsource.

  • If and when those activities will provide a satisfactory return on your investment.

  • How to make the case for outsourcing in terms your CFO and management team will understand.

  • And, which outsource partner is right for you.

Now you're ready to focus your energies on the more productive, more rewarding initiatives that your employees ask about, that you never thought you'd have the time to address. Outsourcing can help put you in the Winner's Circle with your senior business and financial management team, with your internal HR staff and with the employees you support on a daily basis. This could be the opportunity you've been looking for to completely redefine your HR department, as well as your role within the company!

Mikio Manuel is a regional HR consultant for ADP, Inc. and an Advisory Board member of SHRM's HR Technology panel. ADP's parent, Automatic Data Processing, Inc., is one of the largest independent computing service firms in the world, with approximately 500,000 clients. ADP's Employer Services Division provides payroll, HRMS, benefits administration and pre-employment services such as job fit assessments and background checking. ADP is a registered trademark of ADP of North America, Inc.

Related Link:

SHRM's HR Outsourcing & Vendor Relations Resouce Page 

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