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In, Out or In Between?

Whether and how much to outsource payroll depends on a companys size, needs, technology and costs.

HR Magazine, March 2005 Most people in human resources will tell you that payroll is a thankless chore. You hear complaints when things go wrong but get no compliments for a job well done. The work is constant, detailed and rife with possibilities for error.

“I suspect ever since the first payroll was processed, someone realized how painful it was and looked for a way to outsource it,” says Steve Larson, a senior consultant in the Miami office of HR consulting firm Watson Wyatt Worldwide.

It’s no wonder, then, that payroll outsourcing is going strong after 50 years. Payroll service firms can handle almost everything, from calculating payroll deductions to filing tax reports, freeing up HR for other, more-strategic matters.

But outsourcing isn’t for everyone. The largest companies can afford their own computer systems and staff, and some employers’ payrolls are too complicated for many vendors’ standardized systems. Others have found that outsourcing payroll only partially is the best solution for them.

Whether to keep payroll in-house or outsource it—in whole or in part—depends primarily on an employer’s size and expertise as well as cost and technology. Here’s a guide to help you decide which way to go.

Market Still Growing

Outsourcing payroll allows many employers, especially small and medium-sized ones, to concentrate on their core business. That’s also true for HR staff members, who can devote more time to their core duties. (HR’s role doesn’t magically disappear, though; see “HR’s Pay Role”.)

“There is little about payroll that can be considered strategic, so as HR reduces head count and looks for services to push outside, payroll is one of the top ones to get rid of,” Larson says.

In fact, payroll is one of the most commonly outsourced HR functions. Thirty-five percent of employers outsource it partially and 13 percent outsource it completely, according to a survey released in July 2004 by the Society for Human Resource Management of 298 of its members.

Smaller businesses of up to a few thousand employees have long farmed out payroll, but bigger employers are getting into the act, payroll vendors say.

“What we’ve seen in the past two years is a move toward large employers [3,000 to 50,000 employees] outsourcing more,” says Greg Secord, vice president of marketing and business development for Roseland, N.J.-based ADP Inc.’s national account services.

Historically, big-company payrolls were too complex for vendors to handle, explains Brenda Sural, national payroll practice leader at Hewitt Associates, an HR consulting and outsourcing firm based in Lincolnshire, Ill. But that’s changing with advances in technology.

“Providers are able to more easily build systems that are flexible and able to accommodate the complexities of a large employer payroll,” Sural says.

Still, most clients of payroll firms are small employers that lack the staff, time and expertise for the duty. Fifty-eight percent of companies with fewer than 500 employees outsource payroll, compared with 28 percent of companies with 10,000 or more employees, according to a survey published in July 2004 by the San Antonio-based American Payroll Association (APA).

Assessing Costs

Any decision to outsource payroll—or not—must consider costs. Does it cost less to process payroll in-house than to hire an outside firm? The answer isn’t always clear. Payroll-services firms generally quote rates of $1 to $2 per check for basic processing and $4 to $5 per check for the whole shebang—a call center, time and labor management system, direct deposit, and other add-ons.

There are economies of scale in the payroll business. Large employers and payroll companies can spread fixed costs, such as system maintenance, over many employees. As a result, their per-check costs often are lower than those of small employers that process payroll in-house.

The break point for the payroll function is about 25,000 employees, says Farsheed Ferdowsi, president and CEO of PayMaxx Inc., a payroll company based in Franklin, Tenn. A 25,000-person employer would pay $1.5 million to $2 million annually to outsource payroll, he says. “For that price, it’s conceivable to build your own technology and hire your own staff,” he notes.

But how do you compare vendors’ bids to your in-house costs? While it’s easy to tally direct in-house costs, such as a payroll administrator’s salary and benefits, Larson says, it’s harder to total indirect costs, including the part-time staff costs of time collection and computer support that don’t fall under the payroll department.

Many employers overlook these hidden costs, so they don’t get a true picture of their total expenses, according to a 2003 study of in-house payroll costs by consulting firm PricewaterhouseCoopers LLC. The average cost per check, which many companies believe is between $2 and $6, is really $16, concludes the study, which was commissioned by ADP and based on a survey of senior financial executives at 181 companies with 1,000 or more employees.

A follow-up study in 2004 found that ADP clients’ total costs were an average of $10 per check vs. $16 for similar-sized employers that handled payroll in-house, a 35 percent difference. The one-time costs of initial system installation and the last major upgrade were lower, too, for ADP customers.

The report recommends that employers who want to assess their true payroll costs look carefully at time-and-attendance processes, the number of full-time equivalents involved, technology costs, and the time to process errors and changes.

Technology, Compliance Risks

Technology is a big part of an outsourcing decision, consultants say. Large companies can better afford than small ones the systems and staff to perform payroll and other functions in-house. It’s also expensive to customize solutions to suit a company’s needs and to pay for systems upgrades every three to four years.

Payroll vendors “spend millions [of dollars] on technology,” Ferdowsi says, in part to offer newer features, such as online pay stubs and payroll cards, which small companies often cannot afford on their own.

That’s not to say employers can’t process payroll in-house. Many use commercial software, often an add-on module to their human resource information systems. The challenge, says Watson Wyatt’s Larson, is to set it all up so that payroll and other systems, such as compensation, “talk” to each other.

Beyond technology, many employers, especially those with operations in multiple states, outsource payroll to minimize their legal risk. More states mean different income taxes to track and pay, and more reports to file.

Large employers, but not small ones, generally have the accounting manpower to stay on top of ever-changing tax regulations and to file the numerous reports required by federal, state and local governments, payroll executives say.

Outsourcing appeals to clients like Teresa Jeschke, who has no shortage of things to do as the HR director—and sole HR professional—at UNIRISC Inc., an insurance company based in Arlington, Va. Her firm contracts with ADP, she says, because it handles payroll “consistently and correctly” for UNIRISC’s 50 employees in six states.

That’s important because late or inaccurate payroll tax payments are subject to penalties and interest on unpaid amounts, according to the IRS. When payroll vendors make a mistake, it’s on their dime, not their clients’.

At a minimum, each payroll involves calculating deductions for income taxes, Social Security, Medicare and, sometimes, wage garnishments for court-ordered child support payments. Then there are quarterly and year-end reports to file.

The volume can be staggering. Paychex Inc., a payroll firm based in Rochester, N.Y., planned to file more than 4 million year-end forms for 2004—an average of eight per client—according to Brad Flipse, area vice president of major market services.

Keeping It Inside

With all the advantages of outsourcing, why do some employers handle payroll in-house? One reason is that large companies—generally, those with at least 10,000 employees—can afford the computer systems and staff to process payroll on their own. Their costs are spread over a large workforce, so per-check expenses are lower than for smaller firms. Another reason is payroll complexity. Hospitals and universities, for example, must track different shift differentials, overtime, pay cycles and other variations on a regular basis. Payroll vendors’ systems can’t always be modified to meet their needs. “For some organizations, it can be very time-consuming. If they have pay policies that vary between business units, it can be complex,” says Diane Youden, senior manager of HR services at PricewaterhouseCoopers in Dallas.

That’s the case at Aurora University in Aurora, Ill. Staffing and pay rates fluctuate throughout the year at the school, which employs 350 full-time employees, 125 adjunct faculty, 200 part-time students and 200 summer workers, says HR Director Therese A. Hoehne, SPHR.

“With a set of cycles as complex as ours, [outsourcing] just wouldn’t work,” Hoehne says. Students are on their own biweekly pay cycle, professors are paid twice a month, and adjunct faculty get paid three times per semester.

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The university considered outsourcing payroll a few years ago, but it would have cost $98,500 in the first year—“way too much money,” Hoehne says. Instead, it pays $3,000 per year for software designed specifically for higher education. The HR department has one full-time payroll administrator and access to a university computer programmer.

Finally, some employers don’t outsource because they don’t want to yield control of data they consider private. It’s a matter of corporate culture.

Going Partway

There’s another way to handle payroll: Keep some functions in-house and outsource others. Some payroll experts say this partial outsourcing costs less than full outsourcing, especially since raw payroll data is usually compiled in-house.

Employers that split payroll functions between themselves and an outsourcer typically calculate gross pay, generate reports and distribute paychecks while farming out tax and W-2 filing, garnishments, direct deposit, and check printing.

“We have a piece of it we keep here,” says Erica Doherty, HR director of Practice Management Partners Inc., a 140-person physician billing firm based in Owings Mills, Md. An HR generalist spends about a third of her time collecting time sheets, entering data and running reports, she says. The rest, including biweekly payroll processing and tax filing, is outsourced to ADP.

Practice Management Partners pays ADP $7,800 annually and the HR generalist about $12,000 for payroll duties—less than the cost of a full-time, in-house payroll administrator, Doherty says.

Outsourcing becomes more common for later stages of the payroll process, according to the APA survey. Only 34 percent of APA members outsource gross to net processing—the calculation of income taxes and other deductions—but nearly half outsource tax filing, and 44 percent outsource check printing and distribution. The other respondents perform these duties in-house on a homegrown system, with a vendor’s software or, in relatively few cases, manually.

To decide which functions to keep and which to outsource, assess your internal resources to see which ones you can do well and which ones you cannot, Youden advises.

Also ask yourself if you’re willing to take on liability for those transactions you keep in-house.

“If we offer partial service, we can only take partial liability,” explains Flipse of Paychex.

In, out or in between? HR directors can help their employers weigh the decision by analyzing their in-house resources and costs and comparing them to the cost of a payroll-services firm. The time spent to come up with the right decision could pay off for years to come.

Carolyn Hirschman is a business writer based in Rockville, Md. She has written for a variety of business publications and has covered workplace issues since 1991

HRs Pay Role

Human resources directors are involved with payroll regardless of who processes it because many employment actions affect how workers are paid.

Even when you outsource payroll, your payroll responsibilities do not totally go away, says Steve Larson, a senior consultant for Bethesda, Md.-based consulting firm Watson Wyatt. Theres a lot of interaction thats still required.

New hires, promotions, benefits selectionsHR must communicate these and other changes to an in-house payroll department or an outside vendor to ensure that payroll-system data is accurate and up-to-date.

In addition, HR must make sure the vendor is living up to the terms of the contract and must handle employee problems and complaints, such as missing checks, Larson says.

Even when payroll is outsourced, somebody in-house becomes the liaison between the company and the outsourcing firm, says Farsheed Ferdowsi, president and CEO of PayMaxx Inc., a payroll-services firm based in Franklin, Tenn.

Most employers that outsource payroll still perform in-house source to gross preparation, which is the entry of datapay rates, Social Security numbers, W-4 elections and morenecessary to calculate each employees gross pay. Only 13 percent of respondents outsource this step, according to a 2003 survey of 2,367 members by the American Payroll Association. 

Shop Around

Payroll outsourcing demands close attention to technology integration and service-level agreements, HR executives and consultants say. Here are some basic shopping tips.

Decide what you want. Dont solicit a single sales pitch until youve decidedwith the input of finance and information-technology executivesexactly what you want to outsource. Do you want only basic payroll processing services, or extras such as direct deposit and self-service features? Think about how you want to access data and handle employee inquiries.

Look for experience. HR peers can recommend providers with a track record of reliability and customer service. Consider national and regional providers that work with employers of your size and industry. Talk with three to five vendors to keep the search open yet manageable.

Compare apples to apples. Comparing vendor packages can be tricky. Some vendors charge extra to generate reports; some dont. Some limit the number of direct deposits allowed in a year. Make sure everything you need is included in a bid to avoid misunderstandings and additional costs down the road.

Examine technology. Consider the kind of hardware and software a vendor uses and how easily they can be integrated with your in-house HR system. What services are provided online? How is data privacy ensured? The bottom line is: Will the vendors system truly meet your needs?

Get performance guarantees. Since timeliness and accuracy are so important to payroll, most vendors provide service-level agreements that promise certain levels of performance. Too many errors or late paychecks result in financial penalties against the vendor. Ask potential payroll providers about their performance reporting tools.

Get references. After narrowing the search to two or three firms, ask for references from similar-sized clients that use the same software or services you are considering.

Finally, remember that nothing is written in stone. Contracts can be renegotiated to obtain new services or lower prices. Debbie Laudenslager, HR director of KPS Health Plans, a 160-employee health insurer in Bremerton, Wash., considered bringing payroll inside. But she stayed with her vendor after it offered to lower costs and add a timekeeping system. The result, she says, was a better partnership.

Carolyn Hirschman 


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