New Economy, New Reality: Driving Out Costs in the HR Function
New Economy, New Reality
While the new economy may not have delivered on everyones expectations, in many respects it has had a significant impact on refocusing the debate on the importance of business fundamentals and the application of new technologies (Web-based and otherwise) to the efficient management of business processes. The product of this debate in Europe has been renewed interest in the core/noncore debate and the role of business process outsourcing (BPO) in bringing about the unfolding of vertically integrated public and private organizations into more specialized companies that go to market and add value as part of a larger network of collaborating organizations.
The outsourcing of corporate functions such as human resources (HR) is part of this evolution in corporate sourcing strategies. As the 1990s saw the breakthrough of IT outsourcing in Europe, with the United Kingdom leading the way, IDC believes this decade will see an acceleration of BPO activity, most notably of IT-intensive BPO. In the HR domain this activity will center on those HR processes with high levels of administrative and transactional activity.
This document explores the business concept behind HR outsourcing and how companies are challenging their sourcing strategies in order to face todays tough business pressures.
Adaptability – A Byword for Success
More than ever, organizations in various business sectors are facing a rapid acceleration of technological, societal, and business change that is proving hard to keep up with. Whether one looks at the rate of breakthrough technology inventions, the effects of globalization and deregulation, or the change in consumer preferences, the notion of stability has disappeared for good. As a result, every aspect of a business must become adaptive to change. Top executives have to think harder and faster to make the organization more flexible and agile in a fast-changing and essentially unpredictable world.
Certainly in the tough economic climate of 2002 there is a strong drive within all types of organizations to critically reevaluate internal skills, assets, and processes in order to cut costs and make the organization more adaptive to busi-ness change. Increasingly, the outcome of this reevaluation is the decision to collaborate more closely with external partners and to outsource noncore business processes.
Insource or Outsource?
The business rationale underpinning a decision to outsource HR processes typically varies from industry to industry and organization to organization depending on an organizations perception of what are core and noncore processes and the service providers abilities to undercut or outperform the organizations own internal HR function.
However, there are some strong common drivers, as well as some common inhibitors that all organizations must weigh up as part of the process of understanding whether HR outsourcing offers a viable option or not. How suitable it is to outsource all or a part of the HR function is typically related to questions such as those illustrated in figure 1 – is this function
or process strategic for our company or not, is it customized or standardized, is there a low or high variation in demand, is it a highly administrative task or not, and is it low volume or high volume?
The Rise of Business Services
BPO as a business concept is not new. The use of external specialists in areas such as finance, accounting, and logistics dates back to the mid-19th Century, when the Industrial Revolution triggered the concept of labor specialization and companies servicing each other.
With the growth of a services economy on top of the industrial economy, the number of specialist business service providers has grown dramatically, as has the array of services they provide. A large number of specialist service providers now exist to support organizations not only tactically but also strategically. IDC estimates that in 2000, about 30 percent of corporate spending relating to front- and back-office corporate functions in Western Europe was with external service providers, while the other 70 percent was spent on internal staff and resources used to manage corporate functions in-house. IDC foresees a steep increase in the proportion of spending with external business service providers to about 36 percent in 2010 and 45 percent in 2025.
Change in Corporate Sourcing Strategies
The rise of external business service specialists is strongly related to a change in corporate sourcing strategies of companies competing in an increasingly global and networked economy. The traditional model for large companies in industries such as manufacturing, retail, and finance has seen most corporate functions managed in-house, using internal staff and resources. These range from research and development, engineering, purchasing, and production activities through to distribution, sales and marketing, as well as staff functions such as finance and HR, sometimes with specialized subsidiaries focusing on one of these functions.
This type of vertically integrated organization is gradually but steadily finding itself in competition with more specialized, collaborative organizations that strategically outsource processes to service providers for whom noncore functions are core.
A Good Time to Buy into HR BPO?
As one of the newer breed of collaborative organizations, BP spends about $1 billion a year on a multitude of outsourcing services in areas such as human resources, tax, engineering, financial services, facilities management and desktop services.
In each functional area there are now companies that have been able to grow a successful business out of managing corporate functions that are regarded as noncore by others. The HR BPO market for example, although immature in Europe, has seen rapid growth over the last two years and is forecast by IDC to grow at a CAGR of 27.5 percent over the period 2002–2007. In this period, Accenture, ADP, Arinso, CSC, Ceridian, Hays, IBM, and Xchanging have emerged among the leading group of human resources service providers.
Having moved beyond the higher risk first mover phase (Figure 2), HR BPO is demon-strating higher levels of market acceptance as organizations successfully transition to new HR processes and technologies.
HR Business Process Outsourcing Definition
Human resources business process outsourcing (HR BPO) involves arrangements in which an external service provider manages HR-related processes or even the entire HR function. These services include more complex HR activities, such as benefits management, succession planning, training and development, and performance management. Performance metrics are tied to the strategic business value of services provided and customer satisfaction. Business value is recognized through results, such as increased productivity, new revenue generation, cost reduction, business transformation, and the improvement of shareholder value. Contractual service level agreements are set at the business or process level and include responsibility for IT and non-IT activities.
IDC makes a distinction between BPO and processing services as there is a difference in the innovative and strategic value between the two types of business outsourcing services.
Processing Services Definition
Processing services (PS) are high-volume, automated, and standardized processing services, with performance metrics tied to accuracy, timeliness, and efficiency. Typically, processing services are offered as a standalone off-the-shelf service with contracts that average a year and a relationship at a basic vendor-client level. Examples are payment, check, card, payroll and claims processing.
IDC recognizes an overlap between the various types of services, in particular between ISO, PS, and BPO, but also between outsourcing engagements and the other types of insourcing engagements, such as consulting. For example, it is possible that in a comprehensive human resources BPO contract there are also components of processing services (payroll processing), business consulting, and training. In order to arrive at mutually exclusive categories and market sizing, IDC applies the principle that if other services, such as consulting or training, are provided as part of a more comprehensive BPO contract, these services are also identified as BPO.
Facilitating Change Through Leading Practices in HR
Across Europe more for less is the number one challenge for CEOs and HR executives. The trick remains how to improve the quality and speed of HR services and information while constantly reducing overall administration costs.
New HR technologies and process management excellence are helping HR executives and top management to facilitate this change through a full range of technology-driven services. A growing number of service providers demonstrating in-depth understanding of HR management, combined with many years of experience in integrating and operating HR systems, has led C-level executives to investigate the benefits that leading practices in human capital management can deliver to organizations. The central pillar of this model relies on understanding both the relationship between
HR processes and improved human capital performance, identifying internal and external corporate and line HR budgets, and knowing where genuine cost savings and productivity gains can be achieved.
Driving Out HR Costs
The starting point for many organizations, prior to any HR outsourcing engagement remains identifying the cost components of the central and line HR budget. A recent IDC survey of FTSE 250 companies revealed significantly different interpretations as to what constitutes the HR budget. Twenty-seven percent of respondents who claimed to have centralized their HR budget also indicated, for example, that recruitment and training costs were funded out of business unit or line budgets.
As Figure 3 illustrates, the implication is that among large- and medium-sized organizations (particularly those with widely dispersed workforces) a significant HR spend is not reported centrally or readily identified as being open to process automation or supplier rationalization.
Creating Sustainable Shareholder Value Through HR BPO
Identifying what constitutes the human capital value of an organization and assigning a return on investment figure to investments made in the HR function is intrinsically difficult. HR business process outsourcers, however, are aiming to deliver just that – indeed some are claiming to have created genuine and sustained shareholder value through outsourcing HR processes.
This is an important area of debate. As has been demonstrated in the past few months, share performance is often linked more closely to broader issues of market confidence, interest rates, industry performance, and accounting practices than the business fundamentals of an organization.
However it is in the long-term operational interests of all organizations to seek leaner cost structures and higher workforce productivity than the competition. This is doubly important in a recessionary economy in which the pressure to continue creating shareholder value increases rather than recedes as falling stock markets hurt investor pockets. Outperforming the industry and the stock market average is a critical success factor in attracting investors, sustaining or improving shareholder value, and being able to raise capital for further acquisitions or investments.
Studies have shown that companies that consistently outperform the market during an economic downturn use the recession as an opportunity to focus on strategic leadership and the execution of short-term as well as long-term goals to establish a competitive advantage. The critical difference in regards to the role of HR in this strategy is that while the short-term goals might include organizational restructuring, HR and HR service providers should play an increasingly high profile role in helping to ensure that, in the long term, the necessary HR resources, processes, and information systems are in place to take advantage of an economic upturn when that happens.
To measure the benefits of that long-term strategy, organizations require metrics with which to judge performance year on year. Many different ROI models exist and are being developed. Key measures of human capital value remain – profitability, the expenses-to-sales ratio, and revenue per employee. A fourth measure of human capital value is the ratio of a companys earnings before interest and taxes (EBIT) to the cost of HR services and HR technology investments. If the ratio is increasing, the organization is showing a healthy return on its human capital investments. If it is falling, HR investments are failing the business. The mistake made by many organizations of simply using the expense-to-sales ratio is that the focus becomes cost- rather than investment-driven. The merit of the EBIT-to-HR cost metric is that it is a measure of the organizations ability to achieve desired, sustainable business outcomes through its investment in the HR function.
Strategic Transformation of the HR Function Through HR BPO
HR BPO can deliver business value at multiple levels including increased productivity, new revenue generation, cost reduction, business transformation, and the improvement of shareholder value.
To achieve any of these, however, requires that the HR function undergo a radical transformation. The outsourcing of HR administrative and transactional activities to the service provider and the employees themselves, and the streamlining and integration of control and reporting processes, has a significant impact on the ability of the HR function to think and act strategically. The reduction in administrative overheads and hence better HR staff-to-employee ratios, faster and more accurate reporting, better identification of key issues and challenges, and targeted investment of scarce resources all help to ensure greater flexibility and operational stability to meet the competitive challenges faced by the organization.
Future Outlook
In comparison with the U.S. market, the European market for HR BPO is relatively immature in terms of the range and scope of HR processes being outsourced. Europe is just beginning to realize the value added benefits of specialization and going to market as part of a larger network of collaborating organizations. Competition in the HR BPO market is likewise just starting to shape up with various types of players entering the market with new and often innovative offerings.
IDC believes this decade will show an acceleration of HR outsourcing activity, in particular of IT-enabled HR BPO. Adoption might even happen faster this time. Outsourcing as a business concept does not hold the same fear it used to for European companies, in particular in continental Europe. Most large organizations now have some experience of outsourcing IT on a small or large scale to external service providers in long-term contracts and understand both the benefits and pitfalls. Maybe even more importantly, they have built up skills in managing large and comprehensive contracts with external service providers and defining service level agreements that offer the right balance of rewards and penalties. The IT outsourcing wave in Europe has in many respects helped to pave the way for HR BPO, and service providers and user organizations are now warming up for this next level in corporate sourcing.
Despite the many practical, legal and sometimes cultural hurdles that need to be overcome, there is still an enormous potential for efficiency and productivity gain in the European economy if organizations focus on core competencies and collaborate more closely with one another.
