How Small and Medium Enterprises Benefit From Human Resource Outsourcing

1. 1 How Small and Medium Enterprises Benefit From Human Resource Outsourcing White Paper You Can Make the Most of Your PEO-SME Partnership If You Have a Third Party to Monitor, Monetize and Safeguard Your Business Interests

2. Executive Summary In today's tough business environment, dynamic HR systems demand flexible workforce arrangements and optimum utilization of available resources. Business imperatives also demand cost competencies and focusing management bandwidth on core processes that leaves outsourcing as the tool of choice for small and medium enterprises (SMEs). Since small and medium enterprises (SMEs) often lack the internal resources to develop and deliver full scale HR services, they are increasingly outsourcing this function to professional employer organizations (PEOs). Concerns however remain about the risks involved with market governance and a PEO’s ability to ensure a consistent service quality for an SME. This is where the role of third party brokers such as NetPEO ( www.netpeo.com ) and national memebership association like NAPEO ( http://www.napeo.org/ ) come into focus. Since, the decision to use a PEO is often a "make or buy" decision that can potentially impact both the cost and the quality of an SME's human resources, 1 large consultants such as NetPEO can provide advice and professional expertise to quickly bolster a client's organization through a strong network of PEOs. All this and more is exhaustively covered and referenced in this white paper. At the end of this report, you will also find a list of additional resources that you can consult for an in-depth understanding of this market. 1 Walker, G. & Weber, D. (1984). A transaction cost approach to make or buy decisions. Administrative Science Quarterly, 29, 373-391 2 PEO: A Win-Win Proposition For Employees : Benefit tbetter benefits and a safe workplace For SMEs : Maximum utilization of their workforce, reduced workforce, legal hassles and cost savings

3. 3 Table of Contents How Does an SME Benefit from a PEO.......................................................................... 4 How the Integrative Model Works.................................................................................. 6 The Cost Factor................................................................................................................. 7 Business Conditions That Justify the Use of a PEO...................................................... 7 The Risks Involved in Selecting an Appropriate PEO Vendor .................................... 8 The Importance of Third Party Brokers...................................................................... 11 SME Outcomes and Client Receptivity......................................................................... 15

4. efore we can begin to appreciate the critical role that NetPEO renders in strengthening SME-PEO partnerships, its important to first comprehend the processes by which PEO utilization affects SME outcomes. How Does an SME Benefit from a PEO How an organization manages its human resources is increasingly seen as a source of sustainable competitive advantage. 2 Due to economics of scale, SMEs often face an uphill task in developing an HR system that’s both efficient and cost-effective. 3 . As a result, an increasing number of SMEs are now outsourcing these functions to PEOs. 4 Although a recent development, it is estimated that PEOs currently provide HR services to three million employees and this trend is predicted to continue to grow by 30% per annum. 5 As such, the PEO have become indispensable for rendering a broad array of HR services, as well as 2 Huselid, M.A., Jackson, S.E., & Schuler, R.S. (1997). Technical and strategic human resource management effectiveness determinants of firm performance. Academy of Management Journal, 40, 171- 188; Becket, B.E. & Gerhart, B. (1996). The impact of human resource management on organizational performance: Progress and prospects. Academy of Management Journal, 39, 779-801; Welbourne, T.A. & Cyr, L.A. (1999). The human resource executive effect in initial public offering firms. Academy of Management Journal, 42, 616-632 3 Sexton, D.L., Upton, N.B., Wacholtz, L.E., & McDougall, P.P. (1997). Learning needs of growth-oriented entrepreneurs. Journal of Business Venturing, 12, 1-8; Baron, J.N. & Kreps, D.M. (1999). Strategic human resources. New York: John Wiley & Sons 4 Cook, M.F. (1999). Outsourcing human resource functions. American Management Association, New York. 5 Hirschman, C. (1997). All aboard: The boom in employee leasing may bring good career opportunities for HR professionals. HR Magazine, 42, 80-86 4 What Can a PEO Do for You? PEOs offer businesses a wide variety of services--including payroll management, employee benefit design and administration, tax filing and administration and compliance with state and federal workplace legislation. PEOs also take responsibility for developing and administering lawful employment policies and procedures; employee recruitment and disciplinary actions; recordkeeping; and unemployment, disability and workers' compensation claims and administration.

5. assuming the liabilities associated with being a co-employer with the SME 6 . Potential advantages to the SME from this relationship are also fairly obvious: Greater economies of scale and an ability to negotiate better benefit programs, which imply substantial savings for the SME, besides an efficient access to HR expertise that provide mechanisms to improve the quality of an SME’s HR programs and outcomes. 7 Since, individual SMEs would have little leverage when negotiating rates for health or workers compensation or insurance, PEOs by virtue of representing several thousand SMEs are often able to negotiate more favorable rates from insurance providers. 8 Further, because workers compensation programs are experience rated, a PEO are often able to obtain lower rates through safety programs that can reduce workplace accidents. 9 In addition, the partnership also results in substantial time saving. In many SMEs without a PEO, HR activities are often entrusted to the general manager who should ideally be involved in activities more directly related to revenue generation. 10 . By 6 Baron, J.N. & Kreps, D.M. (1999). Strategic human resources. New York: John Wiley & Sons 7 Klaas, B.S., McClendon, J., & Gainey, T. (1999). HR outsourcing and its impact: The role of transaction costs. Personnel Psychology, 52, 113-136 8 NAPEO. (1993). The business of employee leasing, Alexandria, VA: NAPEO. Nooteboom, B., Berger, H., & Noorderhaven, N.G. (1997). Effects of trust and governance on relational risk. Academy of Management Journal, 40, 308-338. 9 Cook, M.F. (1999). Outsourcing human resource functions. American Management Association, New York 10 for survival. American Journal of Small Business, 6, 49-54; Hannon, M.T., Burton, M.D., & Baron, J.N. 5 How Big Is The Industry? According to the SBA, PEOs control a 2% market share of the payrolls of small to medium-size companies (those with fewer than 100 employees). The market is projected to grow at 30% per annum. In 1997, 1000 PEOs accounted for an estimated 2 million to 3 million employees, up from only 10,000 in 1984. This year, the number is expected to exceed 10 million nationwide. Their collective are estimated at $18 billion. Source: National Association of Professional Employer Organizations, Alexandria, Virginia

6. delegating this task to a professional agency, an SME thus has the potential to affect the opportunity costs associated with time spent on HR and the GM can be rendered free to concentrate on his core activity, i.e. improve the company’s bottom line. Generally, the effect that a PEO has on the SME performance occurs through four major variables: compensation costs, staff time costs, administrative fees, and HR outcomes. How the Integrative Model Works PEOs assume responsibility for payroll processing; employment taxes; compliance matters and correspondence; unemployment insurance; and workers' compensation audits, areas typically handled by the CFO and his or her staff. They also assume the burden of proof-- recordkeeping, documentation and explanation--in these areas. Because employment-related filings and compliance requirements represent a PEO’s domain expertise, it can often do so more efficiently than an SME. As a client company increases in size, these efficiencies of outsourcing increase. PEOs have professionals on staff that stays abreast of the ever-changing laws governing employer-employee relations. Their diligence in ensuring their clients' lawful workplace practices--through recordkeeping and documentation--removes the stress of monitoring the complexities of (1996). Inertia and change in the early years: Employment relations in young, high technology firms. Industrial & Corporate Change, 5, 503-536 6

7. actual cost of wages and benefits plus an administrative fee of between 2 and 6% of payroll to cover the cost of HR services. 11 . Given that an average PEO client employs fewer than 20 workers, PEOs are most cost- effective for businesses with fewer than 100 employees. When an SME crosses that head count, the price of a PEO’s services may a client to determine whether the 11 HR professionals. HR Magazine, 42, 80-86 7 workplace regulations from small business executives who can, instead, focus on day-to- day operations and overall profitability. The time saved on non-revenue-producing activities can thus contribute directly to the company's bottom line. The Cost Factor Although the model can vary from state to Significant Paperwork Reduction state, typically, the client pays the PEO the An SBA study estimated that the average small business owner spends between 7% and 25% of his or her time handling employee-related paperwork. When you add in the time spent on all the other HR tasks, this figure rises to 35% to 45%. Most small business owners recognize just how valuable a commodity their time is and would rather devote their energy to core business operations. By outsourcing these functions to a PEO, they can concentrate on making their businesses grow. (Source: Bruce E. Katz, What a PEO Can Do for You , Journal of Accountancy, Vol. 188, 1999) equal the cost of having a full-time HR staff. Business Conditions That Justify the Use of a PEO To begin with, it’s extremely important for

8. administrative fees charged by a PEO are offset by significant reductions in compensation costs and the cost of internal staff time, otherwise the whole purpose to this exercise would get defeated 12 . According to the Department of Labor, a PEO can handle administrative responsibilities at one-third to two-thirds of the cost an average business would incur to provide similar services. Some of the savings are achieved through staff reductions. PEOs are also a blessing to companies with foreign operations. An off site PEO can enable the company to streamline its accounting procedures in accordance with local regulations, ensure regulatory compliance and obtain a level of insurance and benefits typically reserved for much larger companies. The Risks Involved in Selecting an Appropriate PEO Vendor The biggest concern with regard to a PEO --- as with any outsourcing model -- is whether the PEO would be able to maintain the same quality of service as was earlier being delivered by the SME’s internal staff. 13 . 12 Cook, M.F. (1999). Outsourcing human resource functions. American Management Association, New York 13 Klaas, B.S., McClendon, J., & Gainey, T. (1999). HR outsourcing and its impact: The role of transaction costs. Personnel Psychology, 52, 113-136 8 NetPEO’s Service Bouquet We provide a whole spectrum of HR services This includes:     Payroll services Tax credit Workers’ Compensation Insurance All other aspects of human resource management, related to risk and safety management, compliance, pension administration, benefit auditing and payment remittance In short, NetPEO can provide an integrated human resource solution for your enterprise.

9. 9 Further, relying on outside vendors for HR services implies that in time competition can resort to the same business practice and neutralize the competitive advantage gained from the move. In some cases the services offered by a PEO may be affected by opportunistic behavior and a lack of familiarity with client needs, thereby adversely affecting the HR outcomes set to be derived from this model. This is an area where mediators and brokers such as NetPEO can play a crucial role in helping the client and the PEO overcome these barriers. Further, there is great variation among the PEOs as well. An SME has to be extremely careful in selecting a PEO that best meets its business needs. Client Testimonials NetPEO's customers represent every industry in every nook and corner of the US. From small, family owned businesses to large franchisees, NetPEO works in all enterprises and with all types of customers. Here is what our customers have to say about the essential solutions we provide: _____________________________________________________________________ ___ “ We can not say enough about your staff. Our broker explains things in laymen's terms so they can easily be understood. He has excellent customer service skills and returns calls promptly. NetPEO has truly been a pleasure to work with. - Kati B., Auto Parts & Service _____________________________________________________________________ ___ NET PEO has become a valuable partner that I can rely on whenever insurance questions arise that I need an impartial opinion or reliable answer to. They truly make you feel that they are on your side. -Susan J., Office Furniture _____________________________________________________________________ ___ NetPEO is a great company. Whenever I have questions, I really get the help I need. - Jean G., Dr.'s Office (For more information, simply log on to www.netpeo.com)

10. Das, T.K. & Teng, B. (1998). Between trust and control: Developing confidence in partner cooperation in 10 For instance, one PEO may focus primarily on transactional HR services that are more administrative and routine in nature, enabling SME client to save both time and money; while another may emphasize on providing a broader range of services, including those aimed at affecting long-term HR outcomes. Identifying what vendor can best suit your business requirements is another area of consultancy where NetPEO can help you make a correct choice. Trust is another factor that significantly impacts business outcomes from an SME-PEO contract. Experts contend that there is more trust in an SME-PEO relationship when an SME invests greater efforts in doing a background check on the vendor. This is an area where an organization like NetPEO can assist by dipping into its ready resource of PEOs and their existing client base, whereas an internet search process could be more tedious and time-consuming. The involvement and experience of third-parties can substitute for personal experience with the PEO and, thus, facilitate the development of relational trust by making it more likely that the parties move beyond skepticism. 14 Broadly, we have experienced that trust in an SME-PEO relationship is more likely when SME leaders: (1) Utilize the services of neutral parties, such as NetPEO (2) Collect extensive information from existing PEO clients prior to contracting their services (3) Demonstrate reciprocal concern for the needs of the PEO; and (4) Communicate extensively with PEO representatives 14 alliances. Academy of Management Review, 23, 491-512.

11. Last but not the least, NetPEO can also assist in finding an ideal fit between the economic and strategic factors impacting an SME-PEO partnership, as well as their attitudes and values that is equally crucial for the survival and success of this partnership. The Importance of Third Party Brokers Brokers like NetPEO provide a crucial link between SMEs and PEOs. The fact cannot be over emphasized that the success of any contractual relationship depends largely on an SME’s ability to anticipate its needs, the assistance that it receives from consultancies such as NetPEO as well as a thorough scan and understanding of all contingencies existing within a contract 15 . NetPEO can help you draw the specifics of this co-employment contract that takes into consideration all these factors and more. Another major benefit that the involvement of third party brokers like NetPEO offers is that they do all the ground work of qualifying potential PEO partners for your business. NetPEO enables you access to literally dozens of The Birth of a PEO: How It Started? In the 1970s, a safe-harbor provision in federal tax legislation enabled companies to maintain pension plans for management and key employees that differed from those for regular stag employees--provided the stag employees were leased. Although that safe harbor disappeared, in 1982 with the passage of the Tax Equity and Fiscal Responsibility Act, the trend it established toward employee leasing continued. Leasing companies extended their services to encompass the entire HR area, leading to the birth of the PEO. PEOs now perform myriad tasks. Some states recognize them as "co-employers" since they assume certain legal rights and duties related to employees who work at client locations. (Please note: The IRS does not use the term co-employer--it recognizes PEOs as employers.) The rights and duties PEOs assume are set forth in a contract between the PEO and the client company. (Source: Bruce E. Katz, What a PEO Can Do for You , Journal of Accountancy, Vol. 188, 1999) PEOs, without the you, i.e., the SME 15 Law, Economics, & Organization, 8, 561-581 11

12. 12 having to invest an inordinate amount of time and effort it takes to complete the due diligence process; a process that quite frankly most companies never undertake to their own detriment. Sometimes, especially with SMEs with global operations, outsourcing can lead to unexpected problems. PEOs operating off-site may not understand a firm's employees as well as one of their own executives would. This is an area where NetPEO staff can mediate to broker peace and better understanding among the two parties. Good staff training is also very important to a PEO-SME relationship. This is another area where NetPEO can be of assistance to SMEs and PEOs. For instance, one of the most important tasks that NetPEO renders is to design the future internal organization for monitoring, controlling, and managing the client-vendor relationship. Two broad issues that we generally consider in this regard are: the organization structure, and the skills and competencies required for this internal "extended operations monitoring unit" to work. If we spot an absence of those skills, we make arrangements for staff training that could fill that knowledge gap. The result is a strong link and control over the outsourced processes in terms of not just cost and time saving, but also in terms of establishing along term, sustainable relationship. For instance, during our years of experience of operating in this industry, one lesson that we have learnt is that a "big-bang" or "clean break" approach of moving work in bulk to the second party does not work except for processes that are completely off-line, non- business critical, relatively small, and non-time critical.

13. This cannot of course be said of HR functions that impact an SME’s core asset, i.e. their manpower resource. So with most our clients, we advise a carefully monitored transition that ensures business continuity and gradual skill transfer. This kind of phased transition also eases the speed of organizational change and the impact on existing employees. It may temporarily delay the business impact and may introduce some hardship for the employees, who will have to work for a longer duration knowing that they do not have a long-term future with the company, but we have experienced that this approach exposes the remaining employees to the emotionally draining state that industrial psychologist William Bridges calls the "survivor syndrome" 16 and prepares them well for the next leg of the journey. Again, some firms face unique constraints with regard to how they should manage HR. These constraints can be imposed by business or labor market conditions as well as by a distinctive organizational culture. Whatever be the cause, these companies often develop what are known as an idiosyncratic approach to HR. 17 . Such an approach increases the risks of opportunistic 16 17 Bridges, W.P. (1998). "Change at Work." Work and Occupations. 25(4): 542-545. Klaas, B.S., McClendon, J., & Gainey, T. (2000). Managing HR in the small and medium enterprise: The impact of professional employer organizations. Entrepreneurship Theory & Practice, 25, 107-124; Greer, C.R., Youngblood, S.A., & Gray, D.A. (1999). Human resource outsourcing: The make or buy decision. Academy of Management Executive, 13, 85-96. 13

14. behavior by the PEO 18 that only an agency like NetPEO can track, identify and amend through contractual clauses. We know from experience that when a PEO contract is incomplete or non-specific, the benefits accruing from the SME-PEO relationship will be limited and short-lived. Selecting the Right PEO for Your Unique Business Needs With our strong network of PEOs, NetPEO can help you to select a PEO that:      Offers core services (payroll, insurance and benefits administration and regulatory compliance) as well as value-added services such as employee policies and procedures, communications and employee manuals Has sound infrastructure comprising distinct departments for accounting, payroll, benefits, HR and risk management/compliance Has stable financial history and policies that promote continued fiscal integrity (annual audited financial statements and quarterly limited-scope audits to verify that all taxes are paid and required filings are made on time) Has experienced staff, including HR professionals and certified professional employer specialists Has access to advanced computer technology and experience-rated systems to administer professional employer services  Has a proven track record with other companies of comparable 18 Press 14

15. 15 size, industry and situation, including references SME Outcomes and Client Receptivity Contractual mechanisms are of little value if an SME client choose to ignore a PEO's advice about whether to terminate an employee, the need for employee training, or how can be provided to employees, to cite just three common areas of confusion or conflict. We know from our experience of interacting with dozens of SME clients and PEOs that whenever there is a lack of receptivity, the SME is less likely to be able to take full advantage of the expertise and programs offered by the PEO. In most such cases, the situation can easily be redeemed with the involvement of a third party that does not hold any stake in the partnership. ( Please note that NetPEO does not charge anything from a client SME for its services .) Conclusion The obligations and administrative burdens that a PEO assumes on behalf of its clients are strong incentives for SMEs to outsource these complex employee, tax, benefit and regulatory compliance areas. Nonetheless, the single most attractive advantage that a company hopes to gain through a PEO relationship is the ability to offer employees a much wider selection of benefits--at considerably lower costs.

16. Typically, small businesses find it difficult to offer employees multiple options in terms of health care plans, insurance (life, disability and accidental death and dismemberment), savings and investment plans (401(k) and pension plans) and other employee benefits. Due to larger employee pools, PEOs can offer SME employees the same level and quality of benefits as bigger companies provide. The results could be improved employee satisfaction, better employee retention and the ability to attract high-caliber employees to smaller companies. Client companies also enjoy reduced volatility in unemployment and workers' compensation insurance rates. Additional Resources:   www.napeo.org: National Association of Professional Employer Organizations. www.peo.com: An online, searchable database of PEOs located throughout the world. 16

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