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Large-Market Outsourcing A Lofty Ideal

March 18, 2008
Related Topics: Outsourcing, Featured Article
Jeffrey Brundage, executive vice president for human resources at American Airlines, looked for a single vendor to take over HR administration for the company’s 86,000 employees. But he couldn’t find one.

    "We wanted to work with one vendor, but no single supplier showed any interest in what we wanted to do," he says. Instead, American signed a 7½-year, $217 million human resources outsourcing agreement with IBM and Mercer in March 2007.

    Large-market multi-process HRO is now 10 years old, but the number of vendors serving companies with more than 15,000 employees is limited. Five vendors control 76 percent of the market and 10 hold 92 percent, according to Everest Group. The global market for total HRO hit $31 billion in 2007 and should reach $50 billion in 2010, with a compound annual growth rate of 12 percent, according to Kennedy Information.

    Although the business case for large-market deals is compelling, the viability of single-vendor end-to-end HRO for Fortune 500 companies remains an open question. As the experience at American Airlines indicates, HR executives may want a single HRO vendor, but they might have to settle for a consortium approach.

    "Unlike IT, the very nature of HR may mean that end-to-end outsourcing deals are less suitable," says Jagdish Dalal, managing director for thought leadership at the International Association of Outsourcing Professionals. "HR is a multi-source operation. We’re seeing tasks—payroll, benefits, recruiting, training—outsourced to different vendors, but there are few real end-to-end deals, and the number of these deals will grow only if suppliers build the capability."

    The big contracts are complex and carry heavy upfront costs. Multi-process HRO deals now include an average of six or seven processes out of 11, according to Everest. Among the deals signed from 2005 to 2007, 39 percent were global in their geographic scope. Some vendors are struggling, and the number of large deals signed slowed last year.

    Transformational HRO, which overhauls policies, processes and technology across multiple tasks, rather than just taking out costs in the short term, may take two years or more to achieve results and may be a net-neutral business case in the first few years, according to Everest. In the largest deals, the transformation task alone may take several years.

    Although it is now clear that technology drives the big HRO contracts and real savings are possible by offshoring some components, true integrated end-to-end HRO is still an elusive goal for many companies.

    "If you look at the track record of large HRO deals, it’s not pretty," Brundage says.

Quantum leap
    Brundage wanted transformation, cost savings and accountability. As the world’s largest airline, American is facing the whole roster of problems plaguing the industry. Labor costs at American run $6.7 billion a year and represent 31 percent of total operating expenses. American managed to shave 1.1 percent off labor costs in the first nine months of 2007, but soaring fuel prices and huge pension contributions keep eating away at profits.

    American did very little outsourcing before the 2007 HRO deal. Instead, it was an early adopter of centers of excellence and shared services.

    "During that time, we tried to separate strategic and transactional work and discovered that it’s not simple to find the dividing line," Brundage says. "Our HR function was very strategic, but as we moved down the continuum, it was clear that we faced limitations in our processes and structures, and we needed to address those."

    Brundage knew American needed to make serious capital expenditures for IT but was concerned about the investment.

    "New systems turn over in 18 months and entail significant maintenance costs," he says. "We asked if there was a better way to do it."

    According to Everest, 85 percent of HRO deals include IT components, compared with 39 percent of finance and accounting outsourcing contracts.

    American’s HR function had a tradition of extensive benchmarking and took a strict approach to HR productivity issues. "We knew that we were as productive as we could be with our antiquated IT system," Brundage says. "We decided to make a quantum leap, with no limits on where it might take us."

    Brundage’s direct reports instigated the HRO conversation.

    "We fleshed out all the alternative paths and concluded that a broad outsourcing agreement would best suit our objectives," he says. "Optimally, we wanted transformational change, not just cost savings, and we wanted to work with one vendor."

    Brundage still believes that using a single vendor enhances governance and accountability, but when no vendor was willing to provide all the services, his HR team scaled back the proposal and shifted to a consortium approach.

    "As we removed some of the elements from the project, we found that we were focused on the areas that IBM and Mercer are strongest in—IBM in systems and call centers and Mercer in benefits offerings and administration," Brundage says. "So we spent a year in discussions with IBM and Mercer and learned more about our organization than we ever thought possible. We took as long as anyone in the history of humankind to make the decision."

    Brundage and his HR team set the service level agreements and cost targets and made presentations to the executive committee, groups of employees in all divisions, and finally to the board of directors. "We were extremely transparent about the process," Brundage says. "We did town halls and videos and got a lot of advice."

"Optimally, we wanted transformational change, not just cost savings. ... We wanted to work with one vendor, but no single supplier showed any interest in what we wanted to do."
—Jeffrey Brundage, executive VP for human resources, American Airlines

    IBM now provides support for standardized human resources processes including training, recruitment, staffing and HR-related information technology, plus call center support. Mercer delivers health benefits, pension plan and compensation administration and benefit communications consulting services.

Transformation process
    Brundage anticipated that the HRO deal would lead to HR staff layoffs, but 10 percent of American’s HR employees moved to IBM, and redundant HR employees were offered equivalent jobs in other parts of the company, so the deal did not generate involuntary job loss. During the initial two-year transition, the HR function will drop from 600 employees to 400 employees.

    Within the first month of the deal, American conducted strategy meetings with IBM and launched a Six Sigma effort with the remaining HR employees. American is now working with IBM to bring in training. "We knew that we had to accelerate our improvement efforts," Brundage says.

    The deal incorporates core tasks for the transformed HR organization. One task involves a full evaluation of benefits offerings, with a particular focus on reducing medical plan costs for active employees and retirees while still retaining employees. "This does not mean just scaling back the plans or shifting costs to employees, but expanding wellness programs and looking at a new structure for the plans," Brund­age notes.

    American also is boosting its diversity initiatives and talent management programs with new systems in place.

    "Our shared-services project was constructed to allow us to take the transactional work out of HR and focus on strategy," Brundage says. "But the big change with outsourcing is that it allows us to use systems to produce better results. The transformation has come because we now have a new platform for training, succession planning and compensation planning with greater capability. These are tactical improvements that make HR more effective in supporting the business."

    American expects to save $60 million over the course of the deal and an additional $2 million a year in related administrative expenses, or a total of $8 million annually on a net basis. The company is spending more money in some areas of HR, such as talent management, assessment and compensation planning, than it did before outsourcing, but less money in areas such as call centers.

    "We now have one in Texas and one in the Philippines, with the labor cost savings associated with that," Brundage notes.

    Still, Brundage is clear that he will continue to closely monitor the results.

    "There have been aches and pains here," he says. "Some things slipped through the cracks, and our HR employees are intolerant of screw-ups. But our governance team has acted to correct the problems expeditiously and resolve them satisfactorily."

    In December, Brundage presented the HR budget to the CEO and CFO and was able to report that all targets for costs and headcounts had been met.

Initiating the conversation
    At American Airlines, Brundage and his HR staff proposed outsourcing to top management, but at many companies, the order is issued by the CFO.

    "CFOs are commonly the instigators of HRO," says Stephen Joyce, HR practice leader at the Hackett Group. "The CFO lets HR know that the company needs a 15 percent or 20 percent budget reduction and asks HR how it will achieve that. CFOs focus on the needed cost savings."

"There will be casualties in
terms of service and
disagreements with vendors."
—Stephen Joyce, the Hackett Group

    The frequency of these outsourcing conversations roughly follows the business cycle, with the CEO asking the CFO how the company can maintain profit margins during a downturn or periods of slower growth, and the CFO turning to cost-cutting, Joyce says. "Senior executives are increasingly unwilling to pay for high-touch HR with personal service," he says. "If HR is not on board to make the transformation, then the company will look to HRO. HR may partner with finance to look at an offshore captive, but if the company doesn’t want to handle that internally, it will look to HRO."

    HR executives should step forward before the CFO forces HRO on them, according to Dalal of the International Association of Outsourcing Professionals. "Organizations have realized that HR transaction processing is a commodity," he says. "They see the value in outsourcing and there are enough providers who do a credible job. So executives are now at the point of asking why their company is not pursuing this."

Business case
    Beyond cost-cutting, the intangible benefits of multi-process deals are becoming more clear. "Talent management—not as it is commonly construed by HR but as a pure business issue—is at the top of the C-suite’s list of concerns," Joyce says. "The question is how to take the HR organization and transform it to focus on talent management. The biggest benefit of HRO is that it removes all of the noise from the organization. This is real. The dynamic is that HRO helps change the culture within the client organization."

    HRO mandated from above is a direct response to the lack of action by HR to make the necessary changes. "Resources are not unlimited," Joyce notes. "To get real focus and value from HR, senior executives are picking their priorities, and if they need more resources for talent management, those resources will have to come out of someplace. Talent management is not just HR’s problem, but also a business problem."

    Most HR functions are capable of executing both the transformation and the offshoring tasks, but Joyce notes that many are not willing to move forward, in part because multi-process HRO requires significant planning. Organizational objectives also come into play. If the goal is to cut costs in one to two years, a company may attempt to simply lift and shift HR tasks.

    "But effectiveness and quality may suffer," Joyce says. "There will be casualties in terms of service and disagreements with vendors."

    Hackett’s research report in May 2007 on potential savings from offshoring back-office functions found that the typical Fortune 500 company could save $31 million a year by optimizing HR processes and taking them offshore. Although lower labor costs account for a significant portion of the savings, transformation accounts for the largest portion.

    According to Joyce, three major trends will continue to support the growth of large-market HRO deals. First, a common corporate objective is to make HR run like a business, and outsourcing can support this. Second, HR executives want to get away from chasing systems upgrades, a problem that is growing more acute. And finally, globalization and labor arbitrage—the movement of jobs to countries where labor costs are lower—are imperative. "HR is just starting to realize this," Joyce says.

    Contracts have slowed because suppliers are trying to absorb what they’ve taken on.

    "Another problem is that few advisors have sufficient experience with end-to-end deals and companies have not benefited from their advisors," the outsourcing association’s Dalal says. "The advisors themselves don’t have enough experience with end-to-end HRO."

    Dalal notes that there are advantages to an integrated end-to-end deal with a single vendor, but integration is largely limited to sharing data, not processes. "There is similarity in the data a company uses for both benefits administration and recruiting, but there is little similarity in the processes," he says. "We’ve seen serious problems in some of the end-to-end deals." A consortium approach may be preferable, at least until more capacity comes into the market.

    The multi-process single-vendor approach remains the ideal, and for every anecdotal story about a company taking outsourced HR services back in-house, there are many more about companies sending out RFPs for multi-process single-vendor HRO contracts. HR executives may have to take a breath, however, until more suppliers align with their needs, or new vendors enter the market.

Workforce Management, March 17, 2008, p. 31-37 -- Subscribe Now!

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