Professional employer organizations and their role in small and medium enterprises: the impact of HR outsourcing.

While effective HR services and programs can help firms gain competitive advantage, small and medium enterprises (SMEs) often lack the internal resources required to develop and deliver these services and programs. As a result, SMEs increasingly are outsourcing HR activities to professional employer organizations (PEOs). Questions remain, however, about the conditions under which SMEs will benefit from outsourcing HR to a PEO, as well as about the type of benefits that are potentially available. The very nature of many HR activities raises questions about the risks associated with market governance and a PEO's ability to ensure service quality for SMEs. In order for these questions to be addressed, it is necessary to understand the process by which PEO utilization affects SME outcomes. In this article, we use transaction cost economics, social exchange theory, and the strategic HR literature to develop a framework for understanding the factors and conditions likely to affect whether and how an SME will benefit from using a PEO.

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How an organization manages its human resources is increasingly seen as a source of sustainable competitive advantage (SEA) (Huselid, Jackson, & Schuler, 1997; Becker & Gerhart, 1996; Welbourne & Cyr, 1999). The routines, processes, and cultural norms that are part of an HR system can become a valuable resource by virtue of their effect on employee behavior and attitudes. Clearly, however, developing an effective HR system is a difficult task, one that requires the firm to effectively implement a complex set of complementary HR practices that fit the needs of the organization's business and culture (Ulrich, 1996).

Small and medium enterprises (SMEs) face particularly difficult challenges in their efforts to develop HR systems that lead to SCA (Sexton et al., 1997; Baron, Burton, & Harmon, 1996). While the HR function often plays a critical role in developing the HR system in larger firms (Ulrich, 1996), economies of scale make it difficult for SMEs to maintain a professional HR staff and to internally develop required HR programs and services. As a result, an increasing number of SMEs now use market forms of governance to obtain HR services from professional employer organizations (PEOs) (Cook, 1999). While a relatively recent development, it is estimated that PEOs currently provide HR services to three million employees, with this number growing by 30 percent per year (Hirschman, 2000). Once a contractual arrangement is established with a PEO it becomes the employer of record for covered employees through a co-employment relationship. As such, the PEO becomes responsible for a broad array of HR activities, as well as assuming the liabilities associated with being an employer (Baron & Kreps, 1999). Reliance on a PEO offers SMEs several potential advantages. Greater economies of scale and an ability to negotiate more favorable rates for benefit programs offer the potential for substantial cost savings. Further, the efficient access to HR expertise offers mechanisms by which to improve the quality of HR programs and, in turn, HR outcomes (Klaas, McClendon, & Gainey, 1999).

While PEO utilization may offer advantages, questions have been raised about using market forms of governance to obtain HR services (Greer, Youngblood, & Gray, 1999). Many HR activities require asset-specific investments in order for services to be provided (LePak & Snell, 1999b). And asset-specific investments by a buyer increase the likelihood of opportunistic behavior by the vendor (Walker & Weber, 1984). Further, relying on an outside vendor for HR services means that other firms can acquire those same HR services. This raises concerns about whether advantages generated through PEO utilization can be imitated by competing firms (LePak & Snell, 1999a). Finally, service quality might be limited if the outsourcing relationship doesn't permit HR services to be tailored to the needs of the SME (Klaas, McClendon, & Gainey, 1999).

For SMEs, much uncertainty exists regarding when and how to use a PEO. Questions exist about the conditions under which SMEs are most likely to benefit from PEO utilization, about how SMEs should select a PEO and manage the SME-PEO relationship, and about the objectives an SME should pursue when using a PEO. In order to address these questions, it is necessary to understand the process by which PEO utilization affects firm-level outcomes. The purpose of this article is to develop a framework that highlights the process by which a PEO affects key firm-level outcomes.

PEO Utilization and the SME: An Integrative Model

The decision about whether to use a PEO is, in essence, a "make or buy" decision--a decision that has the potential to affect both the cost and quality of an SME's human resources (Walker & Weber, 1984). Our goal in this article, then, is to understand the process by which a PEO affects both the cost and quality of an SME's human resources.

To identify the specific cost and quality variables that should be examined, it is necessary to first understand the nature of the co-employment relationship that is introduced when a PEO is utilized. When an SME uses a PEO, contractual arrangements make the PEO the employer of record for those working at the SME (Baron & Kreps, 1999). In a typical arrangement, the client pays the PEO the actual cost of wages and benefits plus an administrative fee of between 2 and 6 percent of payroll to cover the cost of HR services (Hirschman, 1997). In return, the PEO provides payroll services and a benefits package, ensures compliance with regulatory requirements, and offers HR services and programs, such as training, performance appraisal, safety audits, employee surveys, and advice on employee relations (Cook, 1999).

Because of the nature of the co-employment relationship, one cost variable that PEOs can affect relates to compensation costs. As noted above, the SME pays the PEO the actual cost of wages and benefits. And while wage costs are unlikely to be affected by a PEO, a PEO does have the potential to affect the costs associated with employee benefits (Klaas, McClendon, & Gainey, 2000). Individual SMEs have little leverage when negotiating rates for health or workers compensation insurance. PEOs represent as many as several thousand SMEs and, as such, may be able to obtain more favorable rates from insurance providers (NAPEO, 1993). Also, because workers compensation programs are experience rated, a PEO may be able to obtain lower rates through safety programs that reduce workplace accidents (Cook, 1999).

A second key variable relates to the costs associated with time spent by SME staff members on HR activities. In many SMEs without a PEO, HR activities are performed by a general manager who is primarily responsible for activities more directly related to producing revenue (Holoviak & DeCenzo, 1982; Hannon, Burton, & Baron, 1996). By eliminating tasks for a general manager, a PEO has the potential to affect the opportunity costs associated with time spent on HR.

A third cost variable relates to the administrative fees charged by outside vendors for HR services. Because there is substantial variation in the administrative fees charged by PEOs (Cook, 1999), there is likely to be variation in whether administrative fees are offset by reductions achieved by a PEO in compensation costs and the cost of internal staff time.

A final variable that can be affected by a PEO is HR outcomes (e.g., employee performance, turnover, and customer service orientation). Greater economies of scale may permit PEOs to provide services and programs designed to improve HR outcomes--services and programs that would be cost-prohibitive for an individual SME. However, given that the quality of HR programs and services offered by a PEO may be affected by opportunistic behavior and a lack of familiarity with client needs, there is likely to be substantial variation in the effect that PEOs have on HR outcomes. Variation in the effect of PEO utilization on HR outcomes is also expected because PEOs differ in the degree to which they emphasize programs aimed at changing employee attitudes and behavior. Some PEOs focus primarily on transactional HR services that are more administrative and routine in order to help SMEs save time and money. Others emphasize providing a broader range of services, including those aimed at affecting HR outcomes (Klaas, McClendon, & Gainey, 2000). For these PEOs, while time and financial savings are still an important part of what is being offered, the magnitude of these savings may be somewhat limited by the costs associated with emphasizing a broader range of HR services.

In sum, then, any effect PEOs might have on firm performance will occur through four SME outcome variables: compensation costs, staff time costs, administrative fees, and HR outcomes. However, transaction cost economics, social exchange theory, and the strategic HR literature all suggest that there is likely to be substantial variation across client organizations in how these SME outcomes are affected by PEO utilization. We draw on these theoretical perspectives in developing a framework for understanding why SMEs differ in the degree to which they benefit from using a PEO.