1

How Small and Medium Enterprises Benefit From

Human Resource Outsourcing

White Paper

You Can Make the Most of Your PEO-SME Partnership If YouHave a Third Party to Monitor, Monetize and Safeguard Your

Business Interests

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. AdministrativeScience Quarterly, 29, 373-391

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PEO: A Win-WinProposition

For Employees: Benefittbetter benefits and a safe

workplaceFor SMEs: Maximum

utilization of theirworkforce, reduced

workforce, legal hasslesand cost savings

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

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 resourcemanagement 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 organizationalperformance: 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 ofManagement Journal, 42, 616-632

3 Sexton, D.L., Upton, N.B., Wacholtz, L.E., & McDougall, P.P. (1997). Learning needs of growth-orientedentrepreneurs. Journal of Business Venturing, 12, 1-8; Baron, J.N. & Kreps, D.M. (1999). Strategic humanresources. New York: John Wiley & Sons

4 Cook, M.F. (1999). Outsourcing human resource functions. American Management Association, NewYork.5 Hirschman, C. (1997). All aboard: The boom in employee leasing may bring good career opportunities forHR professionals. HR Magazine, 42, 80-86

4

What Can a PEO Do for You?

PEOs offer businesses a widevariety of services--including

payroll management, employeebenefit design and administration,tax filing and administration and

compliance with state and federalworkplace legislation. PEOs alsotake responsibility for developing

and administering lawfulemployment policies and

procedures; employee recruitmentand disciplinary actions;

recordkeeping; andunemployment, disability andworkers' compensation claims

and administration.

assuming the liabilities associated with being a co-employer with the SME6. 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 & Sons7 Klaas, B.S., McClendon, J., & Gainey, T. (1999). HR outsourcing and its impact: The role of transaction

costs. Personnel Psychology, 52, 113-1368 NAPEO. (1993). The business of employee leasing, Alexandria, VA: NAPEO.

Nooteboom, B., Berger, H., & Noorderhaven, N.G. (1997). Effects of trust and governance on relationalrisk. Academy of Management Journal, 40, 308-338.

9 Cook, M.F. (1999). Outsourcing human resource functions. American Management Association, NewYork10

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 fewerthan 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 millionnationwide. Their collective are estimated

at $18 billion.

Source: National Association of ProfessionalEmployer Organizations, Alexandria, Virginia

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

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 toSignificant Paperwork Reduction

state, typically, the client pays the PEO theAn SBA study estimated that the

average small business owner spendsbetween 7% and 25% of his or her

time handling employee-relatedpaperwork. When you add in the timespent on all the other HR tasks, this

figure rises to 35% to 45%. Mostsmall business owners recognize justhow valuable a commodity their time

is and would rather devote theirenergy to core business operations.By outsourcing these functions to a

PEO, they can concentrate on makingtheir businesses grow.

(Source: Bruce E. Katz, What a PEO Can Dofor 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

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 defeated12.

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, NewYork13 Klaas, B.S., McClendon, J., & Gainey, T. (1999). HR outsourcing and its impact: The role of transactioncosts. Personnel Psychology, 52, 113-136

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NetPEO’s Service Bouquet

We provide a whole spectrum of HRservices

This includes:

Payroll servicesTax creditWorkers’ Compensation InsuranceAll other aspects of human resourcemanagement, related to risk and safetymanagement, compliance, pensionadministration, benefit auditing andpayment remittance

In short, NetPEO can provide an integratedhuman resource solution for your enterprise.

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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'sterms 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 insurancequestions 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)

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.

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

contract15. 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 infederal tax legislation enabled companies

to maintain pension plans for managementand key employees that differed from those

for regular stag employees--provided thestag employees were leased. Although thatsafe harbor disappeared, in 1982 with the

passage of the Tax Equity and FiscalResponsibility Act, the trend it established

toward employee leasing continued.Leasing companies extended their services

to encompass the entire HR area, leading tothe birth of the PEO.

PEOs now perform myriad tasks. Somestates recognize them as "co-employers"

since they assume certain legal rights andduties related to employees who work at

client locations. (Please note: The IRS doesnot use the term co-employer--it recognizesPEOs as employers.) The rights and duties

PEOs assume are set forth in a contractbetween 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

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.

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

17Bridges, 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

behavior by the PEO18 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

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.

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

17

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