In an in-depth look at how pricing works in HRO, the experts at EquaTerra explain how six crucial components of pricing determine what you pay for outsourced services. To ensure you’re paying the most appropriate fee for service, know your internal costs and the nature of your HR needs.
Price—it’s perhaps the most provocative word in the HRO industry. How is price determined? What is a good price? Who controls it? Each of these critical questions looms large before, during, and after an HRO transaction.
Most troublesome is the multitude of factors that determine the actual price. Why can’t price be straightforward? Why can’t an HRO buyer see a menu of prices, similar to purchasing software or ordering from the menu in a favorite restaurant? These seem to be simple questions to the novice buyer. However, a sophisticated buyer understands that the final price is only derived from a complex set of interactions, not all of which are fully under the buyer’s control.
There are many important components to the HRO pricing equation. In this article, we tackle six areas that are poorly understood by prospective HRO buyers: the HRO providers; the HRO marketplace; pricing models and cost components; negotiation; HR technology; and buyer management policies and practices. How these six forces interact with one another at any given point is dynamic and difficult to predict. Hence, HRO pricing is not simple and continues to be a complex and provocative topic.
• HRO Providers. Service providers have become smarter about how they price their solutions since the industry’s founding in 1999. They have also become much more astute in selecting their clients. The list of prospect criteria is longer and more specific than ever before.
Questions they ask include has this client ever outsourced before? Has the client recently undergone significant transformation initiatives? Who is the executive sponsor? Are the business unit leaders autonomous? What is the key catalyst (aka “the burning platform”) that is causing the client to buy HRO now? Have other HR service delivery alternatives (e.g., shared services, selective outsourcing, etc.) been tried before? What is their current HR operating budget? How much HR spend occurs outside the HR budget for services such as training or contingent staffing? Does the prospect have a reputation of being a great client or a horrible one? As incredible as it seems, it is an increasingly difficult proposition for the provider’s pursuit team to get permission to bid on your business. As a potential buyer of HRO, you have to sell yourself almost as hard as the HRO providers are selling to you. This does not sit well with established Fortune 1000 corporations used to having suppliers fawn over their business.
• The HRO Marketplace. An HRO buyer needs to understand past, current, and future market conditions, as they are likely to occur again. Years ago, too many HR outsourcers chased business, and they lacked bid discipline. This allowed buyers to get “great” deals (low pricing) that turned out to be less enduring than what both parties would like to have.
HRO providers were desperate to win business at almost any price, and buyers were willing to let them do it. As a result, HRO prices consistently fell 15 percent a year from 2000 to 2004 before increasing slightly in 2005 and again in 2006 (Fig. 1). Currently, there is a shortage of qualified HRO providers in the marketplace. In EquaTerra’s quarterly Pulse Survey of its HR advisors, a majority cited this capacity shortage for four consecutive quarters. This has caused pricing to continue to increase, and it is forecast to increase modestly in 2007.
• HRO Pricing Models and Cost Components. Important cost components of HRO pricing include the financial base case and various cost components of the HRO provider itself.
• Financial base case: Clients seeking the best transaction price need a clear understanding of their internal delivery cost for the outsourced services. This information is captured through a financial base case that identifies in detail the economic factors related to internal service delivery, associated financial assumptions, multi-year status quo projections, and internal future-state assumptions and initiatives.
The financial base case provides clients with a baseline business case to compare against service provider pricing proposals. Just as importantly, buyers should share their “as is” financial base case (not their internal, future-state business case) with their selected HRO providers. Sacrilege? No. If a buyer desires a lower price, providing a 5- to 10-year projection of their current HR costs (with necessary investments and productivity improvements) dramatically lessens the profitability risk for HRO providers. Hence, a lower risk premium is factored into their price. This seems backward to most procurement departments, but it is factual in the HRO industry.
• HRO Provider Cost Components: Numerous service requirement decisions made by the client will directly affect the cost of HRO. Identification, risk/benefit analysis, and strategic adoption of transformationalactivities can be leveraged to generate beneficial transaction pricing. Most service provider price drivers are not binary; rather, client preferences fall across a range of requirements that combine to drive overall transaction price.
Price-influencing factors include the scope of outsourced processes, the service delivery model (amount of client-unique processes vs. standardized processes), volumetrics (number of monthly and annual transactions per HR process), geographic solution (onshore vs. offshore/multi-shore service delivery mix), technology preferences (platform and client vs. service provider location), and status of in-scope employees (retained vs. transitioned vs. terminated). Assessing your preferences for each of these price factors will help you calibrate your price expectations with the realities of market-driven pricing for the service providers.
For example, requiring a customized service delivery model that retains much of your current processing from onshore service centers supported by client legacy IT infrastructure will produce transaction pricing on the high-end of the market. Alternatively, adopting a service provider’s standardized transaction processes delivered from a blended onshore/offshore service center mix supported by service provider IT systems will produce lower transaction costs. Where clients fall on the pricing spectrum is driven by complex preferences on risk appetite, cost-consciousness, organizational courage, and transformational desire.
HRO pricing models include fully fixed, cost plus, fixed base plus variable adjustment, and fully variable.
• Fully fixed pricing: This pricing model features a fixed fee to be paid for a defined scope of transactions and level of service delivery within a defined time frame. As the fees and scope are fixed, this pricing model is ill-suited to transactions that experience volumetric variability. Both clients and service providers are exposed to significant financial risk by volume fluctuations for in-scope transactions. If volumes increase, the service provider experiences eroding margins and may counter with degraded service delivery. If volumes decrease, clients are over-paying for the services on a per-transaction basis, and seek redress.
Fixed price transactions are generally not suitable for client environments that experience volume fluctuations or for clients that do not have detailed transaction volume history informing their decision.
• Cost plus: This model is a bottom-up approach that applies a negotiated profit margin to the service provider’s cost of delivering services. In its base form, this model produces significant risk for the client. Service providers are incented to mitigate service delivery costs to bolster guaranteed margins. But even poorly run service provider environments produce a margin as the client is burdened with cost overruns borne by the service provider.
This approach is usually only an option when the client has very poor data or no volumetric data. The scope cannot be firmly articulated, or the time frame for executing a transaction is compressed and data collection is not possible. An extraordinary solution, this model is a last resort pricing option for HRO clients.
• Fixed base plus variable adjustment: This HRO pricing model standard is defined by a baseline price to be paid (the fixed component) for a defined baseline volume of transactions adjusted periodically by additional resource charges (ARCs) and reduced resource credits (RRCs; pronounced “rooks”) applicable to volume fluctuations (the variable component).
Clients and service providers alike typically find appropriate risk mitigation and risk sharing in this model. Clients enjoy volume flexibility and unit price certainty. Service providers are attracted to the bifurcation of their ability to recover fixed costs to deliver services and the ability to earn predictable margin on volume fluctuations largely out of their control. The fixed-price-plus-variable-adjustment model is by far the dominant model in today’s HRO market.
Fully variable: This approach is marked by a fully variable price where both fixed and variable cost elements are included in the unit price (e.g., telephone and electric bills). This model more closely mirrors how clients internally do business—paying more for increased consumption and less for decreased consumption. Service providers, on the other hand, are reluctant to contract under this model as it produces risk in their ability to recoup the fixed costs of service delivery if volumes are variable.
For clients and service providers alike to be successful, reliable volumetric history is essential to understand and predict the client’s future transaction demand. HRO buyers with well-documented volumetrics typically garner a lower price from their HRO provider.
It is also important to understand the various pricing mechanics; the core mechanics of how the price can be adjusted will help clients achieve better transaction pricing. These mechanics include base charges and ARCs and RRCs; deadbands and repricing bands; resource units and volume baselines; inflation; and many others.
• Negotiation. Negotiating a commodity or product contract with a supplier is a drastically different proposition than negotiating a long-term outsourcing contract. In the former, the buyer holds most, if not all, the negotiating leverage. If one supplier won’t agree to terms, price or specifications, other eager suppliers will. Taking this negotiating approach to an HRO relationship leads to higher, not lower, prices. An HRO contract is akin to a divestiture with a 10-year service contract back to the parent company.
Unlike an acquisition in which there is only one boss (the acquirer), an HRO relationship has two bosses and feels more like a merger or joint venture than a procurement relationship. Buyer negotiation teams that use a more collaborative style marked by respect of the HRO provider’s commercial needs realize that HRO providers are not substitutable, understand that providers are assuming substantial risk, and are much better equipped to secure a lower price than buyers with a classical procurement mindset.
• HR Technology. HR technology in HRO agreements is subject to blueprint fragmentation. The HRO buyer often demands “standardization,” “simplification,” and “plain vanilla” technology implementations. But buyers’ inability to execute against this desire drives their HRO pricing much higher. Buyers resort to custom code, which usually results in more interfaces, poorly documented processes, and a higher cost. Decoupling core HR components such as payroll and master data leads to higher costs.
Letting certain business units or countries change the basic technology blueprint leads to higher costs. Whether an HRO buyer prefers a commercial application or an HRO provider’s proprietary platform, adopting that technology solution’s best practices and standardization results in lower HRO costs.
• Buyer Management Policies and Practices. This category may be the single biggest determinant in HRO pricing. A lack of consistent policies and enforcement drives your HRO price higher. A buyer’s desire to customize and tailor its HRO solution—instead of relying on established best practices—drives the HRO provider’s delivery costs higher, and hence price is increased. Examples of poor policy adherence include not mandating self-service for all employee and manager populations, lack of demand/consumption management, business unit autonomy, poor rationalization of benefits and compensation policies, too many job codes, and many others. A disciplined HRO buyer that can control its own stakeholders and buyer constituencies can do wonders for securing a lower HRO price.
Another common buyer practice that drives up HRO cost is a lack of clear decision rights among its stakeholders and their interfaces with their HRO provider. Who must be informed of an HRO pricing or service decision? Who must be consulted? Who is the decision maker? Not having these decisions mapped out in day-to-day workflow of the relationship will bog down the efficiency of your HRO provider and will lead to higher costs.
Getting the best HRO price is not merely a negotiation. It is not treating your HRO provider like a commodity supplier. As discussed, achieving the best pricing for your HRO transaction is dependent on numerous interrelated factors. Clients must understand their internal cost of HR service, comprehend the cost drivers for service providers, explore the financial and service delivery impacts of available pricing models, and examine their own behavioral and organizational weaknesses to derive the best HRO price the market can provide.
Mark Hodges is chairman of EquaTerra and can be reached at Mark.Hodges@EquaTerra.com. Adam Sak is a former lead HRO negotiator at the firm.