A moderated exchange between two leading HR services providers.
By Michael Beygelman and Darren Simons
HROT: Let’s start with some definition of terms. Michael?
Beygelman: Total cost of ownership (TCO) is not unlike a financial approach that is designed to help organizations determine direct and indirect costs. It is also akin to an accounting approach that can be used in full cost accounting or instances where there are hard/soft/other (perhaps social) costs.
Typically, or should I say conceptually, when TCO is used in a benefit analysis, it should provide a cost basis for determining the economic value of an investment.
Now when we get into value creation we begin to transcend TCO concepts and perhaps start treading on the concept of economic value added (EVA). Or perhaps the RPO (other HRO) industries need to evolve past the TCO concept and need to look at EVA. Historically TCO has included things like internal rate of return (IRR), return on investment (ROI), and EVA, and it is this I question, whether or not EVA should be part of TCO or if EVA is the next level.
A TCO analysis might include not only cost to operate but also cost to acquire and manage (e.g. how much did it cost you to get the deal done and manage the relationship?). A TCO analysis is sometimes used by accounting and finance people to better understand potential impacts of any investment. An EVA approach might take all of these things into account.
And on the topic of corporate finance, EVA has typically been defined as an estimate of economic profit, which is the value created in excess of the required return of the organization’s stakeholders. Quite simply, EVA is the profit earned by an organization minus the cost of financing the capital used to produce the profit. The EVA idea is the value created when the return on the firm’s capital deployed is greater than the cost of that capital that is deployed.
So how does EVA and/or TCO pertain to our discussion of value creation?
HROT: It would seem to. But let’s frame this a bit more closely. Outsourcing creates the ability for companies to impact their human resources beyond financial benefit in terms of productivity, employee branding, retention, etc. How can an HR executive create a rubric that their CEO, COO, CFO accepts to illustrate these benefits? Does it make sense for the provider to develop this for them?
Beygelman: I think that the outsourcing partner needs to work with their corporate HR counterparts to further investigate the concept of EVA in the context of HR. Ultimately, while an outsourcing partner might physically do the work to create the EVA for HR model or framework, their corporate HR counterpart is equally responsible for identifying the items of value, and collectively both parties will develop methodologies for how to accurately measure and appropriately value these items.
A newly developed and/or modified EVA approach designed for HR might take what appear to be "qualitative" attributes and begin quantifying them. As with EVA (for finance), where cost of deploying the capital is taken into consideration of the capital that is generated as a result, HR can assess the cost of deploying and managing a program (or not deploying—it could work both ways), and the downstream benefits/risks, as part of a new EVA for HR calculation to begin quantifying value creation in HRO.
HROT: The services provided need to change at certain key points in an outsourcing relationship, but a customer’s contract might not account for growth. How can a provider illustrate that outsourcing needs to evolve mid-program to account for changing customer goals, culture, and direction beyond the finances?
Beygelman: What I find interesting is the ability to potentially change the problem to address this question—meaning when one problem cannot be solved eloquently, consider changing the problem to something that might be more solvable and achieve your ultimate purpose.
For example, we can change the problem statement to say that prior to engaging with a customer, a new EVA for HR model or HRO value creation must be established and made part of the contracting process and the subsequent governance model. The model might call for specific outputs (i.e. overall program/economic value creation that is required by the client organization). What is interesting is that if what is required is $5 in EVA creation (for example), the focus will change from whether the $5 needs to be created by subtracting $10-$5, or subtracting $100-$95, because the client organization has a required level of value creation (based on this new model).
So in a future state, if the industry moves towards this concept, the provider can freely discuss target EVAs with the customer and the provider’s approach on how they plan to attain them. It also allows for less-confrontational change management because if mid-contract the client organization needs to generate $10 of EVA, the client and the provider can create a new EVA (economic) model on how to achieve this objective (e.g., yes, they might require more input to get more output, but the model would validate this). The other nice thing about this concept is that it can accommodate a client requiring increasing (year over year) EVA for HR in a contract term (i.e. $5 in year one, $6 in year two, $10 in year five, and so on). This would necessitate (or even mandate) that the provider adapt their service delivery model to the new EVA for HR requirement realities. This is the "rod" approach. Now the "carrot" approach might be to develop a similar model but with EVA for HR value sharing, that if the provider attained the "desired" but not "required" targets, there would also be financial benefit for them.
Overall, I don’t think that a model is sustainable whereby the HRO service provider is called to generate incremental EVA for HR year over year for a customer, yet the customer expects this to be the whole purpose of the HRO initiative and retains all the add-on EVA. That might work temporarily, or in one-off situations, but ultimately it will likely lead to a disequilibrium between the parties.
HROT: Darren, this notion of creating and measuring an evolving RPO value proposition raises parallel questions. How do companies measure the value of the engagement in the first place? What different methods or models make sense for which organizations? Are some modes better than others? And how do you measure and create sustainable value over the lifetime of the engagement?
Simons: Companies first started outsourcing the recruiting function with a primary goal of cost reduction. Today, however, many organizations are looking to outsource to a third party to improve operational performance and create extended value to the enterprise. Measures often are driven back to commodity-based transactional comparisons and have not kept pace with RPO’s evolving value proposition.
Measuring value needs to start by aligning the measurement tothe strategic intent of the outsourcing engagement. Once strategic intent (cost savings, value producing, transformational) has been agreed to and communicated to all stakeholders along the extended value chain, a measurement system can be established.
In the early days of RPO, the primary objective of certain engagements was to have the current process done cheaper and or to make the cost itself more variable (first generation). However many firms are looking for more out of their recruitment function and not just reduce/contain costs.. Many of today’s engagements (second generation deals) go further, aspiring to improve operational performance and service levels, extend the firms brand, hire better talent, free up the business to focus on higher-value-added activities, and to use it as function to derive competitive advantage. Aspirational firms are looking towards the next evolution in RPO ( third generation deals—strategic talent optimization) as a way to create strategic and exponential value through integration/expansion of multiple processes.
A total cost of ownership approach is perfectly suited to engagements and companies whose primary objective is cost savings and/or a drive to variable cost. The history of TCO can be traced most directly to Gartner and evaluating IT investment. It is a great model when comparing static products and/or investment into commodity-like purchases.
TCO focuses on the cost side of the equation and examines not only investment needed to acquire a good or service but also ongoing and incremental expenditures. TCO has become a benchmark analysis for making both make and buy decisions and can be applicable for an RPO engagement depending on the strategic intent of the buying organization. First generation buyers or those that are focused on cost reduction find TCO a very beneficial tool. Advanced TCO users are able to factor in risk reduction in terms of creating a variable cost and setting up a system to allow for cost avoidance in the area of downturns.
The pros of TCO are clear. It’s easy to use; it’s inear, discrete, and understood by a broad and cross-functional audience. Its primary measurements align with the procurement function and traditional accounting measurements.
The cons are equally clear. It’s static and usually does not take into account fluctuations in inputs or mix of goods. It’s one dimensional as its view is on the cost side of the equation with little or no consideration of expanded value or return on joint investments (unless it incorporates Michael’s constructs.)
HROT: And what does that look like?
Simons: The perspective of total value created, however, extends the measurement of value beyond the transaction itself and looks to the extended business environment to look at causes and outcomes of value being created. This type of strategic view of value is ideally suited for organizations looking to improve operational performance, repurpose manager time to core business activities that generate more value to the organization, and to groups that recognize that human capital itself is a variable that can be harnessed to extend the enterprise value proposition.
Where is value attributed or derived? Is it the using manager in the form of having better talent or having to spend fewer hours on the recruitment process? Is it the shareholder in the form of more profits because key talent was hired faster? Value is derived from many touch points and must be examined holistically.
Positive benefits can touch across the entire value stream— shareholders, employees, work groups within the firm. But those outside the firm, such as suppliers and customers of the firm, must be considered in a dynamic model. This model incorporates TCO as matter of course and balances it against tangible and intangible benefits that impact the entire business. Consider a value equation that compares total benefits (value) to both the original TCO and engagement TCO—the difference being value created or destroyed.
By examining shareholder value we find that transaction view of TCO is not comprehensive enough to accommodate the value being driven from an engagement.
For example, shareholder return must look at two distinct prongs, cost savings and revenue/margin enhancements. Both are additive to the firm’s profitability and create value. There are plenty of example:
• Better talent is sourced and hired that leads to new product innovation driving firm profitability.
• Turnover is decreased through better hiring; and this leads to better customer retention increasing the profitability of the firm.
• The employment brand is positively increased and it bleeds over to influence consumer buying behavior increasing sales for a product or service.
Again, the pros are clear. You get a holistic view of business impact (investments and returns). And it enables, encourages, and rewards value creation.
The cons are that it can be difficult to measure based on availability of data. Also the complexity of the model is greater than TCO. It’s difficult to structure agreements and contracts around.
Measuring and managing to a total value created methodology requires that the organization and the provider work very closely in determining both measurements and data collection and formalization of management principles.
HROT: So, the third generation?
Simons: That would take the total value created model and extend it beyond a view of just direct recruitment. What other processes when combined or integrated could create value in the other work streams? Evolving the previous model to incorporate impacts into adjacent and complimentary value streams—i.e., onboarding, contract hiring, independent contractors—allows us to not only examine value in the various work streams but integrated value. This model is highly variable in terms of measurements as it is dependent on how afar the process extends into the broader enterprise. This model is and will be an evolution of the total value created model.
Recruitment is a function that is directly affected by macro-economic turns and also with shifts in business direction and strategy. Unfortunately, most contracts and measurements that are executed do not contemplate these inflection points and instead focus on a point in time when a contract was formed. In this static view of RPO, the engagement produces value by costing less with the same outputs and assumes that inputs (supply and demand) remain constant.
In today’s dynamic business environment, this myopic view results in contracts that are solely focused on TCO and not forward looking, resulting in an engagement structure that actually discourages evolution of a model to meet the changing needs of the business. Additionally, this inhibits the innovation needed for the creation of new value and creates a cycle of stagnation that can negatively impact the business.
This is seen where engagement produce benefits that the model itself provides (cost savings, shift to variable cost, scalability) and after the initial period of benefit (mostly TCO reduction) there is limited new value creation or long term quality degradation.
A dynamic value creation approach would be to treat the engagement as if it were a joint venture. Using methodologies like total value created to prioritize and make investments (sometimes joint) to reach the value creation potential of the engagement is a progressive, non-transactional view. Joint investment decisions encourage and hold the partnership as an entity accountable for creating value and managing ROI decisions. Transparency allows for not only shared risk but the ability to ensure alignment to key business outcomes.
This type of model requires that there is a strong governance structure that is aligned to value creation and that management and leadership of the engagement is focused on business priorities that will drive value and not to a static contract. This progressive approach requires more sophistication from both the buying organization and the service provider. Enabling continuous value creation is the responsibility of both parties in the partnership.
The point is that while value is often created, it is not so often accurately captured and articulated. There are many models that can be used to examine the benefits of an engagement. But strategic intent needs to drive selection of the appropriate model for an engagement.
Michael Beygelman is president of Adecco RPO, North America. Darren Simons is vice president and general manager of SourceRight Solutions.