Friday, July 28, 2006

TCO: A Case Study

Some time ago, a fortune 500 company acquired another fortune 500 company. At the time, the acquiring company was a PeopleSoft shop for payroll and HRIS. The acquired company had been outsourcing payroll and accessed a hosted HRIS system for their HR needs. Both companies were roughly the same size and a decision needed to be made: how should the combined company process payroll and what should be the combined company’s HRIS?

Situations such as this arise fairly frequently. You would think the answer is easy. Everything else being equal, jus do what’s cheaper, right? Of course first off, everything isn’t always equal. Quality and risk concerns and all kinds of other non-financial factors need to be considered.

And what of the question of what is the more cost effective solution? Well in this particular case, the manager in the legacy PeopleSoft shop was asked to determine the comparative costs of bringing the entire company onto PeopleSoft or on the outsourced platform. The manager did an “economic evaluation” and concluded that outsourcing the combined company’s payroll and HRIS would cost the company an additional $2.2 million per year!

How accurate and credible was this evaluation? Was there an inherent conflict of interest with having the PeopleSoft IT manager conduct the study? Last week I stated: “The interesting thing about TCO, is that it provides the ability to baseline costs in a holistic manner. Any change to the environment can then be evaluated more accurately as the impacts of all departments and processes can be evaluated.”

TCO to the rescue!

In this case, the TCO model could be credibly used to:
  • Evaluate the assumptions made in the economic evaluation by comparing component costs to companies that had previously participated in a broad based TCO study
  • Could project future state staffing and delivery models in a consistent manner using TCO methodologies
  • Could identify previously overlooked costs in the initial evaluation
The results of the application of the TCO model to this case revealed that the more likely outcome was that converting the outsourced portion of the company to PeopleSoft wouldn’t save $2.2 million per year, but rather only $200,000. Adjusting for better benchmarked assumptions allowed for better estimates of future upgrade costs, revealed termination penalties in the current outsourcing contract, better estimated future state staffing models, and recognized more accurate outsourced pricing given a doubling of the company size.
Interestingly, the ROI analysis that the CFO applied changed the economics back towards inhouse processing because he dismissed the contract termination fees and the higher data conversion fees as capitalized merger expenses, seemingly not “real” cost. An interesting approach I thought, but not one I thought the shareholders would agree with, this is a clear example of how TCO and ROI don’t always match up. In the end, however, the economic situation was viewed as a basic wash.

The non-financial case became even more important, and critical to the non financial case was the concept of risk. It is important to note that in the time between when the initial economic evaluation was conducted and when my own analysis was presented to the CFO, the acquiring company had lost their payroll manager, the PeopleSoft It manager and 3 other key individuals to turnover. Positions had gone unfilled for months and were backfilled with more expensive contract labor. Additional costs were incurred for recruiting, and IT initiatives were put on hold. Risks became clear, and the impact on cost became more transparent. The impact did not go unnoticed by the SOX compliance auditors either.

The lessons from this story are many. Some that I would like to highlight are the following:
  • Utilizing TCO methodologies allows for a more accurate “all in” analysis of cost
  • Using credible benchmarking of costs can illuminate bad assumptions or outright obfuscations
  • Even with agreed upon costs, reasonable people can still disagree on the financial treatment of costs and the impact on ROI.
  • Although non-financial business case elements are typically full of “soft” costs, many times these soft costs become hard dollars.
  • Risk analysis and mitigation should always be a primary component of any evaluation of this sort.
For those who are curious as to how this case was resolved, The CFO left the company (I’m not sure why, maybe the share holders were also “reasonable” people who disagreed on the treatment of capital expenses), a new CFO took a look at the business case and ROI analysis, and the new combined company no longer uses PeopleSoft for payroll and HRIS.
Although no company names were used in the presentation of this case study, the names were changed to protect the innocent. Of course, if ever pressed, this was a fictional case study. How is it stated in all those novels we read? Ahem:

This case is a work of fiction. Names, characters, places, and incidents are either products of the author’s imagination or are used fictitiously. Any resemblance to actual events or locales or persons, living or dead, is entirely coincidental.
Ok, I feel better now.
About the authorDonald Glade is President and Founder of Sourcing Analytics, Inc., an independent consulting firm specializing in helping companies optimize their HR / benefits / payroll service partnerships through relationship management, financial analysis, and process improvement.

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