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 author – Donald 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.

An Introduction to TCO

Earlier this week, Elaine commented on my article from last week How Much Can Outsourcing Really Save. Elaine writes:

“Frankly, there are so many articles published stating different outcome of offshoring and outsourcing ventures. More often than not, people are confused on which side to believe in and which is telling the truth or lying.”

Elaine is, of course, correct in the sense that the savings that can be derived from outsourcing will be debated forever. Although, I would maintain that no one is actually lying. It all depends on how you count the beans.

It is for this reason that I believe that the Total Cost of Ownership (TCO) model is the most effective at determining the cost impact of changing any administrative environment. Today, I’d like to introduce the concepts around TCO.

TCO was first introduced as a concept 10 years ago by the Gartner Group. It was used to determine the cost of maintaining a computer workstation. The cost that was determined was surprisingly high. Later, Arthur Andersen was commissioned to do a study to disprove it, and the controversy hasn’t died down since. Elaine’s comment can attest to that.

In 2003, I conducted a study while at PricewaterhouseCoopers, and determined that the average cost for producing a paycheck is $16 for companies that administered payroll inhouse. Again, this was a surprisingly high number and has caused its own controversy in the market.

The reason TCO identifies higher than anticipated costs is because it is specifically designed to capture ALL costs of production or administration.What are these costs? They are the costs associated with the people (labor) doing the administration, the people implementing the systems and the people maintaining the systems. We also include the costs that are associated with the employees but are not part of the salary (non labor) such as tax and benefits load, physical infrastructure (rent, utilities, property tax), general and administrative (telephone, computer, office supplies).

Costs are further identified as either one time costs or as ongoing / recurring costs. This is important because one time costs such as implementation costs or cost for upgrades can cause cost spikes in certain years. The onetime costs, therefore, are depreciated over a certain period of time. Theses costs are amortized over three years in the studies I have conducted.

Individual companies sometimes depreciate capital expenses over 5 or seven years.The costs that are considered will typically cross multiple departments and budgets within an organization. If a TCO model isn’t used to identify costs, typically only certain department costs will be included and the cost is understated. This is why TCO produces dramatically higher cost than expected.

The calculated costs can be represented in any number of ways. It can be on a per widget manner such as $16 per paycheck. It can be presented as a total cost over the expected useful lifetime of a product such as $40,000 for a car after principal, interest, maintenance, etc over 10 years (less for an American car), it can be expressed as an annual run rate ($3 million per year), or even on a per employee basis. You name it; it can probably be expressed in a different way.

And the funny thing about numbers, depending on the expression, the numbers can seem either really big or really small. $16 per paycheck may not seem like much unless you start thinking about a company that produces 1 million paychecks per year.The interesting thing about TCO in any case, 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. This is how TCO relates to ROI. It is also where the controversy takes on a life of its own as reasonable people can disagree on what impact change can have on a system. For instance, will automating a particular process result in a head count reduction of 1 or 2 people? Is the redeployment of personnel real cost savings? How do TCO and ROI relate to build an actual business case for change?

And of course, how do figures lie and liars figure? Over the next few weeks I will be going more in depth on these questions and on TCO. I welcome input from the readers to help me focus the discussion on what will be most helpful to you.

About the author – Donald 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.

How Much Can Outsourcing Really Save?

I set this article aside some time ago with the intention of commenting on it at some point. Now is as good a time as any.

The story, “Survey: Outsourcing saves less than claimed” is based on a survey conducted by TPI. The gist of the story is summed up in the lead:

“Outsourcing of information technology and business services delivers average cost savings of 15 percent, a survey found on Thursday, disproving market claims that outsourcing can reduce costs by more than 60 percent.”

Now I don’t know about anyone out there reading this blog, but I’ve never really heard claims of 60% savings through outsourcing. So I went to Google and started looking for myself. Then I went to Yahoo and continued looking; and darned if I couldn’t find any study or article or blog entry or anything claiming that companies can save more than 60% through outsourcing.

In all, I tried about 20 search strings. Now granted, some of the searches yielded a lot of results, but the first few pages didn’t show anything so I moved on. If any of the 1.2 million people reading this article can cite a study claiming such huge savings, please let the rest of us know. And when you do, you’ll win the door prize for most effective web search guru. Of course, people do tend to exaggerate at times. For instance, I know that just slightly over 800,000 people are reading this now. That’s nowhere near 1.2 million. So maybe our friends at TPI were just exaggerating.

Maybe they’ve seen claims of massive savings from offshoring (for a refresher on the difference between offshoring and outsourcing, click here). I hesitate to believe that TPI, one of the leaders in the sourcing consulting business, would confuse offshoring with outsourcing. But even if they did, I found this article which claims “that India’s wage rate for computer programmers is 15% that of a programmer in the United States. But in that same article, we hear from an industry expert that ‘Realistically, a company might expect to save about 20% through outsourcing.’”

The TPI study article goes on to say that “savings range between 10 percent and 39 percent, with the average level at 15 percent. These are very interesting numbers to me. Why?

Because I have conducted three Total Cost of Ownership (TCO) studies over the past three years. In all, over 260 companies have participated. Each of the companies had over 1,000 employees. In other words, these weren’t small companies.

The studies looked at the TCOs of delivering payroll services, HRIS, and benefits administration in both the inhouse and outsourced environments. In the weeks to come, I will write more about TCO and the studies specifically. What I want to point out today is that the studies showed that on average, outsourcing saved 17% on benefits administration and 37.5% on payroll administration. The TPI numbers, as I said are very interesting to me. They validate what I have seen with my own research.

For goodness sake, the “Lift and Shift” BPO outsourcing model typically goes for a cost minus 15%- 20%. So where does that 60% claim come from? Maybe it was just an uninformed middle manager at a company that was in the process of outsourcing who made the claim. Maybe it was a bad business case someone once saw.

Wherever it came from, the healine Survey: Outsourcing saves less than claimed does everyone a diservice.

Headlines like this really get to me for many reasons. I’ll talk about these in the weeks to come as well, but the biggest reason is that very frequently, the most effective outsourcing is really cost neutral as savings which are realized can be very effectively “reinvested” in the transformation of the HR function. And especially important in the success of any major outsourcing initiative is the proper management of expectations. How many people out there see this headline and simply think outsourcing really doesn’t help companies achieve their goals?

Shame, really. Maybe someone out there can shed some light on this 60% claim and together - 800,000 strong - we can educate the public on the real benefits that outsourcing can bring when done right!

About the author – Donald 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.