HR IN THE SMALL BUSINESS ENTERPRISE: ASSESSING THE IMPACT OF PEO UTILIZATION BRIAN S. KLAAS, HYEUKSUENG YANG, TOM GAINEY, AND JOHN A.

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1 HR IN THE SMALL BUSINESS ENTERPRISE: ASSESSING THE IMPACT OF PEO UTILIZATION BRIAN S. KLAAS, HYEUKSUENG YANG, TOM GAINEY, AND JOHN A. MCCLENDON Within small businesses, organizational leaders are themselves often responsible for the HR function, an area where they typically have limited training and experience. Not surprisingly, small business leaders have raised concerns about the quality of HR programs in their firms and the fact that HR consumes scarce managerial time. While professional employer organizations (PEOs) emerged in response to such concerns, much controversy exists as to whether and how small businesses benefit from PEO utilization. Using a survey of more than 740 small businesses, we examine the relationship between PEO utilization and two key small business outcomes: managerial time required by HR activities and satisfaction with HR outcomes. Our results indicate that firms not using a PEO reported significantly lower levels of satisfaction with HR outcomes than firms that used a PEO for a limited set of transactional services and firms that used a PEO for both transactional and strategic HR services. Among firms using a PEO, satisfaction with HR outcomes was significantly higher among firms that obtained a broader set of transactional and strategic HR services. Firms that used a PEO also reported that HR consumed significantly less managerial time relative to leaders in firms that made no use of a PEO. However, there was no significant difference in the time demanded by HR between firms that used a limited set of transactional services and those that used a broader range of transactional and strategic services. Implications for the role of PEOs and their use within small businesses are discussed Wiley Periodicals, Inc. Increasingly, organizations are confronted with questions regarding the organization and delivery of HR services. For larger firms, these questions revolve around the HR activities that should be performed by internal staff members versus the activities that should be outsourced (Greer, Youngblood, & Gray, 1999; Lepak & Snell, 1999). Small firms face a very different set of questions. Their size typically makes it Correspondence to: Brian S. Klaas, Moore School of Business, University of South Carolina, Columbia, SC 29208, (803) , klaasb@moore.sc.edu Human Resource Management, Winter 2005, Vol. 44, No. 4, Pp Wiley Periodicals, Inc. Published online in Wiley InterScience ( DOI: /hrm.20083

2 434 HUMAN RESOURCE MANAGEMENT, Winter 2005 cost-prohibitive to maintain an internal HR staff, leaving responsibility for HR activities with the general manager or owner (Cook, 1999). As such, for small firms, questions about the organization and delivery of HR services revolve around whether the general manager should assume responsibility for such activities or whether such services should be delivered by outside vendors. Within the small-business arena, professional employer organizations (PEOs), with their reliance on the co-employment relationship, have emerged as a major alternative for those relying on outsourcing (Klaas, 2003). The very nature of While these choices have substantial implications for cost and the HR function organizational performance, little is known about the effects of utilizing a PEO versus the more tradi- within small firms tional approach of relying on the creates opportunities general manager for HR activities. for the PEO Advocates of PEO utilization often point to the challenges facing outsourcing model to small business leaders when they opt to manage HR issues themselves (Hirschman, 2000). Most positively affect organizational typically, the general manager or owner lacks formal training or experience in HR, which may affect performance. the quality of HR programs and decisions (Heneman, Tansky, & Camp, 2000). Moreover, given that time is a scarce resource within most small businesses, general managers are often limited in the amount of attention they can give to HR matters. Furthermore, time devoted to HR necessarily reduces managerial time available for other critical business issues (Angione, 2001). The very nature of the HR function within small firms creates opportunities for the PEO outsourcing model to positively affect organizational performance (Heneman et al., 2000). However, PEOs and their use has been a source of controversy, raising questions about how often this potential is actually realized (Klaas, 2003). Part of this controversy stems from questionable practices by unscrupulous vendors (e.g., failing to obtain the insurance promised to clients or disguising from insurance providers the actual risks presented by clients) (Braga, 2002; Cole, 2002). Controversy also surrounds an even more fundamental issue namely, whether the very structure of the PEO outsourcing model allows for PEOs to affect key outcomes within client organizations (Hirschman, 2000). While outsourcing HR activities creates challenges for organizations of any size, one might argue that these challenges are even greater in this context. Many HR activities are not well suited to arm s-length contractual relationships and may well require strong and trusting vendor-client relationships (Klaas, McClendon, & Gainey, 1999; Lepak & Snell, 1999). Since PEOs must provide services to a large number of clients with relatively few employees each, vendorclient interaction is likely to be more limited, thus restricting opportunities for the development of trust. Moreover, given that many small business leaders often have little background related to HR, there may be limits on their ability to effectively manage their relationship with a PEO (Cook, 1999). Extensive evidence exists to support the idea that HR practices can lead to improved organizational performance and, ultimately, financial results (Becker & Huselid, 1999; Wright, Smart, & McMahan, 1995; Youndt, Snell, Dean, & Lepak, 1996). By delivering HR expertise and services to small businesses that otherwise would be lacking such expertise and service, one might expect PEOs to yield substantial benefits. Unknown is whether the outsourcing model and delivery system associated with PEOs prevents clients from realizing these benefits. In this article, we examine the impact of using a PEO by examining a sample of small businesses that differ in whether and how they use a PEO. Different Types of Outsourcing, Different Kinds of Risk Much has been written in both the academic and the practitioner literature about how outsourcing varies dramatically with the type of activities being outsourced. For example, transaction-cost economics emphasizes the way in which outsourcing rela-

3 HR in the Small Business Enterprise: Assessing the Impact of PEO Utilization 435 tionships change based on whether the outsourced tasks are off-the-shelf or require extensive customization (Walker & Weber, 1984; Williamson, 1996). Where the services provided are off-the-shelf, market competition and contractual mechanisms are generally thought to be highly effective in ensuring quality service delivery. Since the service is readily available elsewhere, competition will motivate efforts to ensure customer satisfaction. Off-the-shelf services also are likely to allow the client to benefit from economies of scale, since the investment required to design and implement a product or service is spread across multiple customers (Shelanski & Klein, 1995). By contrast, a high level of customization requires an asset-specific investment an investment that makes market competition less relevant and has no value if the client-vendor relationship is terminated. Either party making this type of investment is vulnerable to opportunistic behavior by the other (Hart, 1988; Helper & Levine, 1992). Emphasis also is given to how task uncertainty affects the outsourcing relationship. Where substantial certainty exists regarding the nature and/or level of service provided by the vendor, contractual mechanisms again are likely to be effective tools. By contrast, where there is substantial uncertainty, the risk of incomplete contracting rises, making the client vulnerable to opportunistic behavior if ex-post adjustments are needed (Masten & Crocker, 1985). Resource-based theorists further argue that the risks created by asset specificity and uncertainty are magnified to the extent that the tasks being outsourced are linked to core competencies (Barney, 1991; Connor & Prahalad, 1996). Giving parties outside the firm control over possible sources of competitive advantage is thought to be more risky than outsourcing routine, administrative activities. Different Kinds of Outsourcing, Different Kinds of PEOs In thinking about how PEOs affect firm-level outcomes, we must first examine the type of services outsourced to PEOs. However, PEOs differ substantially in their strategy and focus, a factor that has implications for the types of tasks performed for clients (Aaron, 2000). Some PEOs focus on transactional services (e.g., payroll administration, employee benefits, and regulatory compliance). Other PEOs provide a broader range of services. In addition to transactional services, they also provide services in HR areas that are traditionally considered more strategic (Angione, 2001). HR services are thought to be strategic when they are linked to core activities for the general manager (e.g., improving sales or customer satisfaction) and can be used to The primary function support strategy implementation (Becker & Huselid, 1999). For example, performance management of transactional systems help managers direct employee efforts in ways that are PEOs is the costeffective delivery of consistent with strategic initiatives and can be used to directly administrative affect key outcomes within the firm. services. Since the tasks performed by different PEOs vary, we must address separately the likely effects associated with each type of PEO. In the following sections, we discuss the likely effects associated with using a PEO primarily for transactional services and the likely effects associated with using a PEO for both transactional and strategic services. Using PEOs for Transactional Services The primary function of transactional PEOs is the cost-effective delivery of administrative services (e.g., payroll, benefits administration, and regulatory compliance). The PEO contract creates a co-employment relationship, which means that a PEO is the employer of record for the employees of many small businesses. This position gives the PEO greater leverage with regard to obtaining favorable rates for benefit programs. This leverage, combined with expertise in risk management, presumably allows PEOs to lower the costs associated with providing a

4 436 HUMAN RESOURCE MANAGEMENT, Winter 2005 variety of insurance programs (National Association of Professional Employer Organizations [NAPEO], 1993). When a PEO primarily is used for more transactional services, the tasks being outsourced are largely compatible with market contracting. Required tasks generally are performed in a similar manner across clients, thus limiting asset specificity and allowing for economies of scale (Klaas, 2003). Additionally, the administrative nature of the work means that there is greater certainty regarding the nature of the tasks being performed (Cook, 1999). Because of the characteristics of transactional services, market contract- By affecting ing offers small and mediumsized enterprises (SMEs) an attraction and effective mechanism by which to retention, outcomes ensure quality products and services. We argue, then, that small such as skill level business leaders using PEOs primarily for transactional services and performance will spend less time and energy are also likely, in on managing HR issues than firms that perform these services turn, to be affected. using internal resources. Since the use of a PEO for transactional services makes it easier for a firm to provide a broader range of employee benefits, we argue that utilization of a PEO also may affect HR outcomes. This argument is based on the following logic: (a) using a PEO makes it more likely that employees will receive a variety of benefit programs (e.g., health insurance) because PEO utilization makes such programs more feasible (from a cost standpoint); (b) by enhancing employee benefits, PEO utilization will increase total compensation, which has been found to affect key HR outcomes such as employee turnover and attraction (Delery & Doty, 1996); and (c) by affecting attraction and retention, outcomes such as skill level and performance are also likely, in turn, to be affected. Overall, in comparison to small businesses that make no use of a PEO, we argue that those that use a PEO primarily for transactional service will spend less time and energy on HR issues and also will experience more positive HR outcomes in the form of employee retention, attraction, performance, and skill level. Given that using a PEO only for transactional services is compatible with the control mechanisms offered by market contracting, it may seem obvious that such positive benefits will result. While we think these positive benefits are likely, controversy exists over whether such benefits are observed on a widespread basis (Cook, 1999). Our prediction is premised on the assumption that small business leaders will be effective in utilizing contractual mechanisms, in selecting a competent vendor, and in using market competition to ensure effective performance. However, uncertainty about the validity of these assumptions makes it important for researchers to examine the outcomes that actually result from using a PEO for transactional purposes (Hirschman, 2000). Proposition 1: Satisfaction with HR outcomes will be greater in firms that use PEOs primarily for transactional services than in firms that make no use of a PEO. Proposition 2: HR issues will demand less managerial time in firms that use PEOs primarily for transactional services than in firms that make no use of a PEO. Using PEOs for Both Transactional and Strategic HR Services When firms use a PEO to provide a broader range of HR services (in addition to the transactional services), questions might well be raised about how effectively market contracting is likely to result in ensuring service quality. When PEOs provide HR services in such areas as performance management, rewards and motivation, staffing, and employee relations, they are providing services that vary significantly from more routine, transactional services. With these more strategic HR services, there is greater uncertainty about the kind of service that should be provided and how these services should be delivered (Lepak & Snell, 1999). Such uncertainty makes contract specification more difficult and is likely to necessitate ex-post

5 HR in the Small Business Enterprise: Assessing the Impact of PEO Utilization 437 adjustments to the contract following the initiation of services (Williamson, 1996). In addition, HR services that are more strategic may well require that the PEO understand the needs of each client, including how the firm s business and culture affects the services needed (Cook, 1999). Obtaining such knowledge requires an investment that has value only if the relationship between a client and the PEO continues an asset-specific investment. To the extent that the client pays for any such investment, the client will be limited in the ability to use market competition to ensure effective performance and will be more vulnerable to opportunistic behavior by the vendor. It should be noted that strategic HR activities are often utilized to develop core competencies and to gain competitive advantage. For example, organizations may attempt to gain competitive advantage by developing competencies relating to customer service. Doing so is likely to require that the firm combine HR practices, organizational routines and norms, and initiatives that leverage customer service competencies (Gainey & Klaas, 2003). For such a firm, outsourcing strategic HR services might well be questioned because it would cede control over activities linked to a source of competitive advantage and affect the firm s ability to continue learning how HR is used to build customer service competencies. Clearly, potential risks are associated with using a PEO to provide both transactional and strategic HR services. Greater time may be required to address contractual issues at the outset of the relationship and to resolve issues that were not originally addressed in the contract (Masten & Crocker, 1985). Further, if the contract lacks specificity or if asset specificity limits the use of market competition as a control mechanism, the services provided may affect HR outcomes in an unanticipated manner. We argue that firms may be able to effectively manage these risks. Arm s-length contractual relationships can develop to the point where trust emerges between vendor and client (Gulati, 1995). Indeed, it is within the context of a trusting relationship that the parties come to identify with the needs of the other. Where such identification exists, the psychic cost of violating trust is thought to be a significant check on opportunistic behavior (Nooteboom, Berger, & Noorderhaven, 1997). While trusting relationships between clients and vendors are difficult to develop, evidence suggests that trust in a relationship can play an important role in limiting the effects of opportunism even where the task involves uncertainty and asset specificity (Takeishi, 2001). The risks associated with using a PEO for services in more strategic HR areas also may be limited if the PEO s services are standardized Clearly, potential across clients. Providing a standardized set of services across risks are associated clients may seem contrary to the logic associated with strategic HR with using a PEO to services. However, some services provide both in strategic HR areas would likely have value even if customization transactional and is limited. For example, making valid selection tests available to strategic HR improve workforce quality is services. likely to generate benefits even if those tests were designed to be applicable across a wide range of organizations. Further, other standardized services may function more as decision aids designed to help small business leaders address HR issues in a way that is consistent with the unique needs of the firm. For example, while the performance management process might largely be standardized, the very nature of that performance management system may guide small business leaders through the process of setting goals or identifying competencies that are most relevant to their firm. It might be argued that such generic HR packages would do little to affect employee behavior. However, it is important to consider how human resources would be managed in the absence of a PEO. Without a PEO (or a similarly structured vendor), these services must be provided by the small business leader. Evidence suggests that when strategic HR services must be delivered in this manner, they often are not provided or are pro-

6 438 HUMAN RESOURCE MANAGEMENT, Winter 2005 vided in a largely ad hoc fashion (Heneman et al., 2000). As such, it may well be that professionally developed (but generic) HR programs are preferable to the alternative. Furthermore, as noted by Penrose (1959), competitive advantage is driven by what managers are able to derive from a resource, not from the resource per se. Clearly, mechanisms exist that might allow firms to benefit from using a PEO for both transactional and strategic HR services. The presence of these mechanisms makes it likely that HR outcomes (retention, attraction, skill level, absenteeism, and performance) will be more positive in firms that use a PEO for Human resource both transactional and strategic issues offer many HR services than in firms that make no use of a PEO. We also expect that there will be higher lev- challenges for els of satisfaction with HR outcomes in firms that use a PEO for small-business leaders that often both transactional and strategic HR services than in firms that use bear directly on the a PEO just for transactional services. This expectation is based on success of the firm. the fact that where a firm uses a PEO only for transactional services, responsibility for more strategic areas in HR again falls to the smallbusiness leader meaning that these critical areas may receive limited attention. With regard to the time demanded by HR issues, we suggest that small businesses that use a PEO for both transactional and strategic HR services are likely to spend less time on HR matters than firms that do not use a PEO. However, it is likely that the time savings will be the product of the transactional services rather than the strategic HR services. For many firms that do not use a PEO, more strategic HR services may often be ignored. As such, where a PEO provides these services, time savings are not necessarily going to result. Thus, while firms that use a PEO for both transactional and strategic HR services are likely to spend less time on HR activities than non-peo users, they are not expected to spend less time on such activities than firms that use a PEO for only transactional purposes. While we argue that mechanisms exist for PEO utilization to generate positive effects, controversy exists regarding whether these effects will be consistently observed. For small-business leaders, this controversy raises significant questions. Human resource issues offer many challenges for small-business leaders that often bear directly on the success of the firm, thus highlighting the importance of questions about the impact of PEO utilization. Proposition 3: Satisfaction with HR outcomes will be greater in firms that use a PEO for both transactional and strategic services than in firms that do not use a PEO. Proposition 4: Satisfaction with HR outcomes will be greater in firms that use a PEO for transactional and strategic HR services than in firms that use a PEO primarily for transactional services. Proposition 5: HR issues will demand less managerial time in firms that use a PEO for both transactional and strategic services than in firms that make no use of a PEO. Method Sample The sample consisted of small businesses that used a PEO as well as small businesses that did not. The sample of PEO users consisted of 516 companies that were clients of 49 different professional employer organizations. In cooperation with the National Association of Professional Employer Organizations, over 250 PEO leaders were contacted with regard to their willingness to participate in a study investigating the impact of PEO services on HR outcomes. PEO leaders were informed that participation would require questionnaires to be distributed to a random sample of their clients. Information on the PEOs was also collected. The mean number of clients served by these 49 PEOs was , and the mean number of employees served was 4, We recommended that at least 50 clients be sampled (randomly) per PEO. However, because some PEOs had fewer than 50 clients

7 HR in the Small Business Enterprise: Assessing the Impact of PEO Utilization 439 and because we wanted to encourage participation, we gave PEO leaders the option of specifying a smaller number of clients to be surveyed. The number of clients surveyed by participating PEOs ranged from 5 to 50. The mean number of surveys distributed to client organizations was 32. In total, surveys were sent to 1,568 small businesses that were clients of a PEO. To encourage participation, PEOs were informed that they could themselves randomly sample from their client list and then distribute questionnaires to clients or they could provide us with a client mailing list. We indicated that we would randomly sample the number of clients specified by the PEO and distribute surveys accordingly. We provided this option because we did not want to lose the participation of those PEOs who would have been unwilling to share their client list due to concerns about that list being obtained by a competing PEO. No significant difference was observed in relationship tenure or on a single-item client satisfaction measure between clients surveyed using these different distribution methods. Surveys were sent to the PEO s primary contact person at each client (typically the owner or chief executive officer). Surveys were returned directly to the authors, and all participants were guaranteed confidentiality. To encourage survey participation, client leaders were informed that a small financial contribution would be made to the charity of their choosing if they participated in the study. A total of 516 clients returned questionnaires, resulting in a response rate of 32%. The mean number of full-time equivalent employees among the participating clients was 24. Given the small size of these organizations, the owner/manager is likely to be well positioned to serve as a key informant. Our sample of firms that did not use a PEO was obtained by using a mailing list of 1,000 firms from Dun and Bradstreet. To ensure that the non-peo users were comparable to PEO users, we first calculated the percentage of the PEO sample that had fewer than 50 employees, the percentage that had 50 to 250 employees, and the percentage with 250 to 600 employees. We asked that Dun and Bradstreet use these percentages when randomly selecting firms for our mailing list. Our goal was to ensure that the percentage of firms in the non-peo sample in a given size category approximated the percentage in our PEO sample. We then mailed a survey asking about HR practices within small businesses to the primary contact in these firms (typically the owner or chief executive officer). The small business leaders were informed that a small donation would be made to the charity of their choosing if they completed the questionnaire. In total, 277 responded, resulting in a response Given the small size rate of almost 28%. PEO users of these were excluded, resulting in a sample of 247 non-peo users. The organizations, the mean number of full-time equivalent employees was No significant differences in firm size owner/manager is were observed between the PEO likely to be well and the non-peo sample. Comparisons also were made between positioned to serve the PEO and non-peo sample in as a key informant. terms of industrial classification. Only one significant difference was observed, with the PEO sample having a significantly larger number of firms classified as being in mining and construction. Measures Dependent Variables Two dependent variables were used in this study. Satisfaction with HR Outcomes is a fiveitem scale and is designed to capture leader satisfaction with the level of employee motivation, performance, and skill level in his/her firm as well as the firm s ability to attract and retain employees. All items were measured using a five-point response format ranging from very dissatisfied to very satisfied. The coefficient alpha for this measure was.85. HR Time Requirements contains three Likert-type items and is designed to capture the degree to which HR activities consume time and energy within the firm. All items were measured using a five-point response

8 440 HUMAN RESOURCE MANAGEMENT, Winter 2005 rate format ranging from strongly disagree to strongly agree. A sample item from this scale is: Human resource issues take up a lot of our time here. The coefficient alpha for this measure was.82. This approach to measurement was used because of the difficulty of getting small business owners to provide quantitative measures for variables relating to workforce quality and managerial activities. It should be noted, however, that for a subset of the sample, we were able to In comparing firms obtain data on the turnover rate within the firm. The correlation that use a PEO to between the turnover rate and satisfaction with retention item those that do not, it was.69 (p <.001). Similarly, for a is important to subset of the sample, we were able to obtain estimates for actual recognize that firms hours spent on HR activities. The correlation between this estimate choosing a PEO may and HR Time Requirements was.55 be systematically (p <.001). Items for this and the other measures were developed in different from those consultation with PEO executives, small business leaders, and that do not. the executive director for the PEO industry association. Independent Variables We created dummy variables to capture the extent of PEO utilization. The first dummy (No PEO Use) was coded as 1 if the firm made no use of a PEO and 0 otherwise. The second two dummies were created based on responses to items asking about PEO use in 11 different areas of HR. Extent of usage was measured by the following response scale: no usage, a little usage, some usage, a great deal of usage, or PEO entirely responsible for activity. Across all 11 areas, the mean response was 2.47 (SD =.71). Five of these areas were transactional in nature and involve activities such as payroll administration, employee benefits, worker s compensation, and regulatory compliance. The mean response across these transactional items was 3.22 (SD =.62). Six of the areas have the potential to be more strategic in nature and involve activities such as recruiting and selection, training, performance management, employee relations, reward systems, and motivation and morale. The mean response across these more strategic services was 1.84 (SD =.82). The second dummy (Below-Average PEO Use) was coded as 1 if the firm s usage of a PEO was below the mean level of PEO utilization (within the PEO sample) across the 11 areas of usage (and 0 otherwise). The third dummy (Above-Average PEO Use) was coded as 1 if the firm s usage of a PEO was above the mean level of PEO utilization (and 0 otherwise). It should be noted that among firms that use a PEO, the starting point for services relates to transactional services (e.g., payroll administration). As such, firms that are in the below-average use category are relying on the PEO primarily for transactional services. This is evidenced by the fact that there are no firms within the survey that were above average in their use of strategic HR services but below average in their use of transactional services. By contrast, the above-average use category consists of firms who have added more strategic services to their portfolio of transactional services. This is evidenced by the fact that there were no firms in the above-average use category that did not make at least some use of one or more services in the more strategic HR areas. Control Variables In comparing firms that use a PEO to those that do not, it is important to recognize that firms choosing a PEO may be systematically different from those that do not. Differences may exist in attitudes about managing people, with those most committed to the importance of HR being most likely to use a PEO. However, these beliefs are likely to directly affect managerial behavior, and with that, HR outcomes. This possibility suggests that isolating the effect of using a PEO requires that we also examine the impact of managerial attitudes regarding the importance of managing HR effectively. To measure the perceived importance of effective management of human resource issues, we relied on a three-item Likert type scale (HR

9 HR in the Small Business Enterprise: Assessing the Impact of PEO Utilization 441 Importance). A five-point response scale was used, ranging from strongly disagree to strongly agree. A sample item for this scale is: How we manage our people will have a huge impact on our bottom line. The coefficient alpha for this scale is.80. We also controlled for industry. Each firm s industrial classification was captured through dummy variables based on one-digit standard industrial classification (SIC) codes that were created using information provided by the client. The most frequently reported classifications in the sample were business services and personal services (between 15% and 20% each). Wholesale/retail trade; financial services, insurance, and real estate; and durable goods manufacturing were the next most common (between 10% and 15% each), followed by mining and construction, nondurable goods manufacturing, transportation, communications, and utility services (between 5% and 10% percent). Less then 5% of the sample was composed of organizations in agriculture or public administration. Size was measured by the log of the number of full-time equivalent employees. The mean number of employees was (SD = 56.53). Results Table I presents summary statistics for the variables examined in this study. As can be seen, there are roughly similar numbers of firms in the three categories for PEO utilization (no PEO use, below-average use, and above-average PEO use). The mean for satisfaction with HR outcomes is highest among firms in the above-average PEO use category, followed by the below-average PEO use category. Satisfaction with HR outcomes is lowest among those that did not make use of a PEO. The mean for HR time requirements was highest among firms that did not make use of a PEO, indicating more time spent on HR activities. The mean was lower among firms that were in the below-average PEO use category as well as among firms in the aboveaverage PEO category. Table II presents the regression models estimated for satisfaction with HR outcomes. Model 1 estimates the impact of the control variables. While none of the dummy variables for industry were significant, the coefficient for firm size was significant and negative and the coefficient for HR importance was significant and positive. This suggests that satisfaction with HR outcomes was higher in smaller firms and in firms where human capital issues were seen as more important to the success of the firm. Models 2 and 3 contain both the control variables and the PEO utilization variables. Model 2 includes dummy variables for above-average PEO use and below-average PEO use (with no PEO use being the excluded category). Model 3 includes dummy variables for no PEO use and below-average PEO use (with above-average PEO use being the excluded category. The increase in R 2 from Model 1 to Model 2 (or Model 3) is.05 (F = 20.83, p <.01). As can be seen in Model 2, the coefficient for above-average PEO use is positive and statistically significant, as is the coefficient for below-average PEO use. This suggests that firms were more satisfied with HR outcomes TABLE I Summary Statistics Below-Average Above-Average No PEO Use PEO Use PEO Use Overall Mean SD Mean SD Mean SD Mean SD Satisfaction with HR Outcomes HR Time Requirements N

10 442 HUMAN RESOURCE MANAGEMENT, Winter 2005 TABLE II Regression Estimates: Satisfaction with HR Outcomes Model 1 Model 2 Model 3 B SE B SE B SE Intercept No PEO Use.14*.06 Below-Average PEO Use.14*.06 Above-Average PEO Use.32**.06.18**.06 Firm Size.07**.02.07**.02.07**.02 HR Importance.17**.04.15**.04.15**.04 Industry Industry Industry Industry Industry Industry Industry Industry Industry Industry R N * significant at p <.05; ** significant at p <.01. if they used a PEO either for a limited set of transactional services (consistent with Proposition 1) or for a broader range of transactional and strategic HR services (consistent with Proposition 3). Turning now to Model 3 (where above-average PEO use is the excluded category), the coefficient for belowaverage PEO use is significant and negative, suggesting that leaders within firms that made heavier use of a PEO are more satisfied with HR outcomes than those who relied on a PEO less heavily and primarily for transactional services. Thus, support is obtained for Proposition 4. Table III presents the regression models estimated for HR time requirements. Model 1 estimates the impact of the control variables. While none of the dummy variables for industry were significant, firm size and HR importance were positively and significantly related to HR time requirements. This suggests that HR time requirements were greater in larger firms and in firms where human capital issues were seen as being more important to the firm. Models 2 and 3 contain both the control variables and the PEO utilization variables. The increase in R 2 from Model 1 to Model 2 (or Model 3) is.09 (F = 41.66, p <.01). As can be seen in Model 2 (where no PEO use is the excluded category), the coefficient for below-average PEO use is negative and statistically significant (consistent with Proposition 2). Similarly, the coefficient for above-average PEO use is negative and statistically significant (consistent with Proposi-

11 HR in the Small Business Enterprise: Assessing the Impact of PEO Utilization 443 TABLE III Regression Estimates: HR Time Requirements Model 1 Model 2 Model 3 B SE B SE B SE Intercept No PEO Use.68**.08 Below-Average PEO Use.68**.08 Above-Average PEO Use.57** Firm Size.26**.03.23**.03.23**.03 HR Importance.15**.05.18**.05.18**.05 Industry Industry Industry Industry Industry Industry Industry Industry Industry Industry R N * significant at p <.05; ** significant at p <.01. tion 5). This suggests that, compared to managers in firms that make no use of a PEO, managers in the below-average use category and the above-average use category report spending less time on HR activities. In Model 3 (where above-average PEO use is the excluded category), the coefficient for belowaverage PEO use is not significant. These results suggest that using a PEO for a broader range of both transactional and strategic HR services does not necessarily lead to greater time savings relative to using a PEO for a limited set of transactional services. Discussion Human resource issues present significant challenges to many small firms striving to gain competitive advantage. Not only do transactional issues consume scarce time and energy, but many small-business leaders are challenged by the difficulties associated with attracting, retaining, motivating, and developing talented employees (Heneman, Tansky, & Camp, 2000). PEOs emerged as a mechanism by which to offer small business organizations a cost-effective means of obtaining HR services. PEOs use the co-employment relationship to obtain cheaper rates for benefit programs, thus helping offset the costs associated with using a PEO for transactional and/or strategic HR services. However, the PEO industry remains controversial, perhaps because of well-publicized examples of unscrupulous behavior by a select few. While affiliating with any such unscrupu-

12 444 HUMAN RESOURCE MANAGEMENT, Winter 2005 lous vendors is likely to be problematic, questions exist more broadly about the benefits that might result from using a PEO. Indeed, these questions make it difficult for small businesses to evaluate whether and how to use a PEO to address the human resource challenges that they face (Angione, 2001; Cook, 1999). In this study, we examine the relationship between both satisfaction with HR outcomes and time spent on HR activities and whether/how a small business uses a PEO. Findings from our Small-business sample suggest that using a PEO reduces time spent on HR activities compared to firms that did leaders that did not not use a PEO. Interestingly, use a PEO were less using a PEO for a broader range of satisfied with HR both transactional and strategic HR services did not yield significantly greater time savings com- outcomes than pared to using a PEO primarily for those that made transactional services. One explanation for this result is that transactional services can be provided more limited use of a PEO. without significant day-to-day involvement by the small-business leader, but strategic HR services require the leader s direct involvement. The focus of the PEO in providing more strategic services is to help the small-business leader engage in key HR activities more effectively, not necessarily less frequently. Time savings may not occur, since the programs offered by the PEO ultimately may result in the smallbusiness leader spending more time giving feedback, managing performance, and recruiting and selecting employees. While PEOs, no doubt, strive to help small-business leaders be efficient when engaging in strategic HR activities, the small business leader will still be performing activities that might have been ignored in the absence of the PEO. Our findings also indicate that using a PEO has the potential to affect satisfaction with such outcomes as employee attraction, retention, motivation, performance, and skill level. Small-business leaders that did not use a PEO were less satisfied with HR outcomes than those that made more limited use of a PEO (focused on transactional activities) and those that relied on a PEO for a broader range of transactional and strategic services. From one standpoint, it is not obvious why using a PEO only for transactional services would positively affect satisfaction with HR outcomes. However, it is important to note that using a PEO for transactional services may enable small businesses to obtain benefit programs for their employees in a cost-effective manner. By making benefit programs more cost-effective, PEO utilization may allow the small business to provide health insurance and other benefit programs. Providing such benefit programs may improve the ability of the firm to attract and retain employees, which then could affect employee skill level and performance (Huselid, 1995). It should be noted that small-business leaders using a PEO more extensively (both for transactional and strategic HR services) were significantly more satisfied with HR outcomes than leaders in firms that did not use a PEO or in firms that made less extensive use of a PEO. This finding is interesting because there is reason to question whether using a PEO for services in more strategic areas of HR will yield benefits. The tasks being outsourced are such that questions might be raised about the effectiveness of contractual and market mechanisms. The positive effect associated with using a PEO for both transactional and strategic HR services is also interesting in that questions exist about whether vendors in this context would understand the unique needs of each client. While using a third party to obtain strategic HR services may present challenges, it is important to consider the context in which PEO services are being provided. First, the size of the businesses being served here may preclude PEOs from developing HR services designed specifically for a given client s culture and business. PEOs may have little choice but to develop fairly generic services that require the small-business leader to play a key role in making these services fit their particular needs. For example, services may take the form of decision aids that help small-business leaders work through the development of a struc-

13 HR in the Small Business Enterprise: Assessing the Impact of PEO Utilization 445 tured-interview format. To the extent that the PEO structures its services so that the small-business leader is responsible for addressing the unique needs of their firm, it may be less necessary for the vendor to become intimately familiar with the needs of each client. It may also be that some of the services provided by PEOs in more strategic areas are standardized across clients. For example, PEOs may provide clients with access to standardized tests regarding cognitive ability. Doing so does not require that the vendor invest in acquiring firm-specific knowledge about the client, but it still has the potential to affect employee skill level and performance. As such, while services in more strategic areas within HR may seem ill suited to the outsourcing model, it may well be possible for PEOs to offer services in a manner that adds value for the small business. While we traditionally think of services in more strategic areas within HR as requiring in-depth knowledge of the firm s culture and business (Lepak & Snell, 1999; Wright et al., 1995), within the small-business environment vendors may provide services that positively affect HR outcomes without developing such firm-specific knowledge. In part, this ability is due to the way HR services are likely to be delivered in the absence of any services from a PEO. In many cases, small business leaders have little background or experience with HR issues. Thus, providing standardized services, decision aids for smallbusiness leaders to develop customized HR solutions for their firms, and access to advice and counsel may well allow the small business to gain value through using a PEO. Moreover, providing services in such a manner is likely to place less stress on the outsourcing model. Less firm-specific knowledge is needed, minimizing the need for asset-specific investments and decreasing the firm s vulnerability to opportunistic behavior. Furthermore, to the extent that services are standardized, it becomes easier to specify contractually the services that will be provided. While some might suggest that providing services in such a standardized manner limits the likely impact on HR outcomes, it may well be that standardized services still yield outcomes that are superior to what would result in the absence of a PEO. One reason to question whether using a PEO for strategic HR services could yield improvements has to do with concerns about whether contractual mechanisms and market competition would ensure effective service delivery when there is both task uncertainty and asset specificity. While we suggest above that PEOs limit task uncertainty and asset specificity via standardization, it is also possible that this concern is addressed by moving away from an arm s-length relationship to one where trust and strong personal bonds are prominent. While it takes time for such It may well be that relationships to develop, they do standardized have the potential to limit the services still yield threat of opportunism and promote the development of firmspecific knowledge (Nooteboom outcomes that are et al., 1997; Takeishi, 2001). superior to what In interpreting the results of would result in the this study, it is important to stress that we focused on two outcome absence of a PEO. variables PEOs are designed to affect. Our goal was to address questions regarding whether the PEO outsourcing model is capable of yielding benefits in terms of time savings for small-business leaders and satisfaction with critical HR outcomes. It is important to stress, however, that we did not assess whether the benefits that might results from using a PEO are sufficient to offset the costs. We also want to stress that our findings do not suggest that using a PEO (either for purely transactional purposes or for both transactional and strategic purposes) will necessarily yield the benefits observed here. Without question, there is substantial variation across PEOs in the quality of services provided and their fundamental business objectives. For example, the co-employment relationship has been used by some within the PEO industry to help clients hide workers compensation risks from insurance providers. If offering this vehicle to clients is the primary objective of a PEO, it is unclear if those using such a PEO would obtain benefits in the form of time savings or improved HR outcomes. Similarly, the PEO industry is loosely regu-

14 446 HUMAN RESOURCE MANAGEMENT, Winter 2005 lated in many states, and there have been instances where PEOs have failed to deliver on the most basic of their contractual obligations (Cook, 1999). The clients surveyed for this study all worked with PEOs that agreed to participate in a study where customers would rate their satisfaction with their PEO services. It may well be that the PEO clients surveyed in this study were more likely to be working with reputable PEOs and were confident regarding the quality of their services. This caveat suggests that obtaining the benefits described here may require significant care and caution with regard to PEO selection. In interpreting these results, it is also important to recognize that while we attempted to control for relevant variables, it is possible that systematic differences existed between firms using a PEO and firms that did not. These differences could affect whether the firms benefit from PEO utilization. Finally, it is important to stress that we used subjective measures for both of our dependent measures. While the nature of the sample made these an appropriate choice, it is important to acknowledge that such subjectivity could have affected the observed results. This factor is particularly salient given that we relied on a single source of information from each firm when obtaining our measures. Conclusion The management of human resources presents significant challenges for many small businesses. While PEOs emerged to assist small-business leaders in this area, much controversy remains regarding the appropriate use of a PEO. Questions exist regarding whether PEOs and the outsourcing model actually can be used to affect HR outcomes relating to employee behavior and performance, and how often PEOs are able to deliver on their claim to save time for small-business leaders. Our findings suggest that time savings do result from using a PEO for transactional services. However, our findings indicate that additional time savings do not necessarily result from using a PEO for both transactional and more strategic HR services perhaps because the latter demands the involvement of the small-business leader. Our findings also suggest that using a PEO can positively affect satisfaction with HR outcomes, with satisfaction being highest among firms that used a PEO for both transactional and strategic HR services. In highlighting these findings, it is important to note that there was substantial variation in the benefits actually obtained from using a PEO suggesting that whether a given firm benefits from using a PEO is likely to depend on the PEO that is selected and the relationship that emerges between the PEO and the small business. Acknowledgments This research was funded by the Society of Human Resource Management Foundation and by the Riegel & Emory HR Center at the University of South Carolina. BRIAN S. KLAAS is a professor of management and chair of the Management Department at the Moore School of Business, University of South Carolina. His research interests include HR outsourcing, workplace dispute resolution and employee relations, compensation, and HR in the entrepreneurial firm. He received his PhD from the University of Wisconsin-Madison. HYEUCKSUENG YANG is an assistant professor of management at Yonsei University in Korea. He received his PhD from the Industrial Relations Center at the University of Minnesota in He also served as an assistant professor at the University of South Carolina. His research has been published in such journals as the Journal of Applied Psychology and Personnel Psychology.

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