Professional Employer Organizations and Their Role in Small and Medium Enterprises: The Impact of HR Outsourcing

Transcription

1 Copyright 2003 by Baylor University E T& P Professional Employer Organizations and Their Role in Small and Medium Enterprises: The Impact of HR Outsourcing Brian S. Klaas While effective HR services and programs can help firms gain competitive advantage, small and medium enterprises (SMEs) often lack the internal resources required to develop and deliver these services and programs. As a result, SMEs increasingly are outsourcing HR activities to professional employer organizations (PEOs). Questions remain, however, about the conditions under which SMEs will benefit from outsourcing HR to a PEO, as well as about the type of benefits that are potentially available. The very nature of many HR activities raises questions about the risks associated with market governance and a PEO s ability to ensure service quality for SMEs. In order for these questions to be addressed, it is necessary to understand the process by which PEO utilization affects SME outcomes. In this article, we use transaction cost economics, social exchange theory, and the strategic HR literature to develop a framework for understanding the factors and conditions likely to affect whether and how an SME will benefit from using a PEO. How an organization manages its human resources is increasingly seen as a source of sustainable competitive advantage (SCA) (Huselid, Jackson, & Schuler, 1997; Becker & Gerhart, 1996; Welbourne & Cyr, 1999). The routines, processes, and cultural norms that are part of an HR system can become a valuable resource by virtue of their effect on employee behavior and attitudes. Clearly, however, developing an effective HR system is a difficult task, one that requires the firm to effectively implement a complex set of complementary HR practices that fit the needs of the organization s business and culture (Ulrich, 1996). Small and medium enterprises (SMEs) face particularly difficult challenges in their efforts to develop HR systems that lead to SCA (Sexton et al., 1997; Baron, Burton, & Hannon, 1996). While the HR function often plays a critical role in developing the HR system in larger firms (Ulrich, 1996), economies of scale make it difficult for SMEs to maintain a professional HR staff and to internally develop required HR programs and services. As a result, an increasing number of SMEs now use market forms of gover- Please send all correspondence to: Brian Klaas, Department of Management, Moore School of Business, University of South Carolina, Columbia, SC klaasb@moore.sc.ed Fall,

2 nance to obtain HR services from professional employer organizations (PEOs) (Cook, 1999). While a relatively recent development, it is estimated that PEOs currently provide HR services to three million employees, with this number growing by 30 percent per year (Hirschman, 2000). Once a contractual arrangement is established with a PEO it becomes the employer of record for covered employees through a co-employment relationship. As such, the PEO becomes responsible for a broad array of HR activities, as well as assuming the liabilities associated with being an employer (Baron & Kreps, 1999). Reliance on a PEO offers SMEs several potential advantages. Greater economies of scale and an ability to negotiate more favorable rates for benefit programs offer the potential for substantial cost savings. Further, the efficient access to HR expertise offers mechanisms by which to improve the quality of HR programs and, in turn, HR outcomes (Klaas, McClendon, & Gainey, 1999). While PEO utilization may offer advantages, questions have been raised about using market forms of governance to obtain HR services (Greer, Youngblood, & Gray, 1999). Many HR activities require asset-specific investments in order for services to be provided (LePak & Snell, 1999b). And asset-specific investments by a buyer increase the likelihood of opportunistic behavior by the vendor (Walker & Weber, 1984). Further, relying on an outside vendor for HR services means that other firms can acquire those same HR services. This raises concerns about whether advantages generated through PEO utilization can be imitated by competing firms (LePak & Snell, 1999a). Finally, service quality might be limited if the outsourcing relationship doesn t permit HR services to be tailored to the needs of the SME (Klaas, McClendon, & Gainey, 1999). For SMEs, much uncertainty exists regarding when and how to use a PEO. Questions exist about the conditions under which SMEs are most likely to benefit from PEO utilization, about how SMEs should select a PEO and manage the SME-PEO relationship, and about the objectives an SME should pursue when using a PEO. In order to address these questions, it is necessary to understand the process by which PEO utilization affects firm-level outcomes. The purpose of this article is to develop a framework that highlights the process by which a PEO affects key firm-level outcomes. PEO Utilization and the SME: An Integrative Model The decision about whether to use a PEO is, in essence, a make or buy decision a decision that has the potential to affect both the cost and quality of an SME s human resources (Walker & Weber, 1984). Our goal in this article, then, is to understand the process by which a PEO affects both the cost and quality of an SME s human resources. To identify the specific cost and quality variables that should be examined, it is necessary to first understand the nature of the co-employment relationship that is introduced when a PEO is utilized. When an SME uses a PEO, contractual arrangements make the PEO the employer of record for those working at the SME (Baron & Kreps, 1999). In a typical arrangement, the client pays the PEO the actual cost of wages and benefits plus an administrative fee of between 2 and 6 percent of payroll to cover the cost of HR services (Hirschman, 1997). In return, the PEO provides payroll services and a benefits package, ensures compliance with regulatory requirements, and offers HR services and programs, such as training, performance appraisal, safety audits, employee surveys, and advice on employee relations (Cook, 1999). Because of the nature of the co-employment relationship, one cost variable that PEOs can affect relates to compensation costs. As noted above, the SME pays the PEO the actual cost of wages and benefits. And while wage costs are unlikely to be affected by 44 ENTREPRENEURSHIP THEORY and PRACTICE

3 a PEO, a PEO does have the potential to affect the costs associated with employee benefits (Klaas, McClendon, & Gainey, 2000). Individual SMEs have little leverage when negotiating rates for health or workers compensation insurance. PEOs represent as many as several thousand SMEs and, as such, may be able to obtain more favorable rates from insurance providers (NAPEO, 1993). Also, because workers compensation programs are experience rated, a PEO may be able to obtain lower rates through safety programs that reduce workplace accidents (Cook, 1999). A second key variable relates to the costs associated with time spent by SME staff members on HR activities. In many SMEs without a PEO, HR activities are performed by a general manager who is primarily responsible for activities more directly related to producing revenue (Holoviak & DeCenzo, 1982; Hannon, Burton, & Baron, 1996). By eliminating tasks for a general manager, a PEO has the potential to affect the opportunity costs associated with time spent on HR. A third cost variable relates to the administrative fees charged by outside vendors for HR services. Because there is substantial variation in the administrative fees charged by PEOs (Cook, 1999), there is likely to be variation in whether administrative fees are offset by reductions achieved by a PEO in compensation costs and the cost of internal staff time. A final variable that can be affected by a PEO is HR outcomes (e.g., employee performance, turnover, and customer service orientation). Greater economies of scale may permit PEOs to provide services and programs designed to improve HR outcomes services and programs that would be cost-prohibitive for an individual SME. However, given that the quality of HR programs and services offered by a PEO may be affected by opportunistic behavior and a lack of familiarity with client needs, there is likely to be substantial variation in the effect that PEOs have on HR outcomes. Variation in the effect of PEO utilization on HR outcomes is also expected because PEOs differ in the degree to which they emphasize programs aimed at changing employee attitudes and behavior. Some PEOs focus primarily on transactional HR services that are more administrative and routine in order to help SMEs save time and money. Others emphasize providing a broader range of services, including those aimed at affecting HR outcomes (Klaas, McClendon, & Gainey, 2000). For these PEOs, while time and financial savings are still an important part of what is being offered, the magnitude of these savings may be somewhat limited by the costs associated with emphasizing a broader range of HR services. In sum, then, any effect PEOs might have on firm performance will occur through four SME outcome variables: compensation costs, staff time costs, administrative fees, and HR outcomes. However, transaction cost economics, social exchange theory, and the strategic HR literature all suggest that there is likely to be substantial variation across client organizations in how these SME outcomes are affected by PEO utilization. We draw on these theoretical perspectives in developing a framework for understanding why SMEs differ in the degree to which they benefit from using a PEO. Among firms using a PEO, the SME outcomes shown in Figure 1 are likely to be directly affected by five variables suggested by the theoretical perspectives used in this article. Specifically, constraints on opportunism, trust, firm-specific knowledge, client receptivity to PEO advice, and PEO resources are all thought to directly affect one or more SME outcomes. Figure 1 also displays how characteristics of the PEO, the SME, and the SME-PEO relationship affect these direct determinants of SME outcomes. Finally, the feedback loop shown in Figure 1 indicates that SME outcomes, over time, will affect characteristics of the SME-PEO relationship that, in turn, will affect other key elements of the model. We now examine in detail each component of Figure 1. Fall,

4 Figure 1 The Effects of PEO Utilization: An Integrative Model Constraints on Opportunism Asset-Specific Investments Contract Characteristics SME Cost and Quality Variables Relationship History and Tenure Relational Trust Client Receptivity Administrative Fees Staff Time Costs PEO Resources Service Delivery Model Human Capital HR Systems Size Firm-Specific Knowledge HR Outcomes Compensation Costs SME Outcomes and Constraints on Opportunism According to transaction cost economics (TCE), market forms of governance such as outsourcing offer important advantages. These advantages include economies of scale, access to expertise, and efficiencies resulting from heightened incentive-intensity and the discipline offered by market competition (Masten & Crocker, 1985). Within TCE, it is assumed that vendors will be economically motivated and, as such, will behave in a way that is consistent with their self-interest (Williamson, 1975). Thus, with outsourcing and market governance there is the potential for firms to become vulnerable to opportunistic behavior by their vendor. TCE suggests that within outsourcing relationships, contractual mechanisms and the discipline offered by market competition are the primary mechanisms by which to control such opportunistic behavior (Joskow, 1988; Hart, 1988). The constraints offered by contractual mechanisms depend largely on a firm s ability to anticipate its needs as well as all contingencies and to completely specify these needs within the contract (Helper & Levine, 1992). With regard to contracts between a PEO and an SME, there are likely to be differences in whether specifications exist as to the conditions under which fees can be adjusted as part of contract renewals. Whereas some contracts only permit increases that result from a change in insurance or employment taxes, others place no restrictions on price adjustments during contract renewals. Similarly, contracts may differ in whether they specify the number and type of training programs available to clients as well as how these programs will be delivered (Hirschman, 1997). As a final example, contracts may differ in whether they make explicit the PEO s liability for legal compliance (Cook, 1999). All these examples suggest that there may be significant differences in the constraints on opportunism created by the SME-PEO contract. 46 ENTREPRENEURSHIP THEORY and PRACTICE

5 TCE also suggests that the discipline offered by market competition will be of limited effectiveness when the buyer makes an asset-specific investment in order for the vendor to be able to provide quality services (Riordan & Williamson, 1985). An asset-specific investment is one that has value only if the relationship with the vendor continues. Because an asset-specific investment limits the ability of a firm to switch vendors, such an investment may diminish the degree to which market competition constrains opportunism (Shelanski & Klein, 1995). For example, when services are obtained from a PEO, an SME may make an asset-specific investment in order for the vendor to be able to provide quality services. While many transactional HR activities are thought to require little familiarity with a firm s business or culture, more strategic HR activities are thought to require an in-depth understanding of the issues facing a firm (Delery, 1999; Arthur, 1992). To the extent that an SME pays for a PEO to acquire this in-depth understanding, it has made an investment that has value only if it maintains its relationship with the PEO. Much variation is expected across SME-PEO relationships in the level of assetspecific investments made by the SME. For example, firms that have an idiosyncratic culture or business processes might require a larger asset-specific investment in order for HR services to be provided (Klaas, McClendon, & Gainey, 1999). Variation is also likely in whether the PEO shares the up-front costs associated with making such an investment. Where a PEO shares the up-front costs of an asset-specific investment in order to develop a long-term relationship, opportunistic behavior by the vendor is less likely. Finally, there may also be variation in the degree to which an SME uses a PEO for more strategic HR services (Klaas, McClendon, & Gainey, 2000). Where emphasis is given to more transactional services, there may be less need for asset-specific investments. Consistent with TCE, we suggest that SME outcomes will be adversely affected when constraints on opportunistic behavior are limited due to incomplete contracting or assetspecific investments made by the SME. Since PEO contracts are usually annual contracts (NAPEO, 1993), a PEO that faces few constraints on its ability to behave opportunistically may introduce excessive price increases as contracts are renewed. Also, whether a PEO produces time savings for an SME s managerial staff depends largely on whether service providers are available to provide prompt service (Hirschman, 1997). Where there are few constraints on opportunism, this availability might well be affected by efforts to cut labor costs or efforts to re-allocate resources in order to generate new revenue. Time savings at the SME might also be affected if opportunism makes ex post contract adjustments difficult and time consuming. Finally, where the PEO perceives few constraints on opportunism, HR outcomes are less likely to improve as a result of PEO utilization. Specifying the exact nature of programs designed to affect employee motivation and commitment is difficult to do in advance (Klaas, McClendon, & Gainey, 1999). As such, PEOs behaving opportunistically could limit the resources they devote to such programs (Greer, Youngblood, & Gray, 1999), resulting in fewer improvements in HR outcomes. Constraints on opportunism are unlikely to affect SME compensation costs, however. Because SMEs pay the actual cost of wages and benefits, PEOs are less likely to gain from higher compensation costs (Cook, 1999). While we propose a relationship between SME outcomes and opportunism constraints, we also would argue that this relationship should be examined with the range of PEO services held constant. We argue this, in part, because the type of HR services that are designed to affect HR outcomes also are the type of services that require assetspecific investments either by the SME or the PEO. Proposition 1: When asset-specific investments and incomplete contracting limit constraints on PEO opportunism, SMEs will (with the range of PEO services held Fall,

6 constant): (1) pay more in administrative fees; (2) experience less reduction in staff time costs; and (3) experience less improvement in HR outcomes. SME Outcomes and the Role of Relational Trust in the SME-PEO Relationship Opportunism plays a central role in transaction cost economics largely because it is assumed that vendors are economically motivated and will act in a way that benefits the organization that they represent (Williamson, 1975; Williamson, 1996). Social exchange theorists (Blau, 1964) argue that vendors may not necessarily behave opportunistically even if there are few constraints on their ability to do so (Ghoshal & Moran, 1996). While many market-based relationships are arms-length in nature, over time, buyers and vendors may develop relationships that are characterized by open and frequent communication and a willingness to adjust to the needs of the other party (Gulati, 1995; Ring & Van de Ven, 1992). At some point, relational trust develops, characterized by deep, personal ties and a tendency to identify with the other party (Lewicki, McAllister, & Bies, 1998). According to social exchange theorists (Blau, 1964), when relational trust emerges within a relationship, opportunistic behavior is less likely (Nooteboom, Berger, & Noorderhaven, 1997). For instance, if relational trust emerges between PEO representatives and SME leaders, the PEO representatives will identify with the needs of the SME and be motivated to pursue the interests of the SME as well as the PEO. Because opportunistic behavior would be a violation of that trust, engaging in such behavior would impose psychic costs that, perhaps, would be sufficient to offset any economic motivation to behave opportunistically (Coleman, 1990). This suggests that where relational trust is high, a PEO would be less likely to behave opportunistically even when there are few constraints on that opportunism. Proposition 2: Relational trust will moderate the relationship between opportunism constraints and SME outcomes. Figure 1 also suggests that trust is likely to have a direct effect on SME outcomes. Because market-based contracting is thought to expose buyers to opportunism, buyers often respond to this risk by carefully monitoring vendor activities (Barzell, 1982; Hart, 1988). This need for monitoring has the potential to at least partially offset time savings that might be generated by the outsourcing of HR activities to a PEO. However, where relational trust is high, the other party s motives are assumed to be positive. As a result, it is assumed that the other party will behave in a trustworthy manner across a wide variety of circumstances (Lewicki, McAllister, & Bies, 1998; Coleman, 1990). By reducing the perceived need to monitor vendor activities, relational trust should reduce the cost of staff time devoted to HR activities among firms using a PEO for HR services. Proposition 3: The cost of staff time devoted to HR activities will be lower when relational trust has emerged within the SME-PEO relationship. The Emergence of Relational Trust in SME-PEO Relationships As Figure 1 suggests, relational trust plays an important role in determining the benefits that result from PEO utilization. However, as has been noted in the social exchange literature, relational trust does not develop easily and, once developed, is fragile (Jones & George, 1998). In light of this, it is important to examine what factors within the SME and the PEO contribute to the emergence of trust. Given that relational trust plays a critical role in determining whether an SME will benefit from PEO utilization, it is impor- 48 ENTREPRENEURSHIP THEORY and PRACTICE

7 tant that both SME and PEO leaders understand how such trust develops. This is true even if the emergence of trust depends on processes controlled largely by the other party within the SME-PEO relationship. For example, by understanding how processes controlled by the PEO affect the emergence of trust, SME leaders are better positioned to evaluate and select a PEO partner and to manage their relationship with the PEO. As Figure 1 indicates, both PEO resources and relationship tenure and history are likely to be important in determining levels of relational trust in the SME-PEO relationship. PEO Resources. A key managerial challenge facing many PEOs is that they must provide services requiring both specialized expertise and familiarity with client needs to a large number of small, geographically dispersed clients (Klaas, McClendon, & Gainey, 2000). In responding to this challenge, PEOs have explored a variety of service delivery models in an attempt to ensure appropriate levels of coordination and communication as well as effective incentives and control devices (NAPEO, 1993). We argue here that whether trust emerges between SME leaders and PEO representatives will depend on the service delivery model used by the PEO. Specifically, trust is more likely to emerge in an SME-PEO relationship if the service delivery model used by the PEO permits repeated interaction with the same set of PEO representatives. Because relational trust emerges from interpersonal relationships, in order for it to develop, the same set of individuals must interact extensively across time (Gulati, 1995; Jones & George, 1998). Thus, service delivery models that encourage such repeated interaction are likely to facilitate the development of relational trust. Such repeated interaction is likely to occur when the PEO uses client service teams that are responsible for a small number of clients and consist of individuals with both specialized expertise and cross-functionality (NAPEO, 1993). Such repeated interaction is also likely when the PEO uses generalists to serve as the interface between the client and the PEO s subject matter experts. Such repeated interaction is less likely when the service delivery model utilizes call centers organized on the basis of functional specialization. When such an approach is used, a client is serviced by whichever PEO representative is available in the area of specialization where the client needs assistance. While service delivery models of this type offer advantages in terms of managerial control and administrative efficiency, over time, the client will work with a number of different PEO representatives (Klaas, McClendon, & Gainey, 2000). Service delivery models emphasizing call centers of this sort inhibit the development of relational trust because they do not facilitate repeated interaction between SME leaders and the same set of PEO representatives. Another PEO resource that may encourage the development of relational trust revolves around policies and practices that contribute to the retention of PEO staff representatives. Within the strategic HR literature, it is well established that effective human resource practices as well as a supportive organizational culture encourages employee retention (Becker & Huselid, 1999; Becker & Gerhart, 1996). SMEs that work with PEOs that possess such practices and cultural characteristics are more likely to develop relational trust with their PEO. Higher retention rates make it more likely that the SME will interact with the same PEO staff members over time and, thus, that relational trust will emerge. Proposition 4: Relational trust is more likely to be developed in SME-PEO relationships when the PEO has the following organizational resources: (1) a service delivery model that encourages repeated interaction between SME leaders and the same set of PEO staff members; and (2) human resource practices and cultural characteristics that encourage the retention of PEO staff members. Fall,

8 Relationship History and Tenure. The tenure and history of the relationship between a client and its PEO is also likely to affect relational trust. While the level of trust at the outset of a relationship may sometimes be high (McKnight, Cummings, & Chervany, 1998), more typically, the personal ties that form the basis of relational trust are unlikely to emerge quickly (Gulati, 1995). Extensive amounts of positive interaction (in which each side demonstrates the willingness to adjust to the needs of the other) are typically thought to be necessary in order for deep, personal ties to emerge. Thus, the development of relational trust is likely to require that parties invest significantly in developing a long-term relationship characterized by effective service delivery and positive interactions between SME leaders and PEO staff members. Proposition 5: Relational trust will be greater in SME-PEO relationships that are characterized by high levels of tenure and positive interaction between SME leaders and PEO representatives. A key component of relationship history relates to the behavior of the SME toward the PEO. During the initial stages of any relationship, some level of skepticism exists regarding the motives and credibility of the other party. Only after this initial skepticism about the other party is resolved is it possible for interaction to lead to the development of relational trust. Indeed, initial skepticism about the other party may prove to be a significant barrier to the development of relational trust (Lewicki, McAllister, & Bies, 1998; McKnight, Cummings, & Chervany, 1998). However, SME leaders may be able to minimize this barrier. By investing greater efforts to gather in-depth data from existing clients of the PEO during the search process, initial skepticism about the PEO will reduced if positive information is obtained. The experience of third-parties, then, can substitute for personal experience with the PEO and, thus, facilitate the development of relational trust by making it more likely that the parties will move beyond skepticism regarding the other party (Das & Teng, 1998). It is important to also note that relational trust emerges from an iterative process in which over time each side of a relationship displays an increasing level of concern for the well-being of the other party and, in doing so, assumes some risk that the other party will not reciprocate (Mayer, Davis, & Schoorman, 1995). This implies that relational trust is unlikely to emerge unless there is reciprocity from the SME (Gulati, 1995). SME leaders may be able to facilitate the development of trust by showing concern for the needs of the PEO and exposing themselves to the risk that they will not be compensated for their efforts. For example, displaying flexibility regarding the timing of the delivery of PEO services when consistent with SME needs may serve to demonstrate concern for the PEO and, thus, encourage the reciprocal process through which relational trust can emerge. Relational trust and the other variables that flow from it impose a burden on SME leaders with regard to the time that must be devoted to communication with PEO representatives. The quality and frequency of communication between two parties is a significant predictor of trust (Nooteboom, Berger, & Noorderhaven, 1997). As such, while a PEO is used, in part, to save time through reduced administrative burdens, relational trust may be more likely to emerge when SME leaders devote some of the resulting time savings in regular and open communication with PEO representatives. Proposition 6: Relational trust will be more likely to emerge in SME-PEO relationships when SME leaders: (1) collect extensive information from existing PEO clients prior to the initiation of services; (2) demonstrate concern in a reciprocal fashion for the needs of the PEO; and (3) communicate extensively with PEO representatives. 50 ENTREPRENEURSHIP THEORY and PRACTICE

9 SME Outcomes and the Role of Client Receptivity Many PEO services focus on administrative areas such as payroll, employee benefit programs, and regulatory compliance. Services in these administrative areas are designed primarily to reduce compensation costs and SME staff time costs. Further, they typically do not require the ongoing cooperation and involvement of SME leaders (Hirschman, 2000). Other PEO services target HR outcomes and are less easily compartmentalized (Klaas, McClendon, & Gainey, 2000). Programs offered to affect HR outcomes are designed to guide and advise SME leaders on HR issues that are typically viewed as core areas in terms of managerial responsibility and leadership for the general manager of an organization. Because of the nature of the co-employment relationship, PEOs are limited in their ability to ensure compliance with their advice on these employee relations matters (Cook, 1999). Further, it is well established that contractual mechanisms within market governance are of limited value in resolving disputes over the process by which to accomplish required tasks (Connor & Prahalad, 1996; Dow, 1987). Within this context, contractual mechanisms are of little value should an SME client choose to ignore a PEO s advice about whether to terminate an employee, about the need for employee training, or about how feedback is provided to employees. Thus, where there is a lack of receptivity to the advice provided by the PEO, the SME is less likely to be able to take full advantage of the expertise and programs offered by the PEO. Client receptivity is also critical because one way that PEO utilization affects HR outcomes is through the learning that occurs when SME leaders observe the consequences when they follow guidance offered by the PEO. Much knowledge about employee relations issues is tacit in nature, and best understood through experience (Ulrich, 1996). For example, within an organizational hierarchy, tacit knowledge is thought to be transmitted when subordinates follow the directives of a superior and observe the consequences of the approach taken. With contractual relationships, however, a similar mechanism does not exist for ensuring the transmission of tacit knowledge (Connor & Prahalad, 1996). Thus, where there is a lack of client receptivity, tacit knowledge is less likely to be transmitted to SME leaders. And transmission of this tacit knowledge, over time, is likely to affect HR outcomes within an SME. Proposition 7: Among SMEs using a PEO, HR outcomes will be most positive when SME leaders are receptive to PEO advice and counsel. The Emergence of Client Receptivity in SME-PEO Relationships While it might be assumed that SME leaders who contract with a PEO are likely to seek out the PEO for advice and counsel regarding how to improve HR practices, evidence suggests there is substantial variation in the primary motivation behind the utilization of a PEO. Just as some SMEs are motivated by a desire to build human and social capital in their workforce, many others are primarily interested in the cost and times savings offered by the PEO (Klaas, McClendon, & Gainey, 2000; Lever, 1997). Indeed, among those primarily interested in cost and time savings, there may, in fact, be some skepticism about whether effective management of HR can lead to improved business performance (Klaas, McClendon, & Gainey, 2000). Because skepticism about whether effective management of HR can lead to improved business performance may be rooted in long-held attitudes and beliefs (Ulrich, 1996), PEOs are likely to be more effective in changing those attitudes and beliefs where relational trust exists in the SME-PEO relationship. However, where relational trust exists in the SME-PEO relationship, it is more likely that recommendations about HR programs Fall,

10 and practices will be accepted even if the basis for those recommendations are not fully understood by SME leaders. As such, we argue that client receptivity will be positively related to relational trust in the SME-PEO relationship. Proposition 8: Client receptivity to PEO advice and counsel will be positively related to relational trust within the SME-PEO relationship. SME Outcomes and the Role of Firm-Specific Knowledge The strategic HR literature argues that the impact associated with HR practices will depend on the degree to which those activities support a firm s corporate strategy and are linked to the conditions facing the firm (Wright, Smart, & McMahan, 1995). This conclusion suggests that effective delivery of HR services requires that service providers develop firm-specific knowledge. When HR services are provided by internal HR professionals, such firm-specific knowledge may develop through the natural course of providing HR services (Wright et al., 1997). Physical proximity and informal interaction between service providers and both employees and managers facilitates the development of knowledge about business processes and organizational dynamics (Ulrich, 1996). When PEOs provide services, the lack of physical proximity and informal interaction makes it more difficult for firm-specific knowledge to develop. However, such knowledge is still likely to be critical. While transactional HR activities are not likely to require firm-specific knowledge, efforts to affect employee performance, retention, and skill are increasingly seen as requiring knowledge of conditions and processes at a firm (Wright et al., 1997). Thus, we argue that SMEs will experience better HR outcomes when characteristics of the PEO, the SME, and the SME-PEO relationship permit PEO service providers to gain firm-specific knowledge about client organizations. Proposition 9: The degree to which an SME experiences improved HR outcomes as a result of PEO utilization will depend on the degree to which its PEO service providers possess knowledge about business processes and conditions at the SME. The Emergence of Firm-Specific Knowledge in SME-PEO Relationships Because firm-specific knowledge required for effective delivery of HR services is not easily compartmentalized and transmitted, learning about such matters often occurs over time through informal means as more routine services are provided (Ulrich, 1996). The importance of informal learning means that aspects of the PEO, the SME, and the SME- PEO relationship will affect the development of firm-specific knowledge. PEO Resources. Because firm-specific knowledge is not easily transmitted, it is critical that the SME work repeatedly across time with the same PEO representative or team of representatives. Such repeated interaction is less likely when a firm s PEO employs a service delivery model that emphasizes call centers with functional specialization (Cook, 1999). With such a service delivery model, greater priority is given to ensuring a timely response based on appropriate technical information than to ensuring that the SME works with the same individual or team over time. Because each SME client will work with a variety of service providers over time, it is difficult for service providers to accumulate firm-specific knowledge. By contrast, when a client interfaces primarily with generalists or teams assigned specifically to them, repeated interaction and the accumulation of firmspecific knowledge is more likely. 52 ENTREPRENEURSHIP THEORY and PRACTICE

11 Another PEO resource likely to be critical in determining firm-specific knowledge is the ability to retain PEO staff members. Organizational culture and managerial practices play a key role in determining employee retention and, as a result, can serve as a resource for the PEO (Barney, 1991). Where organizational culture and managerial practices allow the PEO to be more effective at retaining staff, it is more likely that the SME will interact with the same PEO representatives over time, thus allowing for the accumulation of firm-specific knowledge. Proposition 10: There will be higher levels of firm-specific knowledge about client organizations when the PEO has resources that (1) permit an SME to interact repeatedly with the same PEO representatives over time; and (2) encourage the retention of PEO representatives. Relationship History and Tenure. Consistent with the arguments made above, Figure 1 also suggests that relationship tenure is a critical determinant of firm-specific knowledge. The accumulation of knowledge about the idiosyncrasies of a firm s business processes and culture takes time given that much learning occurs via informal and experiential means (Connor & Prahalad, 1996). Thus, if neither the SME nor the PEO takes steps to encourage the development of a long-term relationship, it may be less likely that firmspecific knowledge will develop among PEO service providers. Proposition 11: The tenure of the relationship between an SME and a PEO will be positively related to the level of firm-specific knowledge within the PEO. Figure 1 also suggests that the client s willingness to be forthcoming about the idiosyncrasies of the personalities and processes in his/her firm is likely to depend on the degree to which SME leaders trust PEO staff members. In order for third-parties to acquire the firm-specific knowledge required to affect HR outcomes, it is necessary that SME leaders share potentially sensitive information about people and processes at the firm (Becker & Huselid, 1999). As such, relational trust is likely to play a critical role in determining whether SME leaders are willing to openly communicate about people and management processes within the SME. Proposition 12: Relational trust in an SME-PEO relationship will be positively related to the level of firm-specific knowledge possessed by a PEO representative. SME Outcomes and the Role of PEO Resources Figure 1 suggests that PEO resources directly affect SME outcomes. While understanding this relationship is clearly important for PEOs, it is also critical for SMEs who must evaluate and select a PEO based on factors such as organizational resources. The importance of understanding this relationship is highlighted by the fact that efforts by a PEO to develop a resource that will affect a particular SME outcome will sometimes hinder efforts to affect different SME outcomes (Cook, 1999). As such, understanding the complex relationship between PEO resources and SME outcomes is critical if SMEs are to select the type of PEO that will help them achieve their particular objectives. One reason that SMEs contract with a PEO is to save money through lower compensation costs. The ability of a PEO to deliver on these potential cost savings is likely to depend on two types of resources. First, PEO size is likely to increase negotiating leverage with insurance providers and enable the PEO to get better insurance rates for client organizations. As such, PEO size is likely to be an important resource, translating into lower benefit costs. Another key resource that may lower compensation costs relates Fall,

12 to human capital resources. One way of lowering SME compensation costs is for the PEO to find ways to reduce the accident rate across its client base. Since worker s compensation rates are experience rated, the ability to change safety practices within client organizations is likely to be critical (Cook, 1999). Thus, SMEs that select PEOs with the human capital required to affect safety practices are likely to benefit by reductions in overall compensation costs. Human capital resources are also likely to affect both HR outcomes and SME staff time costs. Whether SME leaders experience time savings from using a PEO depends, in part, on whether service providers competently execute administrative processes (Klaas, McClendon, & Gainey, 2000). When there are errors in the execution of administrative processes, time savings for SME leaders are, in essence, consumed by the need to address the consequences of any such errors. Similarly, whether SMEs experience improved HR outcomes depends on whether service providers are effective in diagnosing the source of HR problems and designing effective HR programs and interventions (Baron & Kreps, 1999). Thus, human capital among service providers is likely to affect both HR outcomes and staff time costs within SMEs. A final PEO resource relates to the service delivery model used to provide HR programs to client organizations. Many SME clients use a PEO primarily to save money and time. As such, it is not uncommon for PEOs to focus primarily on transactional HR services (e.g., payroll, benefits, and regulatory compliance). These transactional HR services tend to be more routine and administrative in nature and can often be delivered in a standardized way across client organizations (Hirschman, 1997). Among PEOs that focus primarily on transactional services, less attention is given to HR services that are designed to improve the management of people within the SME. The service delivery model is driven by the focus on saving time and money for the SME, which often leaves little room for programs and services to be tailored to the unique needs of individual clients. By contrast, in an effort to differentiate themselves, other PEOs emphasize both transactional HR services as well as services more closely linked to core managerial and leadership activities within the SME (Klaas, McClendon, & Gainey, 2000). Such PEOs compete not on price, but rather on the basis of unique services that are designed to give the SME a competitive edge in attracting, retaining, and motivating employees. Thus, emphasis is also given to services that revolve around facilitating the effective management of people within the SME. However, services designed to change managerial and employee behavior require a service delivery model that allows for the PEO to tailor its services to the needs of each client organization. As such, a service delivery model that allows for some degree of customization is likely to be critical for PEOs that attempt to differentiate themselves from the transactional PEO model. And where the service delivery model permits customization, we would expect more positive HR outcomes to result. Services related to staffing, performance management, motivation and rewards, and employee relations often revolve around efforts to change managerial and employee attitudes and behavior (Becker & Huselid, 1999). And such interventions are less likely to be effective unless they have been designed and implemented in a way that is consistent with business processes as well as organizational culture and dynamics (Delery & Doty, 1996). However, customization of services inevitably will affect PEO costs, and, in turn, administrative fees charged to client organizations. As such, for SMEs, different PEO service delivery models offer a different set of tradeoffs. While models that emphasize customization make possible greater improvements in HR outcomes, they may also result in higher administrative fees. 54 ENTREPRENEURSHIP THEORY and PRACTICE

13 Proposition 13: PEO size will be associated with lower SME compensation costs. Proposition 14: Human capital resources in the PEO will be associated with lower compensation costs, lower staff time costs, and more positive HR outcomes. Proposition 15: SMEs working with PEOs that utilize service delivery models that emphasize customization of HR services will experience more positive HR outcomes and higher administrative fees. Feedback from SME Outcomes As can be seen in Figure 1, a feedback loop flows from SME outcomes to relationship tenure and history. And because relationship tenure and history are thought to affect trust and the development of firm-specific knowledge, SME outcomes at one point in time are likely to affect key elements of the model as well as SME outcomes in subsequent time periods. Implications Obtaining SCA is thought to require resources that are valuable, rare, and difficult to imitate (Barney, 1991). And increasingly, the HR system is seen as having the potential to create such resources (Becker & Gerhart, 1996; Becker & Huselid, 1999). Questions exist, however, about whether SMEs should attempt to create these resources through the use of an outside provider such as a PEO. To help address these questions, the article presents a framework for understanding the process by which PEO utilization affects firm-level outcomes. According to our framework, substantial differences exist among SME outcome variables in terms of their determinants. Moreover, the framework suggests that factors that allow a PEO to improve one SME outcome may also make it more difficult to achieve positive effects on a different SME outcome. Thus, while some SMEs sacrifice part of the overall financial savings that could result from PEO utilization in order to gain improvements in HR outcomes, other SMEs focus primarily on time and cost savings. With regard to SME-PEO relationships that focus largely on cost and time savings, the framework offered here suggests that administrative fees, compensation costs, and staff time costs can potentially be affected by variables identified within transaction cost economics as well as social exchange theory. However, it is important to note that when an SME focuses on cost and time savings, they are primarily using services that are largely transactional in nature and that can be performed in a standardized way across multiple clients (Cook, 1999). Little in the way of asset-specific investment is required (Lepak & Snell, 1999a), which means that SMEs can readily change vendors should they become dissatisfied with the services provided. Moreover, transactional services are more routine in nature and, thus, more easily controlled through contractual means (Greer, Youngblood, & Gray, 1999). Because of this, traditional market governance mechanisms (i.e., contractual agreements and market competition) are likely to be effective at constraining opportunism and ensuring effective delivery of services. As such, for SMEs primarily interested in using a PEO to save time and money, it may well be that traditional market governance tools may be sufficient to achieve the desired outcome. While the framework offered here suggests that social exchange variables could affect an SME s ability to achieve time and cost savings, these effects would Fall,

14 be expected primarily in situations where there are limitations on the effectiveness of market governance tools (Ghoshal & Moran, 1996). If this is true, factors likely to lead to relational trust, firm-specific knowledge, or client receptivity may be less critical to SMEs using a PEO simply for cost and time savings. For such SMEs, emphasis might appropriately be given elsewhere. For example, in selecting a PEO, attention might be focused on resources likely to lead to cost and time savings. This includes resources such as PEO size as well as human capital resources and service delivery models that lead to administrative efficiency. With regard to managing the SME-PEO relationship, building strong personal relationships may be less essential for obtaining cost and time savings, assuming the SME makes effective use of contractual mechanisms and appropriately uses market competition to motivate vendor performance. When cost and time savings are the primary focus, efforts to avoid incomplete contracting are critical. Similarly, efforts to regularly compare PEOs on the basis of prices and service characteristics may be critical in order to ensure that market competition motivates effective vendor performance (Greer, Youngblood, & Gray, 1999). The framework presented here suggests very different implications for SMEs that use a PEO to affect the full range of SME outcomes identified here. In large part, this is because the factors that determine HR outcomes are very different from the factors that determine cost and time savings. The factors that determine whether a PEO will improve an SME s HR outcomes make it unlikely that the traditional tools associated with market governance will be sufficient. In order for HR outcomes to be affected, greater levels of asset-specific investments are likely to be required, thus making the SME more vulnerable to opportunistic behavior. This vulnerability is heightened by the fact that the services required to affect HR outcomes are less routine and, therefore, less easily specified within the PEO contract (Klaas, McClendon, & Gainey, 1999). As such, the social exchange process takes on greater importance. Relational trust within the SME-PEO relationship can constrain opportunism and, thus, supplement traditional market governance tools. Beyond this, the ability of a PEO to affect HR outcomes depends heavily on the social exchange process. Both firm-specific knowledge and client receptivity affect a PEO s ability to impact HR outcomes and these variables depend on the development of trust. The importance of trust, firm-specific knowledge, and client receptivity in circumstances in which SMEs use a PEO to affect a broad range of SME outcomes raises questions about how firms should ensure that these variables emerge within the SME-PEO relationship. Consistent with the framework offered here, the PEO selection process is likely to play a critical role. Just as with SMEs that focus on cost and time savings, it is necessary for SMEs emphasizing the full range of outcomes to give consideration to PEO resources when selecting a vendor. However, a different set of PEO resources is likely to be critical for SMEs attempting to affect a broad range of outcomes. For these SMEs, relevant considerations include whether a PEO employs a service delivery model that permits repeated interaction with the same set of PEO services providers, whether PEO policies and cultural characteristics promote the retention of PEO staff, human capital resources, and PEO size. Simply picking the right PEO is unlikely to be sufficient to build relational trust. It was suggested here that trust would be more likely to emerge when SME leaders obtain in-depth information from existing clients in order to reduce the natural skepticism often present at the outset of any relationship skepticism that may hinder the development of relational trust. The framework suggested here also highlights the importance of working to build long-term relationships with the vendor for firms attempting to affect the full range of SME outcomes. While market competition is an important tool by which to 56 ENTREPRENEURSHIP THEORY and PRACTICE

15 motivate vendor performance, the development of relational trust may not be consistent with the frequent use of threats to change vendors based on modest differences in price or service characteristics. Similarly, efforts to reciprocate when the PEO shows genuine concern for the needs of the SME and attempts to communicate regularly and openly with service representatives were suggested as being important to the development of relational trust. When focusing on cost and time savings, SMEs are outsourcing a set of activities that are easily compartmentalized and removed from the organization (Ulrich, 1996). When emphasis is given to the broader range of SME outcomes, the PEO is involved in core managerial responsibilities and, thus, it is essential that SME leaders work to build and manage the SME-PEO relationship. One implication of the framework offered here is that SMEs that use a PEO primarily to save time and money might approach selecting a PEO and managing its PEO relationship differently from an SME that is attempting to affect a broader range of SME outcomes. What has not been fully addressed to this point is the consequence for the SME of using a PEO primarily to achieve cost and time savings as opposed to using it to affect a broad range of firm-level outcomes. The framework offered here suggests that cost and time savings may well be readily accessible through effective management of the risks associated with market governance. While there is likely to be variation across SMEs in how well the tools offered by market governance are used (Williamson, 1996), market governance offers viable mechanisms for ensuring that PEO utilization results in cost and time savings (assuming that is the primary focus of the relationship). Furthermore, given the factors that affect cost and time savings, firms that effectively manage the risks associated with market governance are likely to quickly experience benefits. More significant challenges exist for SMEs that use a PEO to improve HR outcomes as well as to reduce costs and administrative burdens. From the standpoint of PEO selection, the resources required to affect HR outcomes as well as cost and time savings may be more difficult to assess and evaluate. The PEO resources required to affect HR outcomes often are related to organizational routines and cultural factors that may be difficult for a third-party to assess (Barney, 1991). Beyond this, even where the PEO possesses the resources needed for the emergence of trust, firm-specific knowledge, and client receptivity, the development of these factors requires time and a willingness by the SME to consistently invest in the SME-PEO relationship. And because investment in the SME- PEO relationship is asset-specific, the potential for opportunistic behavior should not be ignored. While there are significant challenges and risks associated with using a PEO to affect a full range of SME outcomes, there are also potentially significant financial benefits. The financial impact associated with improved employee retention, skill level, and performance can be very substantial (Huselid, 1995). Equally important, the very challenges and risks associated with using a PEO to affect a full range of SME outcomes creates the potential for SCA. While the cost and time savings available through PEO utilization may be readily imitated, the SME-PEO relationship required to affect HR outcomes cannot be quickly duplicated. Moreover, the complexity of the process involved in developing such an SME-PEO relationship introduces further barriers to imitation. This suggests, then, that using a PEO to affect the full range of SME outcomes has the potential to create resources for the SME that will allow for SCA. While organizational resources that lead to SCA are typically housed within the firm, here they reside in the SME-PEO relationship. Clearly, then, using a PEO to achieve cost and time savings is very different from using one to affect the full range of SME outcomes. While both approaches might well Fall,

16 be beneficial for the SME, using a PEO to affect the full range of SME outcomes introduces greater risks and challenges as well as, potentially, greater payoffs. However, these risks and challenges may have implications for which SMEs should use a PEO to affect the full range of SME outcomes. As was already suggested, while client receptivity to PEO advice and counsel may not be critical for SMEs focused on cost and time savings, it is essential for those SMEs pursuing the full range of SME outcomes. The model offered here is premised on the idea that using a PEO to affect HR outcomes requires that SME leaders be willing to involve the PEO in key managerial decisions regarding their staff. Where there is resistance to doing so, PEO utilization may be more appropriately focused on achieving cost and time savings. Further, many of the variables that determine how a PEO affects HR outcomes take time to develop within the SME-PEO relationship. As such, focusing on the full range of SME outcomes may be appropriate only for those SMEs with an investment time horizon that allows for the development of trust and firm-specific knowledge. Due to financial constraints, this long-term time horizon may be difficult for some SMEs to adapt. In addition, greater skill in managing outsourcing relationships may be required for SMEs that use a PEO to affect a full range of outcomes. Selecting a PEO requires at least some understanding of the tasks to be performed. While routine administrative tasks are relatively easily understood, tasks designed to affect HR outcomes are less easily grasped (Ulrich, 1996). Further, managing an SME-PEO relationship is likely to require an understanding of traditional tools associated with market governance, as well as the process by which trust, firm-specific knowledge, and client receptivity emerge. The framework developed here is based largely on theory and research regarding interorganizational relationships in other institutional contexts. Empirical research specifically examining the role of PEOs in SMEs is quite limited and, as such, our framework is designed to serve as a guide for research in this area. Empirical examination of the propositions offered is critical from the standpoint of being able to provide more definitive guidance to SMEs considering PEO utilization. The framework developed here further suggests a number of relevant issues for future research. First, this framework highlights the need to distinguish between different models of PEO utilization. Assessing the effects of using a PEO requires that efforts be made to assess the objectives of the SME, as well as the range of services offered by the PEO. While it is sometimes assumed that there is homogeneity among PEOs and SMEs, this assumption may well interfere with the efforts to understand the role of PEOs in SMEs. Second, many of the dynamics underlying the propositions offered here occur over time. For example, trust and firm-specific knowledge develop gradually. As such, future research might well benefit from efforts to examine the effects of PEO utilization longitudinally. Issues such as how SMEs transition from using a PEO to achieve cost and time savings to a relationship in which the PEO is used to affect the full range of SME outcomes may also require longitudinal research designs. Third, because SMEs can pursue different objectives when using a PEO, future research might profitably explore how SME leaders decide what objectives to pursue when selecting a PEO. Consideration should be given to economic and strategic factors, as well as attitudes and values among SME leaders. Related to this, research might work toward the creation of a contingency model that identifies when SMEs should avoid using a PEO, when they should use a PEO primarily for cost and time savings, and when they should use a PEO to affect a broad range of SME outcomes. Fourth, the framework offered here highlights the importance of how SMEs evaluate PEO resources when selecting a PEO. In some cases, these resources relate to organizational routines and processes that may be difficult to assess. Therefore, research focusing on the identification and mea- 58 ENTREPRENEURSHIP THEORY and PRACTICE

17 surement of PEO resources, as well as on the development of metrics relating to such resources, may well be of benefit to SMEs considering the use of a PEO. Finally, our framework highlights the joint role of both the PEO and the SME in determining SME outcomes. From a methodological standpoint, this is likely to require that data be collected from both PEOs and the SME in order to fully examine the impact of PEO utilization. While collecting data from multiple key informants within both the PEO and the SME imposes significant burdens in terms of data collection, such an approach may be necessary given the nature of the SME-PEO relationship. The framework offered here highlights factors that are critical to determining whether an SME will benefit from using a co-employment relationship to outsource HR activities to Professional Employer Organizations. While some HR activities are largely routine and administrative in nature, others are increasingly seen as a source of sustainable competitive advantage. Within the outsourcing literature, while administrative tasks are seen as well suited to outsourcing, other, more value-added HR activities would be seen as questionable candidates for the outsourcing model. By looking at the process by which PEOs affect SME outcomes, we have attempted to generate insight into the conditions under which SMEs might be able to benefit from using a PEO to achieve cost and time savings; the conditions under which SMEs might be able to benefit from using a PEO to affect a full range of SME outcomes; and the steps that might be critical to ensuring that PEO utilization yields the desired benefits. REFERENCES Arthur, J.B. (1992). The link between business strategy and industrial relations systems in American steel mini-mills. Industrial and Labor Relations Review, 45, Barney, J. (1991). Firm resources and sustained competitive advantage. Journal of Management, 17, Baron, J.N., Burton, D.M., & Hannon, M.T. (1996). The road taken: Origins and evolution of employment systems in emerging companies. Industrial and Corporate Change, 5, Baron, J.N. & Kreps, D.M. (1999). Strategic human resources. New York: John Wiley & Sons. Barzell, Y. (1982). Measurement cost and the organization of markets. Journal of Law & Economics, 25, Becker, B.E. & Gerhart, B. (1996). The impact of human resource management on organizational performance: Progress and prospects. Academy of Management Journal, 39, Becker, B.E. & Huselid, M.A. (1999). Overview: Strategic human resource management in five leading firms. Human Resource Management. 38, Blau, P.M. (1964). Exchange and power in social life. New York: Wiley. Coleman, J.S. (1990). Foundations of social theory. Cambridge, MA: Belknap Press. Connor, K.R. & Prahalad, C.K. (1996). A resource-based theory of the firm: Knowledge versus opportunism. Organizational Science, 7, Cook, M.F. (1999). Outsourcing human resource functions. American Management Association, New York. Das, T.K. & Teng, B. (1998). Between trust and control: Developing confidence in partner cooperation in alliances. Academy of Management Review, 23, Fall,

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20 62 ENTREPRENEURSHIP THEORY and PRACTICE