Vital functions: HR outsourcing is booming, as companies send everything from payroll to training outside. But take out too much of the company's core, and you risk losing its heart and soul.

When ComUnity Lending was planning a major expansion into new regions several years ago, company executives realized that employment regulations varied widely state to state, and that mastering them would be no small challenge. To make it easier, the Morgan Hill, Calif-based mortgage lender, which funded $4 billion in loans in 2003 and has about 1,500 employees, turned to someone else to handle everything from payroll to legal guidance on employment matters. "We came to the conclusion that HR was a specialty," says CEO W. Darryl Fry. "It was not one of our core competencies, and our culture is: 'we stick with our core competencies.'"

Fry's way of thinking is far from unusual these days. A growing number of companies in recent years have outsourced part or most of their human resources operations. Indeed, annual revenue for the North American HR outsourcing market grew from about $13 billion in 2000 to $15 billion in 2002, and is projected to reach $23 billion in 2007, according to Rebecca Scholl, an analyst for Gartner, the Stamford, Conn., research firm.

At the same time, however, some executives and human resources experts remain wary of the trend. They argue that a number of HR tasks are so closely entwined with the culture of a company, that letting go of them is dangerous. In outsourcing training, for example, an employer runs the risk of putting generic employee education courses in the place of in-house work-force development programs that are born out of a company's own way of doing things. That's a false step for any enterprise that hopes to differentiate itself, says Patrick Wright, professor of human resources at Cornell University's School of Industrial and Labor Relations.

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A similar problem could emerge with compensation. What had previously been the kind of unique offerings that made an employer stand out to high-quality job recruits could become, instead, "plain vanilla," says Peter Cappelli, professor of management at the Wharton School at the University of Pennsylvania. Further, if anything goes wrong with the outsourced service, it is the employer, not the vendor, who will bear the blame. The very idea of outsourcing, especially when it involves shipping jobs overseas, outrages many employees, to say nothing, in this political season, of many voters.

Even at companies that have embraced the idea of sending more work outside. HR executives warn that with all the options available, outsourcing is increasingly complicated and needs to be handled with care. Telecommunications giant AT & T spent a full year evaluating its HR activities, trying to assess which might naturally lend themselves to outsourcing. After carefully examining proposals from six different vendors, it outsourced a large chunk of its HR operations--benefit plan management, compensation communications and employee relations administration, among other things--to Aon Corp, in June 2002, says Mirian Graddick-Weir, AT & T's executive vice president of human resources. Plotting compensation strategy, however, was determined to be too essential and was kept in house.

BP Amoco, considered one of the trailblazers in HR outsourcing, still holds on to what one executive calls "strategic" tasks, such as performance appraisals, employee discipline and work-force planning, among others. "What stays is what's required to help people build competencies," says Senior Vice President Don E. Packham, a BP human resources executive.

Outsourcing Without Gutting

With the pressure to keep strategic HR functions close to the vest, while maintaining a company that is lean and competitive, CEOs and their HR chiefs face increasingly tough decisions. Having no clear-cut rules to follow, each company must determine how much of the organization's functions can be outsourced without damaging its core.

It's not an entirely new challenge, of course. For years, employers have turned to outside specialists for assistance with HR transactions such as payroll and pension administration. But these days, more and more employers are looking to place as much work as possible in the hands of a single contractor. Plus, the array of HR functions landing outside is going far beyond payroll. Today, the largest outsourcing businesses can assume up to 18 different jobs, everything from employee recruitment, relocation and development to the more conventional administration of pension and health benefits, says Jay Whitehead, president and publisher of the trade magazine Human Resources Outsourcing Today.

It's not hard to see why CEOs would be attracted to the concept. "Companies are under extreme profit pressure," Whitehead says, so HR, which is not a profit center, is a prime target for cost savings. The numbers bear him out. "Cost reduction" was the most popular reason--given by 68 percent of respondents--when 125 companies were asked why they initially considered HR outsourcing, according to a 2002 report by The Conference Board, the New York-based business research group.

Although hard numbers are difficult to come by, companies that outsource a bundle of functions--payroll, benefits and HR technology, for example--can typically see savings of 15 to 20 percent or more, estimates Mare Pramuk, an analyst with IDC, the research and consulting firm in Framingham, Mass. And the employers surveyed by The Conference Board seemed satisfied with their results so far; none planned to bring home HR services already outsourced.

AT & T, which contracted to move 400 members of its HR staff into positions at Aon, reports "double-digit savings," says Graddick-Weir. And BP Amoco, which made headlines when it inked a $600-million contract in 1999 with outsourcing firm Exult to assume a wide variety of HR tasks, has seen savings in the U.S. of $80 million so far, says Packham. Among other things, BP has cut the number of employees working in U.S. HR services from about 200 to 35.

Although reducing HR costs is the primary goal, it's not the only one. Some companies want to rid themselves of the more routine HR tasks, such as payroll management, so their HR departments can tackle such critical matters as work-force development. "It's allowing your people to focus more on the strategic and less on the transactional," says Bryan Doyle, outsourcing line-of-business leader and a director at Hewitt Associates, an HR outsourcing firm based in Lincolnshire, Ill.

About 57 percent of employers responding to the Conference Board survey mentioned "service improvement" as a reason to turn to outsourcing. Southern Company, which uses contractors for functions including resume screening and administration of 401(k) plans, found that outsourcing gave it access to technology that would have been hard to develop in house. One example is an outsourced Web site allowing employees to change pension allocations.

In some cases, the prospect of having to upgrade internal HR information systems is what leads companies to look outside. That was the case with Sony Electronics, which three years ago contracted with Hewitt to perform its HR information systems work. The move led to a 30 percent reduction in HR costs at Sony's U.S. electronics subsidiary, says Edward Cotter, senior vice president of human resources.

ComUnity Lending sent its work to Gevity HR, a "professional employer organization" that, in essence, becomes the co-employer of its clients' work forces. Gevity's familiarity with state employment requirements has allowed ComUnity Lending to make a faster move into the 38 states where it now has operations, says Janene Towner, the lender's chief operating officer. "We have no knowledge of Alabama," she says, using that state as one example. "We call Gevity; it's done."

At the same time, employers experienced with outsourcing caution that the transition from "in" to "out" is not always smooth. For one thing, employees can be less than thrilled when HR is given over to strangers. "Sometimes people like doing anything with a live person down the hall. Whether health care, pension or life insurance, some people like to sit down face-to-face and talk to people," says Chip Howden, manager of benefits for Southern Company. For another thing, employees may be befuddled by what the changes entail. BP Amoco's Packham recalls that when one group of managers wanted to reward employees with a special recognition bonus, confusion ensued, in part because the route they'd always used before--going to HR--had been replaced by filling out what turned out to be less-than-user-friendly forms.

For some aspects of HR, outsourcing simply may not be appropriate. AT & T, which has a partly unionized work force, has kept labor relations in house. And companies with work forces around the world may find that extending HR outsourcing to overseas operations is thorny. "One would think you could have a pan-European solution: Why not one payroll center in Europe that handles all countries in Europe?" BP's Packham asks. "But no one has been able to do it because of the political and regulatory barriers country to country."

Then, there is the nature of outsourcing--HR or otherwise--and the ethical dilemma that accompanies it: people or profits? Whether in the payroll office or the factory, outsourcing often entails job reductions. As the U.S. economy remains mired in negligible job creation, outsourcing, especially to other shores, stirs considerable anger among many Americans. So much so, in fact, that overseas outsourcing is becoming a contentions political issue this year. At least 14 state legislatures have introduced measures to discourage the practice, according to Marcus Courtney, president of WashTech, a Seattle-based labor organization for high technology workers. Likely Democratic presidential nominee Sen. John Kerry has even started calling executives who outsource "Benedict Arnold CEOs."

"You are increasingly dropping the living standards of American workers who are, in turn, your best customers," Courtney warns. For now, most outsourced HR work remains in North America, says Pramuk of IDC, but the future is another story. Several large outsourcing companies have already opened call centers in India that do such things as answer employee questions about benefits enrollment, he says. (See editorial, page 64.)

Whether the jobs go abroad or stay stateside, outsourcing often brings headcount drops in HR of 30 to 40 percent, says David Ulrich, a professor of business administration at the University of Michigan. That leads to the odd twist of human resource folks, the traditional wielders of the layoff sword, downsizing themselves. Executives should not expect boundless enthusiasm for the task. "ATMs didn't make bank tellers happy," Ulrich notes.

Some just don't believe in outsourcing most functions. At Domino's Pizza, most HR functions, such as a help desk that assists employees with payroll and benefit matters, are staffed by employees, not outsiders. CEO David Brandon believes tasks such as employee training are so important to solidifying what he calls "the culture of company" that companies take a risk when they let someone else do the job. "I think they lose control of their culture and their ability to communicate with and nurture their relationship with the team," he says.

At least potentially. But those CEOs with the right touch--and armed with the right information--also potentially can execute the near perfect balance between outsource and in house, achieving the efficiency and cost savings, but keeping the heart of the company whole.

RELATED ARTICLE: TO OUTSOURCE OR NOT TO OUTSOURCE?

THE EXPERTS ARGUE that some Human Resources functions are administrative in nature and can be easily outsourced. But other functions are "strategic" and should be kept in house. The trick, of course, is deciding which is which. Here's one way of analyzing the challenge.

                HR FUNCTION                BENEFITS

ADMINISTRATIVE  * Payroll                  * Cost savings of up to 20
                * Benefit plan management    percent through workforce
                * Information systems        reduction
                  management               * Freeing up HR staff to
                * Employee training          focus on strategic tasks
                                           * Service improvement

STRATEGIC       * Employee recruitment     * Use of advanced technology
                * Compensation planning      that would be difficult to
                * Performance appraisals     develop in house
                * Leadership development   * Additional cost savings
                                           * Solution to HR budget
                                             crunches

                RISK

ADMINISTRATIVE  * Generally low risk
                * Bad service is attributed to
                  company, not HR provider
                * Outsourced training can result in
                  "cookie-cutter" courses

STRATEGIC       * Could render previously unique
                  compensation packages "plain
                  vanilla"
                * Loss of control over hiring,
                  work-force development