They're NotEmployees,

Two fast-moving trends are changing the

way companies manage talent. Ifyou don't

pay attention, you'll lose your competitive

edge before you know it.

70

Two EXTRAORDINARY CHANCES have Crept Up on thebusiness world without most of us paying muchattention to them. First, a staggering number of peo-

ple who work for organizations are no longer traditionalemployees of those organizations. And second, a growingnumber of businesses have outsourced employee rela-tions; they no longer manage major aspects oftheir re-lationships with the people who are their formal em-ployees. These trends are unlikely to reverse tbemselvesanytime soon. In fact, they'll probably accelerate. Andthey're happening for some very good reasons, as we'll see.

That said, the attenuation ofthe relationsbip betweenpeople and the organizations they work for represents agrave danger to business. It's one tbing for a company totake advantage of long-term freelance talent or to out-source the more tedious aspects of its human resources

HARVARD BUSINESS REVIEW

by Peter R Drucker

management. It's quite another to forget, in tbe process,that developing talent is business's most importanttask - tbe sine qua non of competition in a knowledgeeconomy. If by off-loading employee relations, organiza-tions also lose tbeir capacity to develop people, they willhave made a devil's bargain indeed.

Every working day, one of tbe world's biggest private em-ployers, the Swiss company Adecco, places nearly 700,000temporary and full-time clerical, industrial, and technicalassociates with businesses all over the world-perhaps asmany as 250,000 workers in the United States. Adecco istbe temp industry giant, but it bas only a small share ofa totally splintered global market. In tbe United Statesalone, there are thousands of such companies that to-gether place some 2.5 million workers each day. World-

wide, at least 8 million, if not 10 miiiion, temp workers areplaced each day. And 70% of all temps work full time.

When tbe temp industry first started nearly 50 yearsago, it supplied low-level clerks to take tbe place of ledgerkeepers, receptionists, telephone operators, stenogra-phers, or the ladies in the typing pool who were sick or onvacation. Today there are temp suppliers for every kind ofjob, al! tbe way up to CEO. One company, for instance,supplies manufacturing managers who can lead newplants from their inception until the facilities are in fullproduction. Another supplies highly skilled health careprofessionals such as nurse anesthesiologists.

In a related but distinct development, the professionalemployee organization (PEO) was the fastest-growing busi-ness service in the United States during the 1990s. Thesebusinesses manage tbeir clients' employees as well as

FEBRUARY 2002 71

They're Not Employees, They're People

their clients'employee relations-that is, the administra-tive, HR kinds of tasks associated with managing thoseemployees. PEOs were virtually unknown oniy ten yearsago but by 2000 had become the "coemployers"of 2.5 mil-lion to 3 million blue-collar and white-collar U.S. workers.There are now at least 1,800 such organizations; they evenhave their own trade association and their own monthlyjoumai.

PEOs, like temp agencies, have vastly expanded theirscope in recent years. The first PEOs in the late 1980s of-fered to do bookkeeping, especially payroll, for theirclients. Now PEOs can take care of almost every task inemployee management and relations; record keeping andlegal compliance; hiring, training, placements, promo-tions, firings, and layoffs; and retirement plans and pen-sion payments. PEOs originally confined themselves totaking care of employee relations at smallbusinesses. But Exult, probably the bestknown PEO, was designed fromthe start to be the coemployerfor global Fortune 500 compa-nies. It numbers among itsclients BP Amoco, Unisys, andTenneco Automotive. Foundedjust four years ago, it has al-ready gone public and is tradedon the Nasdaq. Another PEO,designed originally to handlepayroll functions for businesseswith fewer than 20 employees,is about to take on managingthe 120,000 employees of oneofthe largest U.S. states.

Both the temp industry and the PEOs are growingquickly. Adecco is expanding at a rate of 15% a year. In thesecond quarter of 2001, Exult's revenue grew 48%, from$43.5 million to $64.3 million. And the PEO industry asa whole is growing at a rate of 30% a year. Collectively,PEOs expect to be the coemployers of lo million U.S.workers by 2005.

The reader may wonder. How can a manager functionif she's not in charge of hiring, promoting, or firing thepeople in her department? I posed this question to a se-nior executive at BP Amoco whose workers, includingsenior scientists, are now managed by Exult. His answer:"Exult knows it has to satisfy me if it wants to keep thecontract. Sure, they make the decision to fire someone ormove them. But normally only because I suggested itor after they consulted with me."

If by off-loading employee

relations, organizations also

lose their capacity to develop

people, they will have made

a devil's bargain indeed.

Peter F. Drucker is the Marie Rankin Clarke Professor ofSocial Science and Management at the Peter F. DruckerGraduate School of Management, Claremont GraduateUniversity, Claremont, California. He has written more thantwo dozen articles for HBR.

Clearly, sometbing is happening in employee relationsthat does not fit with what the management books stillwrite about and what we teach in business school. And itsurely does not fit with the way HR departments at mostorganizations were designed to function.

Strangled in Red TapeThe reason usually offered for the popularity of tempo-rary workers is that they give employers fiexibility. But fartoo many temps work for the same employer for longperiods of time - sometimes year after year - for that tobe the whole explanation. And flexibility surely does notaccount for the emergence of PEOs. A more plausibleexplanation for tbe popularity of these trends is thatboth types of organizations legally make "nonemployees"

out of people who work for abusiness. The driving force be-hind the steady growth of tempsand the emergence ofthe PEOs,I would argue, is the growing bur-den of rules and regulations foremployers.

The cost alone of these rules andregulations threatens to stranglesmall businesses. According tothe U.S. Small Business Adminis-tration, the annual cost of govem-ment regulations, government-required paperwork, and taxcompliance for U.S. businesses

employing fewer than 500 employees wassomewhere around $5,000 per employee in

1995 (the last year for which reliable figures are avail-able). That amounts to about a 25% surcharge on top ofthe cost of employee wages, health care, insurance, andpensions - which in 1995 was around $22,500 for theaverage small-business employee. Since then, the cost ofemployment-related paperwork is estimated to have risenby more than io%.

Many of these costs can be avoided altogether by usingtemporary workers in place of traditional employees.That's why so many companies are contracting witbtemp agencies for workers-even though the hourly costofa temp is often substantially higher than the wage-and-benefit cost of a full-time, formal employee. Anotber wayto reduce the bureaucratic costs is to outsource employeerelations-in other words, to let a specialist do tbe paper-work. Aggregating enough small businesses to manage atleast 5CK> employees as one workforce-which is, of course,wbat a PEO does-can cut employment-related costs by40%, according to SBA figures.

It is not only small businesses that can cut their laborcosts substantially by outsourcing employee relations. A1997 McKinsey study concluded that a global Fortune 500

72 HARVARD BUSINESS REVIEW

They're Not Employees, They're People

firm-in other words, a very big company indeed-couldcut its labor costs 25% to 33% by having its employee rela-tions managed by an outside company. This study led tothe foundation of Exult a year later.

The outsourcing of employees and employee relationsis an intemational trend. Altbough employment laws andregulations vary widely from country to country, the coststbey impose on businesses are high everywhere in thedeveloped world. For instance, Adecco's biggest market isFrance, its second-largest market is tbe United States, andthe company is growing at a rate of 40% per year in Japan.Exult opened an employee management center in Scot-land in 2000 and has offices in Lxjndon and Geneva.

Even more onerous tban tbe costs of complying witbemployment laws are the enormous de-mands that the regulations place onmanagement's time and attention. Be-tween 1980 and 2(xx), the number ofU.S. laws and regulations regarding em-ployment policies and practices grewby about 60%, from 38 to 60. The regu-lations all require managers to file mul-tiple reports, and they all threaten finesand punishment for noncompliance.

At least 8 million, if not

10 million, temp workers are

placed each day worldwide.

And they're not justfilling

in at reception desks; today's

temps are metallurgists, nurse

anesthesiologists-even CEOs.

even if the breach was unintentional. According to theSBA, the owner of a small or midsize business spends upto a quarter of his or her time on employment-relatedpaperwork.

Then there is tbe constant, and constantly growing,threat of lawsuits: Between 1991 and 2000, the number ofsexual harassment cases filed with the Equal EmploymentOpportunity Commission more than doubled, from about6,9txi a year to almost i6,(XX) a year. And for every casefiled, ten or more were being settled in-house, each re-quiring many hours of investigation and hearings, as wellas substantial legal fees.

No wonder that employers {especially smaller compa-nies, which constitute the overwhelming majority) com-

plain bitterly that they have no timeto work on products and services,on customers and markets, on qual-ity and distribution - t h a t is, theyhave no time to work on results. In-stead, they work on problems - tbatis, on employee regulations. They nolonger chant the old mantra "Peopleare our greatest asset" Instead, tbeyclaim "People are our greatest liabil-ity." What underlies the success oftheemployment agencies and the emer-gence of the PEOs is that they bothenable management to focus on thebusiness.

This argument, by the way, mayalso explain the success of magu/7arf(>ra5-the manufacturing plants on theMexican side ofthe U.S. border, and,increasingly, in Mexico proper, thatassemble parts made in the UnitedStates, the Far East, or Mexico intofinished products for the U.S. marketIn fact, avoiding hours of paperworkis probably a stronger incentive formanufacturing companies to out-source this kind of assembly workthan tbe often questionable savingsin labor costs. The Mexican companythat is the maquiladora's landlordacts as tbe coemployer, handling allemployee regulations and activities-wbich are as complicated in Mexicoas they are in the United States-thusfreeing up the U.S. or Japanese plantowner to focus on the business.

Tbere is not tbe slightest reason tobelieve that the costs or demands of

, . y • ^ ^ employment rules and regulations

/ I 1 ^m ^^" '̂ ^^1'̂ ^^^ '^ ̂ y developed coun-\ /v I ^ ^ try. Quite the contrary: No matter

FEBRUARY 2002 73

They're Not Employees, They're People

how badly the United States needs a patient's bill ofrights, that will undoubtedly create another layerof agencies with which an employer will have to deal -another set of reports and paperwork, another avalancheof complaints, disputes, and lawsuits.

The Splintered OrganizationBeyond the desire to avoid the costs and distractions ofregulations, there is another major reason for both therise of temporary workers and the emergence of PEOs:the nature of knowledge work and, most particularly, thefact that knowledge workers are extraordinarily spe-cialized. Most large, knowledge-based organizations havelots of experts; managing all of them effectively is a bigchallenge - one that temp agencies and PEOs can helpto address.

Not so long ago, even in the 1950s, as much as 90% ofthe U.S. workforce was classified as "nonexempt"- subor-dinates who did as they were told. The "exempt" werethe supervisors who did the telling. Most nonexemptemployees were blue-collar workers who had few skillsand little education. They typically did repetitive taskson the plant floor or in the office. Today, less than one-fifth of the workforce is blue-collar. Knowledge workersnow make up two-fifths of theworkforce, and while they mayhave a supervisor, they are notsubordinates. They are associ-ates. Within their area of exper-tise, they are supposed to do thetelling.

Above all, knowledge workersare not homogeneous: Knowl-edge is effective only if it is spe-cialized. This is particularly trueamong the fastest-growing groupof knowledge workers- indeed,the fastest-growing group in theworkforce overall - knowledge technolo-gists such as computer repair people, para-legals, and software programmers. Because knowledgework is specialized, it is deeply splintered work, even inlarge organizations.

The best example is the hospital-altogether the mostcomplex human organization ever devised, but also, inthe past 30 or 40 years, one ofthe fastest-growing types oforganizations in all developed countries. A fair-sized com-munity hospital of 275 or 300 beds will have around 3,(xx>people working for it. Close to half of them will be knowl-edge workers of one kind or another. TXvo of thesegroups - nurses and specialists in the business depart-ments - are fairly large, numbering several hundred peo-ple each. But there are about 30 paramedic specialties:physical therapists, lab workers, psychiatric caseworkers.

Employers no longer chantthe old mantra "Peopie areour greatest asset." Instead,they claim "People are ourgreatest liability."

oncological technicians, the teams of people who preparepatients for surgery, the people in the sleep clinic, the ul-trasound technicians, the cardiac-cUnic specialists, andmany, many more.

Each ofthese specialties has its own rules and regula-tions, educational requirements, and accreditation pro-cesses. Yet in any given hospital, each specialty area com-prises only a handful of people; there may be no morethan seven or eight dieticians, for instance, in a 275-bedhospital. Each group, however, expects and requires spe-cial treatment. Each expects-and needs-someone higherup who understands wbat the group is doing, whatequipment it needs, and what its relationship should beto doctors, nurses, and the business office. Also, there areno career-advancement opportunities within the hospi-tal for any ofthe specialists; notoneof them wants to bethe hospital's administrator or has any chance of get-ting the job.

Few businesses currently have as many specialists ashospitals do, but they're getting there. A departmentstore chain I know of now counts 15 or 16 distinct knowl-edge specialties-for instance, the retail buyers, the dis-play people, the salespeople, and the promotions andadvertising group - and employs only a handful of eachkind of specialist in any one store. In financial services,

too, there is increasing specializationamong knowledge workers and fewer

career opportunities for themwithin the organization. For in-stance, the experts who selectthe mutual funds to be offeredto retail customers probably willnot become salespeople, servic-ing individual accounts. And itis likely that they will not be par-ticularly interested in managinganything larger than a smallgroup at the firm - a handful offellow specialists, at most.

Hospitals in the United Stateshave largely tackled this prob-

lem of specialization through piecemeal outsourcing. Inmany hospitals, each knowledge specialty is managed bya different outsourcer. For instance, the group that ad-ministers blood transfusions may be managed by a com-pany that specializes in this procedure and that simulta-neously runs the transfusion departments at several otherhospitals. Like a PEO, it is the coemployer of the bloodtransfusion staff. Within this network, the individual trans-fusion specialists have career opportunities: If they per-form well, they can move up to manage the transfusion de-partment at a bigger and better-paying hospital, or theycan supervise several transfusion units within the network.

Botb the large temp company and the PEO do acrossthe board what in the hospital is done piecemeal. Eacb of

74 HARVARD BUSINESS REVIEW

They're Not Employees, They're People

their clients - even the biggest - lacks the ability to effec-tively manage, place, and satisfy highly specialized knowl-edge workers. Thus, temp firms and PEOs perform a vitalfunction for employees as well as their employers. Thisexplains why PEOs can claim, and apparently document,that the people whose coemployer they have become re-port high job satisfaction - in contradiction to everythinghuman relations theory would have predicted. The met-allurgist in a midsize chemical company may be well paidand have an interesting job, but the company needs andemploys only a handful of metallurgists. No one in uppermanagement understands what the metallurgist is do-ing, should be doing, could be doing.There is no opportunity, except a re-mote one, for the metallurgist to be-come an executive; that would meangiving up what he has spent yearslearning to do and loves to do. Thewell-run temp agency places the met-allurgist where he can make maxi-mum contributions. It can place thesuccessful metallurgist in increasinglybetter-paid jobs.

In a PEO full-service contract (andmany PEOs won't offer any other) itis expressly provided that the PEO

The knowledge economy has

given rise to the splintered

organization-one in which

leaders struggle to manage

varying groups of experts

within their companies.

In most cases, professional

employment organizations

are better equipped to handle

such knowledge specialists.

has the duty and the right to place people in the jobs andcompanies where they best fit. Balancing its dual respon-sibilities-to the corporate client and to the employee-isprobably the PEO's most important and challenging job.

Companies Don't Get ItHR policies still assume that most if not all ofthe peoplewho work for a company are employees of that company.But as we have seen, that is not true. Some are temps andothers are employees ofthe outsourcers who manage, say,the company's computer systems or cal! center. Still

others are older part-time workers whohave taken early retirement but still workon specific assignments. With al! thissplintering, no one is left to view the or-ganization in its entirety.

Temp agencies claim to be sellingproductivity - in other words, to be do-ing the organization's oversight job forthem - but it's hard to see how they candeliver. The productivity of the peoplethey supply to a customer depends notonly on how and where those workers areplaced but also on who manages andmotivates them. The temp agency has nocontrol over those last two areas. ThePEO, too, manages only its clients' formalemployees, not necessarily part-time,temp, or contract workers.

This lack of oversight is a real problem.Every organization must take manage-ment responsibility for all the peoplewhose productivity and performance itrelies on - whether they're temps, part-timers, employees of the organizationitself, or employees of its outsourcers,suppliers, and distributors.

There are signs that we are moving inthat direction. A European multinationalconsumer goods maker is about to spinoff its large and highly regarded em-ployee management function into a sep-arate corporation that would act as thePEO for the parent company and itsemployees throughout the world. ThisPEO would also manage the multina-tional's relationships with, and utiliza-tion of, people who are not traditionalemployees of the organization. Eventu-ally, this in-house PEO will offer itselfas the coemployer for those who workfor the multinational's suppliers and dis-tributors and for its more than 200 jointventures and alliances.

FEBRUARY 2002 75

They're Not Employees, They're People

A Source ofCompetitive AdvantageIt is actually more important today for organizations topay close attention to the health and well-being of alltheir workers than it was 50 years ago. A knowledge-basedworkforce is qualitatively different from a less-skilled one.True, knowledge workers are a minority ofthe total work-force and are unlikely ever to be more than that. But theyhave become the major creators of wealth and jobs. In-creasingly, the success-indeed, the survival-of every busi-ness will depend on the performance of its knowledgeworkforce. And since it is impossible, according to thelaws of statistics, for an organization to hire more than ahandful of "better people," the only way that it can excelin a knowledge-based economy and so-ciety is by getting more out of the samekind of people - that is, by managing itsknowledge workers for greater produc-tivity. The challenge, to repeat an oldsaying, is "to make ordinary people doextraordinary things."

What made the traditional workforceproductive was the system, whether itwas Frederick Winslow Taylor's "onebest way," Henry Eord's assembly line,or W. Edwards Deming's "total qualitymanagement." The system embodies theknowledge. The system is productivebecause it enables individual workersto perform without much knowledgeor skill. In fact, on assembly lines and inTQM shops, a highly skilled individualcan be a threat to coworkers and to theentire system. In a knowledge-based or-ganization, however, it is the individualworker's productivity that makes the en-tire system successful. In a traditionalworkforce, the worker serves the system;in a knowledge workforce, the systemmust serve the worker.

There are enough knowledge-basedorganizations around to show what thatmeans. What makes a university a greatuniversity is tbat it attracts and devel-ops outstanding teachers and scholars,making it possible for them to do out-standing teaching and research. Thesame is true of an opera house. But theknowledge-based institution that mostnearly resembles a knowledge-basedbusiness is the symphony orchestra, inwhich some 30 different instrumental-ists play the same score together as ateam. A great orchestra is not composed

Whether they are traditional

employees or temps and contract

workers, today's knowledge work-

ers are notjust labor-they are

capital. And what differentiates

outstanding companies is the

productivity oftheir capital.

of great musicians but of adequate ones who produce attheir peak. When a new conductor is hired to turn aroundan orchestra that has suffered years of drift and neglect,he cannot, as a rule, fire any but a few ofthe sloppiest ormost superannuated players. He also cannot hire manynew orchestra members. He has to make productivewhat he has inherited. The successful conductors do thisby working closely with individual orchestra members andwith groups of instrumentalists. The conductor's em-ployee relations are a given; the players are nearly un-changeable. So it is tbe conductor's people skills thatmake the difference.

It would be difficult to overstate tbe importance of fo-cusing on knowledge workers' productivity. The criticalfeature of a knowledge workforce is that its workers are

not labor, they are capital. And whatis decisive in the performance ofcapital is not wbat capital costs. It isnot how much capital is being in-vested-or else the Soviet Unionwould have easily been the world'sforemost economy. What's critical isthe productivity of capital. The So-viet Union's economy collapsed, inlarge part, because the productivityof its capital investments was in-

76 HARVARD BUSINESS REV[EW

They're Not Employees, They're People

credibly low. In many cases, it was less than one-third thatof capital investments in market economies, and some-times actually negative-consider the huge investments infarming made during the Brezhnev years. The reason forfailure was simple: No one paid any attention to the prtvductivity of capital. No one had that as his or her job. Noone got rewarded if productivity went up.

Private industry in the market economies teaches thesame lesson. In new industries, leadership can be obtainedand maintained by innovation. In an established industry,however, what differentiates the leading company isalmost always outstanding prtvductivity of capital.

In the early part ofthe twen-tieth century. General Electric,for instance, competed withrivals like Westinghouse andSiemens through innovativetechnology and products. Butin the early 1920s, after the eraof rapid technology innovationin electromechanics had cometo an end, GE concentrated onthe productivity of capital to give it decisiveleadership, and it has maintained this leadever since. Similarly, Sears's glory days from the late 1920sthrough the 1960s were not based on its merchandise orpricing-the company's rivals, such as Montgomery Ward,did just as well in both areas. Sears prevailed because itgot about twice as much work out of a dollar as otherAmerican retailers did. Knowledge-based businesses needto be similarly focused on the productivity oftheir capi-tal - that is, the productivity of the knowledge worker.

Free Managersto Manage PeopleTemps and especially PEOs free up managers to focus onthe business rather than on employment-related rules,regulations, and paperwork. To spend up to one-quarterof one's time on employment-related paperwork is indeeda waste of precious, expensive, scarce resources. It is bor-ing. It demeans and corrupts, and the only thing it canpossibly teach is greater skill in cheating.

Companies thus have ample reason to try to do awaywith the routine chores of employee relations-whetherby systematizing employee management in-house or byoutsourcing it to temps or to a PEO. But they need to becareful that they don't damage or destroy their relation-ships with people in the process. Indeed, the main bene-fit of decreasing paperwork may be to gain more time forpeople relations. Executives will have to learn what theeffective department head in the university or the suc-cessful conductor of the symphony orchestra have longknown: The key to greatness is to lcx)k for people's poten-

In a traditional workforce,the worker serves the system;in a knowledge workforce, thesystem must serve the worker.

tial and spend time developing it. To build an outstandinguniversity department requires spending time with thepromising young postdocs and assistant professors untilthey excel in their work. To build a world-class orchestrarequires rehearsing the same passage in the symphonyagain and again until the first clarinet plays it the way theconductor hears it. This principal is also what makes aresearch director in an industry lab successful.

Similarly, leaders in knowledge-based businesses mustspend time with promising professionals: Get to knowthem and be known by them; mentor them and listen

to them; challenge them and encouragethem. Even if these people are not tra-

ditional - read, legal - employees,they are still a capital resourcefor the organization and criticalto its business performance. Theadministrative tasks that are in-volved with employee relationscan, and should, be systema-tized - and that means they can,perhaps should, become imper-sonal. But if employee relations

~" ° are being outsourced, execu-tives need to work closely with

their PEO counterparts on the professional develop-ment, motivation, satisfaction, and productivity of theknowledge workers on whose performance their ownresults depend.

Modern organizations emerged from the Industrial Rev-olution. The cotton mill and the railroad were first. Butwhile unprecedented, they were still based on manuallabor, as was all eariier work, whether it was farming,manufacturing, clearing checks by hand, or entering life-insurance claims into a ledger. This was the case as late as50 or 60 years ago, even in the most highly developedeconomies. The emergence of knowledge work and theknowledge worker-let alone their emergence as the chiefsource of capital in our knowledge-based society andeconomy-is thus as profound a change as the switch toa machine-driven economy was all those years ago, per-haps an even greater one.

This shift will require more than just a few new pro-grams and a few new practices. It will require new mea-surements, new values, new goals, and new policies. Itwill predictably take a good many years before we haveworked these out. However, there are enough successfulknowledge-based organizations around to tell us whatthe basic assumption has to be for managing employeesin today's companies: Employees may be our greatestliability, but people are our greatest opportunity. ^

Reprint R0202ETo order reprints, see the last page of Executive Summaries.

FEBRUARY 2002 77