IT Offshoring: Another Look

Wikipedia describes offshoring as a process in which an organisation shifts its business process from one country—usually the parent firm’s country—to another. The online encyclopaedia also refers to a term Bangalored, a euphemism for one losing their IT job as a result of offshoring.

Offshoring has been conducted for decades, but it gained momentum with the spread of the internet and has become an almost universal phenomenon as the world has become increasingly globalised. One of the results has been a shortage of jobs in offshoring nations.

In many of the developed countries that are major sources of offshoring, the dearth of jobs has caused major political issues as domestic production costs have soared.

Nevertheless, firms continue to look for ways to cut the cost of offshoring production, despite the large investments in plant, machinery and other infrastructure that is required.

China is the top destination for production offshoring.

Meanwhile, the digital revolution as a result of the dot com boom and the dramatic fall in international telecommunication costs has seen India emerge as the leading destination for software offshoring.

Long considered a burden, the huge population in India suddenly became a strength, while the nation’s highly skilled, English-speaking young people became a magnet for global firms.

What IT offshoring involves
While a variety of software- and IT-related work is sent offshore, it mainly comprises the following: programming, software architecture, testing, software maintenance, IT research and development, physical product manufacturing (semiconductors, computer components, computers), business process outsourcing and IT-enabled services (such as insurance claim processing, medical billing, accounting, medical transcriptions, digitisation of engineering drawings, and high-end IT-enabled services such as financial analysis and reading of x-rays), as well as call centres and telemarketing businesses.

What are the benefits of IT offshoring?
India’s offshoring industry took root in the early 1990s and accelerated its growth during the Y2K programme conversion. Since then it has become a leading global player in the industry.

One cannot find a global firm that has not outsourced its IT operations—sometimes also human resources and other administrative jobs—to India, either through their own Indian subsidiaries or through a partner firm. The widely known and commonly accepted benefits of offshoring include the following.

Relative advantage
Since the Lehman shock in 2008, the major and, in many cases, sole reason firms cite for offshoring is cost saving.

However, in many cases, these gains go unrealised, mainly because firms do not get their offshoring right.

In a properly managed offshored environment, the benefits are many, although the theory of relative advantage has fuelled debate. Japan and India, for example, are often mentioned in this context.

Japan’s strength in hardware and India’s in software are complementary. Their synergy makes possible a level of consumption and wellbeing that is greater than the sum of what both nations can achieve separately.

Offshoring has led to significant employment and wage gains for workers in India (and in China) and that, in turn, has helped businesses report rapid revenue increases.

Meanwhile, Japan can utilise resources for activities in which they have a relative advantage, such as hardware engineering.

Wealth creation
In a report published a few years ago, the McKinsey Global Institute (MGI) estimated that, for every dollar American firms transfer to India, $1.46 in new wealth is created.

According to MGI, India receives $0.33 through wages paid to local workers, profits earned by Indian outsourcing providers and their suppliers, and additional taxes collected by the government.

The US economy captures the remaining $1.13, mainly through cost savings to businesses, increased exports to India, and repatriated earnings from US-invested offshoring providers.

However, the US also benefits from the additional economic output that can be created when American workers are re-employed in other jobs. This amounts to an additional $0.47.

Data shows that IBM India Private Limited is the largest foreign employer and second largest of all private sector employers in India, providing work for more than 100,000 staff.

Repatriated earnings
Many of the Indian firms that provide outsourcing services are owned, in whole or in part, by US firms.

MGI estimates that an additional four cents of every dollar spent on offshoring services in India thus returns to the US in the form of repatriated profits.

Efficient shift system
The time zone in which Asian countries fall is advantageous for run a shift system, even if they mean higher wages for odd hours. In the West, which is a high wage environment, this option is frowned on in boardrooms because the wage premiums offset any capital savings.

Cheaper Capital Equipment
As offshoring gained momentum from using local, low-cost labour, many firms in India developed their own software systems, and even manufactured hardware devices rather than purchase more expensive, branded products. That includes call centre applications, anti-virus and firewall programmes and physical devices such as firewalls and routers.

What are the pitfalls of IT offshoring?
Despite all the benefits, getting offshoring right is a tough task, involving many aspects.

Studies conducted by major consulting firms reveal that a significant percentage of organisations that shift processes offshore fail to generate the expected financial benefits.

Identifying and managing risk
Firms must identify operational and structural risk. One of our clients, an asset management firm, set up an offshore centre in India. But, as the costs there rose, they decided to move to China.

The firm started with about five staff but the figure rose to more than 500 in around five years. In China they could hire a Unix system administrator who, in Japan, would generally cost ¥10–12mn. However, an over 85% employee attrition rate forced them to quickly rethink the low-wage strategy and adjust salaries to have a stable workforce.

Another example of not getting offshoring right involves a US investment bank, another of our clients. They outsourced their IT to a global consulting firm to provide support from India.

The consulting firm ended up with more than 6,000 employees who performed tasks that 2,000 bank staff had always done prior to outsourcing.

Choosing the right partner
While many firms set up captive centres in India and China, many choose a partner instead.

Partner firms can come up with tall claims and attractive PowerPoint presentations, but it is imperative that an in-depth assessment be conducted. To this end, a penalty and incentive programme should be in place for partners, while performance measuring goals should be set up.

Choosing the right location
Development is not uniform in India, where major cities, such as Bangalore, Mumbai, and Chennai have decent infrastructure and transport facilities, but costs are high.

Second- and third-tier cities, such as Pune, Hyderabad and Kochi cannot compare with the major cities in terms of continuous power supply and internet bandwidth and other infrastructure facilities. However, they offer a huge cost advantage. So the firms have to trade off some merits with potential demerits.

How much do you really save?
The popular perception is that Indian programmers tend to make only about one-tenth of what their US counterpart makes, thus saving the firm a whopping 90% of the project’s expenses.

In reality, however, the savings will be more like 20–40%. So where does the money go?

A significant part of the money is the vendor mark up. In addition, there are huge costs involved in setting up high-speed network connections, videoconferencing software and hardware, travel between vendor and client sites.

Cost overruns due to communication problems and to vendor programmers’ limited experience.

Statistics from a 2004 survey conducted by Gartner, Inc. found that 18% of the firms surveyed had accrued no savings at all by offshoring. Moreover, 9% had experienced an actual increase in costs. So choose your offshoring with care!