Everest Research: Trends in Offshoring

Everest Research Institute, the research division of Everest Group, an outsourcing advisory firm, recently announced that it expected labor arbitrage — the key cost-savings benefit of offshore outsourcing — to continue to drive sourcing decisions for the next 30 years. It struck us that projections don’t often go that far into the future. These researchers were truly putting a stake in the ground for the long-term.

At the same time, Everest said that fears about rapid wage inflation and a growing skills shortage in India as well as other offshoring destinations were “largely misplaced.”

Sourcingmag.com decided to find out what other insights Everest had to share about the offshoring industry. So we interviewed Joe Fernandes, Managing Research Director. He spoke to us from Dallas, where Everest’s headquarters are.

Insight #1. Those people who expect India salaries to reach the level of US salaries within a few years are just plain wrong.

Everest Research Institute's Joe FernandesFrequently, posters in online forum discussions will take the latest news about salary inflation from India and project that Indian salaries will reach US salaries within five-seven-nine years, which will kill it as a location for offshoring work. Here’s where they’re mistaken, according to Fernandes.

First, not only are salaries inflating in the offshore country, but they’re inflating in the host country as well. As he points out, a 10% increase on $20,000 in India equals $2,000. That’s only a little more than half of a 3% increase in the US on a salary of, say, $125,000. The labor arbitrage dollar value is actually higher than before.

Second, when comparing offshore country salaries, you need to consider salaries in different cities. Typically, the salaries quoted are those being paid in Bangalore. If the offshoring country has cities that offer lower salaries, the work will eventually find its way there, all other matters being equal. In the case of India, that would mean Cochin, Hyderabad and Chennai — or 17 other up-and-coming locations. Those alternatives probably cost half as much as Bangalore, said Fernandes.

Third, other factors affect salaries, including some that can’t be predicted — such as events that “create noise around exchange rates.”

Last, you have to look at a weighted average of salaries within a company to get a full understanding. For example, said Fernandes, “If you look at the overall stack of how an IT services shop is set up, you have 60% to 70% of your cost in project managers, which is your most expensive cost. That cost is only going up about 5%. The software engineers — where [salaries are] really growing up by 50% — is 9% of your costs.”

Insight #2. Lower salaries aren’t the only factor that tilts the advantage to offshoring.

Fernandes predicted that the cost structure of the work being done offshore “will continue to go down in the near future.”

How? Aside from suppliers getting more sophisticated about “lifting and shifting” work, they’re also getting “productivity costs out.” He believes that the whole process of moving work offshore can expose its inefficiencies. As he explained, “CMM Level 5 processes are more effective than CMM Level 2 processes.” Making those process improvements in IT removes costs from the system. The same is happening on the business process side.

Should You Fix a Broken Process Before You Outsource It?

Everest Research Institute’s Joe Fernandes comes down on the side that believes that the best offshore service providers can help clients understand what’s involved in repairing services that don’t work well. “In the initial years,” he said, “there would be communication gaps between when [providers] came with their robust systems, but talked to a company that wasn’t there yet. They’ve become much more sophisticated about how to handle a company [like that]… I think the value proposition that suppliers bring to the table helps companies to get there.”

However, he pointed out that outsourcing before fixing does have a downside. “The reason you say, ÔDon’t outsource it until you fix it,’ is less to do with the fact that there may be undue risk. It’s more that you don’t capture all the value as a buyer,” he said. “So you fix the process. It’s costing you $100 million today. And you’re happy with getting the 30% savings. But actually you should be getting 80% because your process is broken. So you outsource it and you get upset.”

Insight #3. Growth of offshoring is accelerating.

Each research firm has a unique way of counting the size of the outsourcing market — and that’s why you see such widely varying amounts cited. For Everest to include a deal in its calculations, there has to be an element of continuity as well as scope — not simply project work and not simply a single function, such as payroll. That means talk of HR outsourcing being a $60 billion market in 2005 actually shrinks to $2 billion or $3 billion by Everest’s count.

The firm estimates the entire outsourcing market worldwide at about $362 billion. Offshoring totaled roughly $45 billion in 2005. By 2007, Everest projects the offshore segment to reach $85 billion.

Everest sees year over year growth of offshoring in the 30% to 35% range. Fernandes believes the market growth will accelerate and “it’s really going to become pervasive in terms of who’s adopting it and the extent of penetration you’re likely to see.”

Insight #4. Business process outsourcing is closing the gap against IT outsourcing in offshoring, but it doesn’t follow the same pattern.

Currently, IT work makes up about 65% of the current offshoring market. IT added up to between $27 billion to $30 billion, and business process outsourcing made up $18 billion.

Interestingly, captive centers — those owned by the client organization — are more common in BPO than in ITO. In 2005 about 60% of BPO offshoring in India was being done in captive centers, whereas only 23% of ITO is captive.

Fernandes explained that the difference might lay in the need for companies to retain more control in these relatively early days of business process outsourcing. As the processes and service providers mature, as they have in the IT space, that will change. In a captive scenario, client organizations are able to take advantage of the labor arbitrage while still retaining control of the functions. “To give you an example, in finance and accounting, you wouldn’t want to give certain control functions to a third party. But if I set up a captive and I had my person there doing some of those control functions sitting in India or sitting somewhere else, I’m [still] saving $200,000 a person.”

Also, he pointed out, offshoring is about access to talent. “People want to do core R&D and they’re looking for talent. They can’t find the talent. Some of them have chosen to use captives as an approach to accessing some of that talent in other locations.”

Insight #5. Although a lot of client companies are offshoring work, the real drive comes from a core group of mega-companies within each spend category.

Fernandes says the core group for IT offshoring in the India-US corridor consists of about 650 companies. That accounts for $7.7 billion in annual market revenue. And 60% of that total actually comes from about 100 organizations.

In BPO, there’s the “same story,” he said. “Real users are only about 400 companies. About 21% contribute about 71% of the market.”

In other words, “it’s a mega-company story,” he said. (Everest defines a mega-company as one with $10 billion or more in annual revenue.) Companies of this size are contributing about 70% of the total offshoring spend.

Insight #6. Expect to see “a lot more [merger and acquisition activity] happening in the marketplace.”

That will be driven by organizations buying out third-party companies to gain facilities rather than building from scratch. The more sophisticated client companies are creating competitive “presence,” said Fernandes, by splitting work among third party service providers and captive centers. “They’re able to shift work one way or the other. They can create a balanced risk portfolio.”

He sees companies using captive centers doing more of the “high end work” over time and outsourcing the commoditized work “locally.”

The capacity that providers are building up now, he said, will “re-orient itself and either get consolidated into players and make them bigger or get brought into the captive companies.”

Insight #7. Service suppliers are creating hub-and-spoke and other models.

As third-party service providers mature, they’re learning how to take buyers’ work and split it among different locations. Work that’s placed in Bangalore — “the gateway for most buyers,” said Fernandes — over time will be moved to Cochin, Chennai and other less expensive locations.

“As they grow out their tentacles and create more delivery centers,” explained Fernandes, suppliers are optimizing their locations and shifting work around, which is much easier for them to do than for buyers to do.”

Insight #8. China has many different “outsourcing stories,” and the biggest one may not be what you’d expect based on reading popular press.

Fernandes sees several outsourcing markets emerging in China. One is as an offshore location for Japanese companies — as well as other Asian countries where China can show a language advantage. The offshore play for Japan, said Fernandes, “could become really big.”

Then, there’s China as a destination for US and European work. That’s the one that gets a lot of coverage in the English language media.

But the major trend Fernandes sees is “China to China” — creating local outsourcing to serve the Chinese market. As he explained, “Many of our clients are taking their manufacturing shops there, they’re taking their petro-chemical, their energy investments there, they’re taking their financial services businesses there… And they can’t build their F&A business that meets what the Chinese requirements are. It’s a distraction. So they’re saying to a supplier, ÔCan you build that for us to service in China?’ It’s not an offshoring play. It’s serving the local buyer who’s selling in China, because they don’t want to spend the time and get distracted to build that capability.”

He expects that domestic IT business to be much higher than the export IT business. (As a comparison, he said, in India, the ratio from a revenue perspective is about 30% to 40% domestic and 60% to 70% export.)

Insight #9. You have to consider “wage inflation” in terms of “source destination pairs.”

Everest holds that you need at least a 40% savings in labor arbitrage to make offshore viable and a 25% savings to go nearshore. Given that, said Fernandes, when mapping out your portfolio of potential work locations, you need to consider each country in light of whether it’s offshore or nearshore. For example, the Czech Republic is a “great” nearshore location in the long-term for European companies. But if you’re a US company, the window for taking work to the Czech Republic is smaller — four to six years — in terms of labor arbitrage.

Insight #10. For proper due diligence in evaluating a given geographic area, you need to examine both risk and economic savings.

Fernandes said the risk analysis needs to focus on questions such as whether you’re being a pioneer in the given space or entering a mature market with sufficient “suppliers, evidence and capabilities.”

Everest tracks about 80 locations — on the city vs. country level — as global sourcing destinations. But each is not equal. “Every function has a different [best] set of cities,” said Fernandes. “For each function there might be a different answer… If you choose IT services, [there are] probably seven or eight that are key. If you choose F&A, there’s another seven or eight that are key. That’s how the market is growing today.”

Once you’ve identified the functions and the cities that best serve that market, then you have to sort out which ones are optimal. “Say, I choose four cities,” said Fernandes. “I don’t necessarily want to be in four different cities. So are there two cities that are most optimal for those four functions? Or is there one that covers them all?”

Even then, he said, the market continues to change. “It’s amazing how some [cities] have matured in a six-month, nine-month [period]. It just needs a couple of suppliers to make the investment and cities move from being non-entities to being a true player.”

Useful Links:

Everest Research Institute
http://www.everestresearchinstitute.com/

Everest Group
http://www.everestgrp.com