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The New Calculus of Offshoring

For years the offshoring boom was driven by one factor: savings. Today the decision is much more complicated.

Even before Ajit Singh made a formal announcement about his company’s offshoring plans, employees knew what he would say. “The more I talked,” recalls the CEO of Bioimagene, a maker of computer-aided diagnostic tools, “the more I think they could see my rationale.”

True, some voiced concern about the restructuring scheme, most of which would play out 8,000 miles and nine time zones away from the company’s Silicon Valley headquarters. There, in the city of Pune, India, the company employed dozens of software developers — about twice as many employees as in the United States — and they cost about 75% less than their American counterparts.

Those Indian employees had been with the company from its 2004 start, as a way to help Bioimagene stretch its initial funding as far as possible. Singh, a 20-year Siemens veteran who joined Bioimagene last fall, took immediate note of the Indian operation, making monthly visits there.

By December, with the economy sinking, Singh was ready to act. Five key employees would have to move halfway around the world. Another 65 would be let go. The decision? To close the company’s Indian office, in order to become more competitive.

But wait. Wasn’t that the same argument that so many companies — one-third of the Fortune 500, in fact — had given for transferring functions abroad in the first place? For about 10 years (earlier, in the case of manufacturers), U.S. businesses had been shipping jobs overseas as eagerly as a prize-hungry kid mails in box tops. From data-entry and customer-service jobs on up the value chain to human resources, engineering, and finance, offshoring became a fundamental tenet of globalization: Let the lower-wage workers overseas handle the labor-intensive stuff, leaving workers (albeit fewer of them) back home to lavish their talents on value-creating analytics.

Pressed for profits, what CFO could resist, especially when it promised quick cost reductions of 40% or more where large quantities of administrative work could be moved to low-cost locations, such as India and the Philippines? Put simply, “CFOs are looking to hold on to market share,” says David Poole, head of Americas Business Process Outsourcing at Paris-based consulting firm Capgemini. “Huge shifts in markets are taking shape.”

As formulas go, offshoring looked both elegant and simple. “Outsourcing was cost-cutting by a different name,” says veteran industry strategist Ram Iyer, founder and president of The Midmarket Institute, an association in Princeton, New Jersey. “Once companies saw the savings they could achieve through labor arbitrage, the decision was made.”

As wage inflation has set in — in India, annual raises of 15% have become the norm — some companies have been prompted to broaden their horizons. Fresh supplies of low-cost labor beckon from countries like the Philippines and China, to name but two of an exploding roster of options. Yet even when wages do move up, improving productivity and training keeps offshoring costs attractive. Therefore, “outsourcing isn’t about making one decision anymore,” says Poole “It’s become a portfolio of choices.”

And, potentially, a portfolio of headaches. Currency fluctuations, terrorist attacks, and financial fraud are but three complications to arise recently — and that’s just in India. Making sense of the options “has become more demanding than ever,” says Patrick Dupuis, CFO of Sitel, an outsourcing firm whose customers include many global giants. Below are some of the factors that any executive entering — or re-entering — the outsourcing realm ought to consider:

Put More Context Around Cost-Cutting

As recently as a year ago — or perhaps one should say particularly a year ago — cost-cutting was still the driving force behind offshoring.

But while some companies forged ahead, others focused on internal IT projects designed to lower costs, or moved toward shared-services models. Anupam Govil, chairman of the Global Sourcing Forum + Expo and CEO of Global Equations, an outsourcing advisory firm, believes that some companies are hesitating because they have become “a little more sensitive to the political aspects…. They don’t want to be seen as taking jobs out of the U.S.”

India’s outsourcing industry is expected to grow at just 7% this year, compared with 16% last year and 35% in 2007. That may, in fact, be good news for clients in search of lower costs, because the decline in business may prompt offshore businesses to cut their rates. Consulting firm Gartner predicts that outsourcing prices will drop an average of 10% this year. “We have people coming in and saying, ‘What can you do for me?’” says Sitel’s Dupuis. “In the rich times, we were saving them enough.” Now companies want assurances that prices are as low as they can go.

And yet there is also growing awareness that agreeing to specific cost-cutting goals isn’t the hard part; maintaining them is. Whether because of poor project management, a different work ethic, communications difficulties, or for other reasons, low hourly rates may not save much money if the total hours needed to accomplish a given task are higher, and that is often the case. “A lot of people who jumped on offshoring for the cost savings never truly understood the market,” says Iyer. “They got some savings, but generally not as much as they thought.” There were unexpected outlays — error rates that rose too high, or more-frequent trips to India and elsewhere — that affected underlying cost assumptions. Toss in wage inflation overseas and wage deflation at home and suddenly the calculus shifts again. Phil Fersht, an analyst at AMR Research and author of the outsourcing blog Horses for Sources, says that the wage differential between a call-center worker in Bangalore and one in Nebraska can be as low as 15%.

Structure Deals Based on Your Own Short-Term Interest

In first-generation outsourcing, contracts tended to be long-term; in fact, 10 years was common. The argument? Lock in the savings. Now, the watchword for every financial executive is flexibility. Circumstances change fast, as companies have painfully learned, and CFOs now place a renewed emphasis on being able to change any and all aspects of the agreement in response to whatever the economy is throwing at them. As a result, the fixed-price, fixed-term contract has become old-school, particularly in more-commoditized areas like IT and call centers. For certain professional services that require a higher percentage of highly skilled workers, such as finance and HR, contracts may tend toward longer terms; providers argue that they can’t attract the workers they need unless the contracts cover longer time periods.

But contract negotiations don’t simply boil down to 2 years versus 10; in essence, companies want to, as Dupuis puts it, “variable-ize” their costs. That means that the bill will rise in lockstep with demand, and vice versa. A call-center contract, for example, might specify a minimum number of “seats” that can be reset every 45 to 90 days. “If volume collapses, say, 50%, a customer using 500 employees can change the number within a month or two,” notes Dupuis. Contracts now build in volume discounts as demand rises, or require 10% efficiency improvements every year, or establish targets for service levels, availability ratios, uptime/downtime, and other criteria.

Those latter stipulations are often dubbed “outcome-based outsourcing,” an acknowledgment of just how topsy-turvy the industry has become. “It’s not a seller’s market anymore,” says Surjeet Singh, CFO of Patni Computer Services, a provider of global IT services. “The market is such that customers can write [more-customized] contracts. More and more pay-for-performance models are emerging.”

Think Globally and Local

A decade ago, all outsourcing roads seemed to lead to India. Earlier this year, consultancy BDO Seidman asked technology CFOs where they would expand outsourcing if they were planning to do so. The most popular destination? The United States, at 22%. China was runner-up (16%), with India a close third (13%). Meantime, the Philippines, Mexico, Costa Rica, and Jamaica have had recent success in winning high-profile clients.

India remains competitive — after all, outsourcing makes up nearly 6% of GDP and employs 2.2 million workers, and an IT employee who would command $100,000 in the United States costs about a quarter of that in India. Some Indian outsourcers are responding to wage inflation there by shifting work from higher cost cities to emerging centers of commerce.

Find the Right Balance Between Agility, Economy, and Strategy

Something similar is happening in the United States. Companies that have been burned by offshoring, or that are sensitive to claims that shipping jobs overseas is un-American, have an expanding array of options at home. Rural Sourcing Inc., which builds development centers in “Tier 3″ U.S. cities (midsize-to-large cities such as Pittsburgh, Cleveland, and Tampa), says revenues this year will be 300% above last year’s.

While Asian and Indian workers have their own distinct cultural attributes, says CEO Monty Hamilton, Americans do as well. “We tend to push back, apply our own critical thinking, and create closer collaboration to reach the best answer,” he says. Rural Sourcing, which offers IT application development and maintenance, is in the midst of choosing the site for a third location, supplementing centers it has already opened in Jonesboro, Arkansas; and Greenville, North Carolina. “We are the new smokestack companies,” says Hamilton.

Stephen Loynd, program manager in the outsourcing group at IDC, points to a related option: outsourcing to home-based workers, a trend that he says may grow at a rate of about 18% a year over the next five years. He argues that many factors are combining to keep workers home — from the price of gas to concerns about the H1N1 virus (swine flu).

And the domestic option can simply be faster. When a disappointing holiday season left online retailer Shop.com hurting, CFO David Morrison says the firm decided that it needed to cut costs by 40%, and fast. Sending the jobs overseas would have required more due diligence than the firm had time for, he says, so instead it chose Corefino, a financial-services outsourcer; Morrison cut the cost of his finance department by more than half in the process.

Some analysts counter that various arguments for keeping jobs at home still can’t trump the economic argument for offshoring them. “Everybody is making a lot of noise about protecting jobs,” says AMR’s Fersht, “but only 20% of businesspeople think that matters.” His conclusion: “Companies have to be seen as being against it, but in reality they have to do it.”

Even companies that have bucked the trend acknowledge that in the short term their costs may rise. When Ajit Singh closed Bioimagene’s India office he did so in the belief that by co-locating engineers and marketers, the company could rev up its innovation cycle, powered by the sort of continuous, unstructured brainstorming that can’t be sparked by e-mails, videoconferences, or social networks. “To become what we wanted to be — disrupters in the marketplace — we had to be in the same location,” he says. “If costs rise 10%, it’s worth it.”

Sounds simple, but only in retrospect.

Josh Hyatt is a contributing editor of CFO.

War of the Words

Perhaps because the outsourcing industry has always been dominated by consultants — the folks who brought you “change agents” capable of “thinking outside the box” — outsourcing has inspired a buzzy and ever-expanding lexicon that is often clever but also confusing. Here’s a guide to some common and not-so-common terms.

Farm-sourcing. A form of in-sourcing or reverse-outsourcing, terms that are used to describe companies that repatriate projects from foreign soil to low-cost regions of the United States. Such back-shoring may locate itself in depressed rural areas (rural-sourcing) or in suburbia (home-sourcing).

Doubt-sourcing. Characterizes the attitude of outsourcing critics who spoof providers as headset-headed drones and U.S. companies as exploiters of cheap labor.

Speedy-sourcing. Describes the practice of big companies hurrying to make deals with outsourcing providers, thereby globalizing their panic attacks.

Small-sourcing. A practice that refers to small companies outsourcing work to remote individuals or teams, often using online intermediaries such as oDesk.

Smart-sourcing. Refers to selecting third-party providers that can add value beyond lowering labor costs, such as innovation in noncore areas.

Right-shoring or blend-shoring. Finding the optimal mix between functions that are performed domestically and those that are moved to foreign countries.

Mid-sourcing. The practice of hiring a firm to serve as a liaison between a U.S.-based and an offshore firm, in essence outsourcing the management of the outsourced work so as to boost quality and improve communications.

Multi-sourcing (also multi-shoring). Dividing outsourced work among a carefully selected group of providers or countries; the opposite of mega-sourcing with one giant such as Accenture or Infosys.

Near-shoring. Bringing offshored work in closer proximity to the United States, by moving it from, say, Asia or India to Latin America. Saves wear-and-tear on management and shrinks transportation costs.

Over-and-out-sourcing. An as-yet (we think) uncoined variant that describes an executive so confused by all other plays on “sourcing” that he or she stops using it entirely — or outsources that jargon-spewing to someone who is contractually obligated to be 20% more relaxed.

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