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The blistering growth in offshore sourcing¹ of IT services is over. IT software export revenues grew an average of 66 percent in India from 1998 to 2001, but only 21 percent in 2002 (Source: Nasscom). The reason is simple: three of the four key growth drivers evaporated almost overnight: Y2K projects, eCommerce-fueled growth in IT spending, and a labor shortage in the U.S. and Western Europe. What about the fourth?

The cost savings due to labor arbitrage remain and have become increasingly attractive to customers struggling to meet their quarterly earnings forecasts. Additionally, the concreteness of the labor savings have silenced the skeptics, as companies regularly report 20 to 50 percent net savings on offshore projects (net after taking into account additional expenses such as increased oversight, travel, and infrastructure costs).

In one recent client situation, the company is considering moving up to 50 percent of its development offshore to capitalize on 80 percent gross savings ($20/development hour versus a fully loaded internal cost of $100/hour, even though the client is headquartered in one of the lowest cost areas of the U.S.). In essence, over the last 18 months, the question most frequently asked regarding offshore IT sourcing has gone from: "Should we move some IT development offshore?" to "How do we best move a portion of IT offshore soon?"

Growth Will Rebound

Although it is too early to say if offshore sourcing will ever again see 60 percent growth rates, we do expect growth to rebound sharply. A recent study of CIOs by Baird & Co. revealed that while only eight percent of respondents currently sourced any IT offshore, a further nine percent were planning to begin sourcing offshore within 18 months. Even more surprisingly, a further 25 percent would be more likely to source offshore if a domestic supplier provided the service. In other words, offshore outsourcing activity could grow to five times its current size purely from sales to new customers (assuming they are of similar size and eventually source offshore to the same extent as existing customers).

This desire to offshore via a traditional service provider is understandable. Using an offshore provider for the first time can prove to be a daunting task. It calls for a far greater degree of process/project control and specification than simply using contractors or consultants. However, offshore providers are keenly aware of buyers' attitudes and are working actively to remedy the situation by increasing their onshore capabilities and by becoming expert in process control and quality.

Sooner rather than later, offshore activity will re-accelerate as buyers become able to ameliorate their concerns -- by using a domestic supplier with offshore capabilities or an offshore service provider that has built its credibility and reputation to rival that of traditional players.

The Medium Term Outlook

Offshore IT sourcing growth is projected to be 21 percent in India next year (Source: Nasscom). Given today's economy and customers' attitudes, that's a very attractive market for U.S. and European IT service providers, most of whom have flat growth and sinking stock prices (40 to 60 percent stock devaluations over the past two years are typical).

As a result, we expect all the traditional IT services companies to move to acquire an offshore capability. However, some are moving faster than others. Those who are not already moving will likely miss the boat. We expect mergers and acquisitions, particularly in the Philippines and India, to increase as U.S. and European service providers seek a quick way to establish scale in offshore operations. Likewise, the "domestic" offshore suppliers will merge to increase scale, a prerequisite for having broad and deep industry knowledge and for the expensive task of setting up and growing U.S. and European operations.

Already a number of Indian companies have established large front office operations in the U.S. and have begun to bid on larger, more sophisticated deals such as full applications development and maintenance outsourcing. A reasonable expectation would be for two to three traditional IT service providers to establish a reputation for offshore excellence and reap the resulting rewards of improved growth. We also expect that one to three offshore companies will make the transition successfully and become able to compete on an equal footing with domestic providers (i.e., a value proposition based on traits such as functional and industry knowledge rather than purely on cost reduction).

Recommendations for Buyers

Outsourcing any function is complex, but offshore outsourcing adds another set of challenges. A few of the more important issues are:

1. Cultural and linguistic differences
2. Onerous travel and time differences
3. Tighter process and change control
4. Higher requirements on documentation and specifications
5. Strong governance and metrics

Of course, offshore sourcing can be contractual rather than outsourcing. When the offshore sourcing is contractual, the risks are lower (due to the generally shorter time frame and lower deal value), but most of the above challenges remain. In general, companies looking to source offshore have three options:

1. Use a domestic provider with offshore capabilities. The chief benefits are the domestic provider has greater expertise in managing offshore assets and may be able to leverage existing offshore assets. However, there is a cost associated with using a domestic supplier's offshore facilities. In the earlier client situation, that potential 80 percent gross saving would be cut to 34 percent if the client chose to source offshore through a U.S.-based supplier, based on its quoted rate of $66/hour. Worse still, this erosion of the cost advantage is not balanced by a reduction of the inherent challenges in going offshore, although it does shift the responsibility for solving these issues.
2. Find an offshore provider with a domestic front office. The domestic front office is critical, since this group understands how to use offshore resources, can help set up the governance necessary to ensure successful delivery, and can often provide the project management and analysis/design skills necessary. The primary downside is that most offshore providers are still developing their onshore capability and do not have industry and business process knowledge comparable to domestic suppliers.
3. Go direct by establishing a dedicated offshore group. While this offers the most control and cost reduction potential, the buyer is no longer a customer but an owner. Most companies will not follow this path due to high requirements on expertise and size or because of the lack of flexibility.

In general, we recommend the second option. The cost savings realized by using an offshore provider outweigh the upfront investment in finding the right offshore partner. Given the challenges to overcome, we also recommend that any buyer start small and use a phased approach rather than the "big bang" approach common in IT applications development and maintenance outsourcing deals. This gives the supplier and customer a chance to work out any kinks on smaller, less strategic projects.

However, there is one exception. We believe that in long term outsourcing relationships, the first option can be viable because the markup can be significantly reduced when the buyer makes a long term commitment due to the improved economics for suppliers of longer term relationships.

Recommendations for Suppliers

Customers increasingly want to take advantage of the cost savings available by leveraging offshore resources. They are still cautious, as offshore sourcing is far more complex than domestic sourcing. However, traditional service providers will soon find that effective leverage of an offshore capability will be a necessary part of any large outsourcing deal.

For offshore providers, the key task is to develop a value proposition beyond a pure labor arbitrage and resulting cost reductions, as there are too many players in that space and the reduced growth has resulted in increasing competition. The new value proposition is likely to include process expertise, industry knowledge and a wider range of services (e.g., business process outsourcing).

There are two viable strategies for improving the value proposition: build the onshore presence and associated skill base, or lock in onshore capabilities through alliances and partners. There are already companies trying each strategy.

The race is on, but not everyone has heard the starting gun.

Lessons from the Outsourcing Journal:

• Reasons for growth have changed, thereby slowing overall growth from the explosive rates seen in the late 1990s.
• Labor arbitrage is the fundamental leverage point driving continued growth in offshore; the number of companies expecting to pursue offshore IT is large compared to the current number of companies already using offshore IT.
• As offshore IT matures, winning suppliers will be those who move quickly -- whether domestic suppliers acquiring an offshore capability, or offshore suppliers building an onshore presence.

¹This article frequently references offshore sourcing. This is purposefully generic, including outsourcing to offshore providers, contractual offshore relationships, and offshore subsidiaries established for the purpose of providing IT services to the parent (e.g., Microsoft's and Citibank's operations in India).

Publish Date: October 2002

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Copyright © 2002 - Everest Partners, L.P.

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