Early Indications April 2009: Reexamining Offshoring

April 28, 2009
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When U.S. firms replace onshore technical and other resources with lower-cost labor in offshore markets, the logic is typically financial. Five years after some of the biggest such decisions, however, it has become clear that the calculations were incomplete. As some jobs repatriate (albeit on a small scale), we can suggest some additional decision criteria for future justifications.

Let’s start with a generic decision to shift 3,000 applications programmers from onshore to offshore in 2004. The calculation assumes a 10% cost of capital, a 34% tax rate, and 2% savings per year as salaries both in the U.S. and abroad grow at similar rates. The base case presumes a net present value of $400,000 savings per job, times 3,000 workers, for a $1.2 billion projected cash saving. Given the realities of activist shareholders and relentless cost-cutting, it would be difficult, and perhaps an invitation to a shareholder lawsuit, to decline those kinds of cost savings.

As the past five years have unfolded, however, some incompleteness in the analysis has emerged. Eight additional factors would be worth addressing in future considerations.

1) Inflation
Compensation growth in India in the past


When U.S. firms replace onshore technical and other resources with lower-cost labor in offshore markets, the logic is typically financial. Five years after some of the biggest such decisions, however, it has become clear that the calculations were incomplete. As some jobs repatriate (albeit on a small scale), we can suggest some additional decision criteria for future justifications.

Let’s start with a generic decision to shift 3,000 applications programmers from onshore to offshore in 2004. The calculation assumes a 10% cost of capital, a 34% tax rate, and 2% savings per year as salaries both in the U.S. and abroad grow at similar rates. The base case presumes a net present value of $400,000 savings per job, times 3,000 workers, for a $1.2 billion projected cash saving. Given the realities of activist shareholders and relentless cost-cutting, it would be difficult, and perhaps an invitation to a shareholder lawsuit, to decline those kinds of cost savings.

As the past five years have unfolded, however, some incompleteness in the analysis has emerged. Eight additional factors would be worth addressing in future considerations.

1) Inflation
Compensation growth in India in the past five years significantly outpaced that of the U.S. to the point where Indian wage inflation ran in the double digits for some of those five years. That compares to flat wage growth (but not benefit costs) in the U.S.

2) Employee loyalty
The years with high wage inflation coincided with high turnover at some offshore firms. The resulting instability contributed to lower performance gains than some onshore clients were expecting.

3) Coordination costs
Another factor widely underappreciated in many cost projections was the increase in coordination costs. Highly compensated, and extremely busy, financial services experts at various firms, for example, have told me that they overestimated offshoring’s value. In particular, they and their teams spent far more time generating and refining requirements documents for a team of programmers on the other side of the world as compared to the in-house resources across the hall who knew the baseline terminology and assumptions of the firm and industry in question. Producing code and generating business value through technology are not the same thing. Put another way, Brooks’ law applies to offshore resources, albeit in new ways.

4) Technology changes in enterprise applications
The rise of software as a service, virtualization, and cloud computing is challenging old models of application development and deployment, as Oracle’s play for Sun Microsystems would imply. In addition, scripting-based programming practices have the potential to transform software still further. 10-year payback scenarios with a traditional computing model held constant are likely to prove problematic as the late years of the model roll around.

5) Public perception
The loss of public goodwill in the performance of offshore call centers (less so in programming) has been unexpected. In 2009 alone, United Airlines, AT&T, Sallie Mae, and Delta Air Lines have pulled back from offshore call-center contracts. As Delta’s CEO stated, “The customer acceptance of call centers in foreign countries is low. Our customers are not shy about letting us have that feedback.” Dell experienced a broad wave of backlash in 2007; such companies as Royal Bank of Scotland’s Natwest unit go so far as to advertise that they do not offshore customer care. Even in programming, offshore resources are prohibited for certain public-sector contracts.

6) Currency dynamics
Both the Indian rupee and the U.S. dollar have undergone significant currency fluctuations, dwarfing that 2% cost savings assumption. In one year alone, a dollar went from buying 39 rupees to crossing the 50 barrier, a swing of about 30% (in this instance, in the U.S. firm’s favor).

7) Corruption
The cost-saving calculations implicitly assumed an apples-to-apples comparison of contract law, financial accountability, and other facets of firm governance. But when Satyam, one of India’s leading offshore firms, disclosed that its founder and CEO had orchestrated a billion-dollar accounting fraud, attention turned to the differences between Indian and U.S. models of corporate governance. Auditors from PricewaterhouseCoopers, who have been suspended from the firm and jailed by authorities, earned “exorbitant audit fees” and are alleged to have falsified key discrepancies between sales figures and bank deposits.

8) Risk
The 2004 NPV model apparently priced risk at zero, a flawed assumption when India is experiencing political tensions with its nuclear neighbor Pakistan, itself a potential “failed state” in the words of the U.S. Joint Forces Command. The Mumbai attacks of 2006 and 2008 provide further evidence that the country is facing a significant threat, in this case from non-state actors. The story continues to unfold, up to the present day. Various insurgent factions are staging attacks connected to India’s monthlong election; 17 deaths were reported on the first day of polling alone.

Even given these additional factors beyond the pro forma case, the economics must continue to be compelling as IBM recently continued its practice of laying off U.S. workers (somewhere between 5,000 and 10,000 so far year to date) and increasing staff in developing markets: employment in Brazil, Russia, India, and China totaled 113,000 in 2008 with the majority of those jobs in India, where headcount doubled (to 50,000) between 2005 and 2007.

Going forward, it will bear watching what happens next. India is becoming expensive, so its firms are in turn offshoring to the Philippines, Vietnam, and elsewhere. U.S. firms are revisiting the cost-benefit equation of onsite programmers as wages have declined, risk has increased, and user dissatisfaction has mounted. China, as in so many matters, bears watching. India’s elections will by definition have unexpected results.

At the least, the past five years of offshoring have proven that the logic of the business case depends as much on what one leaves out as on the numbers assigned. The process of globalization will continue to amaze, frustrate, and surprise, despite the best predictions of smart people. Unexpected consequences, for both good and ill, will continue to challenge firms — and individuals — on all sides of the equation.

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