Outsourcing & Offshoring


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Whitepaper on different aspect of Outsourcing & Offshoring

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Outsourcing & Offshoring

  1. 1. Ravi J. Mevcha PGM06061345 MBA June ‘06 Strategic Management Assignment 1 : Outsourcing & Offshoring What is offshoring? Offshoring is the practice by which companies outsource processes, chiefly IT-based services, across large distances to other parts of the world, often low-wage countries. It is a technical term from financial economics, in which offshore centres are used to describe tax havens attracting foreign investment with low rates of taxation and strict banking secrecy. But regulatory differences play only a very minor part in offshoring, the main aim being to exploit wage cost differentials in the services sector. As a rule the activities involved are simple ones, such as data entry and processing, call centre and support services (help desks) or processes entailing the standardized treatment of insurance claims. But even more demanding tasks such as application development and maintenance or the analysis of computer scans from Europe by Indian radiologists come under the heading of offshoring. The key characteristic of offshoring is that the services are rendered abroad. Normally the provider and client are located on different continents: India, as the major provider, and the United States, as the biggest taker, determine this mental image. But there are also many exceptions to the rule. Cooperation between partners on the same continent is termed nearshoring. From a Central European perspective the East European EU accession countries and Russia, and in some cases Spain and Portugal are countries of destination for nearshoring. Many people are confused by the terms offshoring and outsourcing. In a nutshell, outsourcing is hiring another company to do some of your work. Offshoring is moving some of your work to another country with cheaper labor. The two ideas often overlap – for example, when outsourcing work to a supplier located offshore – but they aren’t the same. In the early days of offshoring, most companies chose to outsource because it was fast and easy. But according to recent research, more and more companies are electing to retain control and ownership by establishing their own wholly owned offshore subsidiaries. In addition more of the benefits fall to the bottom-line. Things are even more confusing in the United States where some offshoring proponents have attempted to divert public criticism by substituting terms like global sourcing, inter-sourcing, blended sourcing and rightsourcing. But beneath the smart word-smithing, it’s still offshoring. Page 1 of 12
  2. 2. For example, Offshore business process outsourcing is the exporting of work from the United States to areas of the world where there is lower labor cost or tax savings. In this type of arrangement, the foreign-based firm provides services for a U.S.-based company that could also be, or usually has been, provided in the U.S. Onshore outsourcing keeps the business process that is being outsourced in the U.S. and utilizes a partner to supply U.S. based labor and expertise for the completion of the work. In most companies, important processes such as customer relationship management (CRM—customer service, pricing, billing, etc.), finance and accounting (F&A—accounts payable, accounts receivable, etc.), and supply chain management (SCM—shipping, warehousing, purchasing) are deeply dependent upon the IT systems that enable them. Yet few companies see managing an IT infrastructure as a core competence. Whatever the importance of IT infrastructure in enabling these and other essential processes, IT itself is for most firms a hygiene factor: critical to the successful operation of the business but not a distinguishing element of their value chains. Because they consider IT to be “noncore,” many firms are looking to outsource the IT component of significant processes, and frequently the processes themselves. For example, applications maintenance outsourcing (AMO) is an increasingly popular way for firms to cope with the escalating demands of managing the tens of millions of lines of code in the CRM software that drives many call centers. Regardless of whether a company selects an offshore or onshore relationship the reasons are typically the same: · Reduce and control operating costs · Improve company focus on its core competencies and strategic imperatives · Access to world-class capabilities and best of breed technology · Re-allocate internal resources to higher-value purposes · Address the issue of limited internal resources · Accelerate re-engineering/transformation efforts · Manage more effectively a difficult or problematic function Offshoring was initially driven by economic pressure and the need to cut costs, but today most executives in financial services say they are committed to the practice and expect it to continue regardless of the economic environment. The offshoring trend is gaining momentum to a point where the vast majority of financial institutions have or are evaluating the implications for their business – whether they want to or not – to understand potential future strategic options. Firms with offshore operations are also finding they can afford to hire workers that are more highly skilled than their domestic counterparts – and still save money – delivering an appealing combination of higher Page 2 of 12
  3. 3. quality and lower cost. This means that international financial institutions need to dramatically refashion their business and operational models. However, the balance of staff is likely to remain in onshore locations. As expected, offshoring is encountering a significant backlash from labor groups, the public, the media and government – but most executives don’t expect it will have much impact on the growth of offshoring in the long-term. Companies are continuing to expand their offshoring capabilities from IT operations to multiple functions, including a wide range of back-office and customer-facing functions. Offshoring offers compelling benefits, but only for companies that do it right. Example : Five years ago, if you were an Indian engineer, the dream was to come to America. A fortune could be made very quickly. Indeed many engineers did come. Now, according to a recent BusinessWeek article on the globalization of the work force, you can live like a king in India. Being paid with American dollars, an engineer can earn 20 times the average yearly income. Execution and rigorous governance are the keys to success. An institution’s first attempt at offshoring generally requires four to five months of planning, followed by a three- to six-month deployment. Average payback time is one to two years a figure that is expected to shrink even further as firms build offshore experience and capabilities. For financial services institutions, India remains the dominant offshoring location and continues to extend its lead over rival countries – despite some challenges over labor turn-over and costs. In the early days, outsourcing was the preferred approach to offshoring, but the captive model has recently pulled into a virtual tie, with more and more companies electing to retain control and ownership through a wholly owned offshore subsidiary. That’s a clear sign offshoring has been accepted as a core element of the global business model for financial services. The impact of offshoring varies widely for financial institutions of different sizes with larger firms driving change across the financial services industry and using offshoring to open up an increasing competitive advantage over their smaller rivals. By estimate, as many as 80 percent of the world’s largest financial institutions (i.e., those with market capitalization exceeding $10 billion) are already working offshore – with less than 20 percent keeping everything at home. For smaller companies, the numbers are split 50:50 between those offshore and those staying home. That disparity creates a significant cost advantage for the larger institutions – and the gap is likely to get wider. Page 3 of 12
  4. 4. Value Chain Dynamics Value Chain Dynamics begins by asking what you should outsource and what you should keep in-house. Conventional wisdom says to hang on to anything that is core and outsource the rest—functions typically derided as “back office” or “infrastructure.” Yet many successful companies do not follow these rules, and those that have are now trying to undo some of those same long-term deals. Making the right outsourcing decisions requires answering three questions: 1. What to outsource 2. Whom to outsource it to 3. How to structure the outsourcing deal WHAT Deciding what to outsource is the most important question when thinking about outsourcing. Get this one right, and you’re on your way to creating a competitive advantage that competitors will find hard to beat. Get it wrong, and you’ll undermine even your best efforts in every other aspect of your business. Page 4 of 12
  5. 5. WHO Every outsourcing decision has two value chains that need to be analyzed: yours and your outsourcing vendor’s. Once you’ve concluded that your value chain doesn’t need to include a given process, you need to determine that your vendor’s has all and only the necessary complementary value chain elements to deliver the performance you need and can respond appropriately as your needs change. HOW How to structure a deal is a function of how and how quickly the basis of competition in your industry will change. Long-term deals only make sense if what you’re outsourcing is very unlikely to figure in your ability to perform against the basis of competition in your industry now or in the future. A flexible approach to outsourcing is critical if a firm is to be able to reconfigure its value chain and deliver the kind of sustained performance that result in consistent shareholder value creation. Getting the right answers to these questions can transform your outsourcing initiatives into what you have always thought they should be: powerful components of your firm’s overall competitive strategy. Outsource correctly, and you can position your company to spring strategic surprises that will defeat your competitors and delight your investors. Get it wrong, and prepare for declining market share, decreasing margins, and a falling stock price. How do you get the answer right? Use an approach we call “Value Chain Dynamics.” One of the reasons focusing on the core can lead to such problems is that it encourages navel gazing: you end up basing outsourcing decisions on what you think you are good at, instead of what you should be good at. So we recommend beginning by identifying your firm’s competitive requirements as defined by the markets you serve. Then, use outsourcing to configure your value chain and that of your outsourcing vendor in order to optimize your competitive position. In other words, core competence thinking can be too “inside out,” when competitive success can require looking from the “outside in.” In short, applying Value Chain Dynamics is critical to making the right outsourcing decisions. It is an essential tool for enabling your organization to compete effectively today and tomorrow. Page 5 of 12
  6. 6. 4 Cs of Offshoring Complexity Compliance · · Scale or Fail? The principle challenge Building global ethics : A key way to facing organization going forward is improve moral and ethics is a longer- enhancing operational efficiency term program of management activities. · · Building a business model to enable The integration of offshore and this transition and the part to be played operation. by offshoring can be central · Finding a balance between short-term · investor demands and long term The survey shows that it’s not possible to stand still – the big challenge ahead strategic development is imperative. will be to scale, focus or fail? Cost Culture · · Recycling savings : The bottom line Tour of Duty : A truly global operating impact can only be sustained if saving model requires more top managerial are recycled back into existing offshore spending years setting up and operation operation. offshore unit to embed ethics and · establish the management framework Finding a balance between short-term investor demands and long term strategic development is imperative. Page 6 of 12
  7. 7. Offshoring as a process of creative destruction From a macroeconomic perspective, offshoring as a business model makes production by the domestic services sector. In the course of what is termed “creative destruction”, such process innovations enable companies to make do with fewer staff. Productivity increases assuming the same output, boosting the owners’ profits. This, in turn, attracts new providers onto the scene, before competition intensifies and margins contract again. On the demand side, the fact that services are provided at lower prices raises clients’ purchasing power. Lower production costs reduce the prices of the goods and services produced for the established clientele. What is more, smaller businesses not previously able to afford software solutions for their in-house processes can also be gained as customers. Aggregate demand is stimulated, growth generated, and jobs created at other companies. And indeed, it is estimated that between 1995 and 2002 the United States would have grown 0.3 percentage points a year less if companies had passed up the possibility of IT offshore outsourcing. Page 7 of 12
  8. 8. Offshoring is part of the solution, not the problem The offshoring debate will continue to rage for some time to. Yet concerns geared strictly to the outsourcing of workplaces miss the essence of the problem. That certain jobs are shed in the course of structural change is a well known phenomenon. Crucial is the creation of new jobs in parallel. On the whole, therefore, offshore outsourcing is far less detrimental to folk and fatherland than the new-style patriots would have us believe. Indeed, as a social model offshoring can even play an important part in securing high-value domestic jobs. The increased productivity generates growth, and in the medium term new jobs as well. So on balance, we can expect positive effects. The political response cannot be the erection of protectionist barriers. In the process of the globalisation of service provision, offshore outsourcing will take place with or without protagonists. The critical factor will therefore be to speed up structural reform in an attempt to field as many winners as possible in the international output rochades. Page 8 of 12
  9. 9. No cheap-jack: Costs are not the only argument in favour of offshoring However, costs are not the only reason for western companies to outsource processes to other countries. As in earlier periods of globalisation, they are driven by a variety of considerations. Essentially, these can be summarized into four motivation groups. But since more than one motive may be relevant simultaneously, the expected effects cannot always be assigned categorically to one single cause. 1. Cost-based outsourcing plays the most prominent part, not only in the public perception. With IT offshoring, the low wage costs in the emerging markets in particular, but also in the East European EU accession countries, are attractive enough to make it worthwhile offshoring processes even when the increased monitoring and initiation costs caused by the distances involved are taken into account. The hourly rate for a software developer with significantly lower costs of just EUR 14 in China. In the Czech Republic and India labour costs, at EUR 8 and 7 an hour respectively, are half less again. Typically, offshore labour costs make up only 15% to 50% of the total costs of a project, against 75% in the home country. But added to this are offshoring-related management and operating costs such as vendor management.All in all, the estimated cost savings work out at between 20% and 65%, although 20% to 30% is the realistic, and typical, figure. 2. If the necessary skilled staff cannot be found in the home country, production may be shifted for procurement motives to countries that possess the required specialists in abundance. Human capital is the scarce “resource” in a knowledge society. Computer specialists and skilled engineering staff are in particularly strong demand. The currently just over 5,000 IT graduates in Germany and the 25,000 in the USA that enter the labour market each year contrast with 120,000 in India and as many as 250,000 in China. The quality of the skilled staff evidently also plays a crucial part, and not just their mere availability. However, it is extremely difficult to compare international qualifications – indeed, this causes problems even at the national level. More meaningful than the theoretical training acquired by university graduates are internationally recognised standards that objectively measure and assess process quality in companies (Capability Maturity Model (CMM), ISO 9000 or Six Sigma certificates) and hence the effective use of specialists. The emerging markets, foremost among them India, have caught up enormously in this regard. Page 9 of 12
  10. 10. 3. One of the oldest rationales behind a commitment abroad is to tap new markets. As a rule, a company’s activities abroad are built up as a complement to its domestic engagement. Particularly in the case of near-end-user products, it is a good idea to use staff locally to take advantage of local knowledge of markets, requirements and tastes. Populous, dynamic growth regions like India, the Philippines or China hold out substantial sales potential for manufacturers of mobile telephones through to business software. To exploit this, a local presence is necessary. Some governments in the new markets even make it mandatory for foreign companies to build up local production facilities before they are allowed to sell their products there. 4. Finally, locational quality acts on the motivation to shift production facilities or services. A business-friendly institutional framework with liberal rules on labour dismissal, and subsidies and tax breaks can exert a pull effect on foreign companies. Restricted business scope, too much regulation or an excessively high tax load in the home country can act as push factors, driving production processes abroad. How would you say outsourcing affects globalization? You can't separate outsourcing and globalization anymore -- they are directly connected and reinforce each other. For example, American companies are the leaders in providing outsourcing services globally. Companies like IBM, EDS, Solectron (manufacturing) and Aramark (food and facilities) have extensive global operations providing outsourcing services to others. At the same time, American companies are outsourcing to global providers, such as Siemens, Capgemini and Flextronics (manufacturing). Then there's the entire offshoring dimension. Whether folks like it or not, it's now a global job market for many types of work. All of this is enabled by the global information infrastructure built during the 1990s and finally secured when we sailed through Y2K with barely a hiccup. The result is the rapid movement toward a network of companies and internal operations, running every hour of the day somewhere, all connected in real time by IT, and all staffed by highly trained professionals working in every corner of the globe. Page 10 of 12
  11. 11. India: The mother country of offshore outsourcing India is the most prominent offshore location in the IT sector. Depending on the statistical source, its share of global offshore outsourcing business is estimated at 70 – 90%. Its service portfolio focuses on application development, taking over the entire IT infrastructure or individual business support services (business process outsourcing), and call centre services. As India’s major trading partner, North America accounts for the lion’s share – two thirds – of the subcontinent’s software and IT-based services exports. Of particular note is the high quality of India’s software and BPO industry: the most companies in the world with CMM Level 5 certification were to be found 2002 in India.10 In this reference model Level 5 denotes the highest stage of maturity of a software supplier’s development processes. India’s IT export boom can trace its beginnings back to the mid- 1980s, when Texas Instruments opened a branch in Bangalore to focus on development, followed a year later by Motorola. Mainly American and West European multinationals from the electronics industry followed suit in the period to the middle of the 1990s; but it was not until the second half of the 1990s that big software houses such as Microsoft, SAP or Adobe opened development centres in India. Page 11 of 12
  12. 12. In a parallel development, the number of Indian companies to which American principals in particular contracted out programming assignments has soared to more than 3,000. Meanwhile, India’s exports of software and services total more than USD 12 bn. If it succeeds in maintaining the momentum of latter years, they will be brushing the USD 38 bn mark by 2008. This trend has been encouraged, first, by India’s greater opening since 1991 to foreign investment and cooperation agreements. Second, the national industry association NASSCOM’s commitment has successfully promoted its members. India has long outgrown the status of a strictly IT discount provider. Its major players operate in a league of their own, building themselves a huge international reputation on the strength of their service quality. Indeed, they have now begun outsourcing work to even lower-priced countries such as China or the Philippines. They are also expanding into western Europe, buying up small local firms. References : 1. Inside Outsourcing, A Deloitte Research Outsourcing Study 2. The Titans Take Holds, Deloitte Research report on Financial Services Industry, 2004 3. Global Financial Services Offshoring, Deloitte Research report on Financial Services Industry, 2005 4. Offshoring : Globalization wave reaches services sector, Deutsche Bank Research, 2004 5. Offshore Outsourcing World News magazine 6. www.searchcio.com 7. www.apioutsourcing.com Page 12 of 12