By Paul Barter and Vikram Sainadh
Offshore IT outsourcing has been one of the most significant IT trends in recent years. The combination of large amounts of reliable, affordable communication infrastructure and increased availability of well-educated low labor cost programmers offshore has promised significantly lower software development costs.
Seeing these trends and seeking lower costs, organizations have increased IT offshoring projects considerably over the last decade. Recently however, the trend has begun to slow and in some cases reverse: firms that were early adopters of IT offshore outsourcing solutions are shutting down their overseas investments and returning development to North America. They have found that many of the promised benefits of IT outsourcing have not materialized—and in some cases solutions are delivered at higher prices or not at all.
While labor costs continue to be lower in many offshore locations, it has become clear that labor costs are only one of the components of successful IT project delivery. Unfortunately, the benefits of low labor costs can be overwhelmed by unanticipated implementation, cultural and social, regulatory and financial risks. Any one of these risks can be responsible for price increases or project delays but the confluence of several risks can and does skyrocket costs and cause the outright failure of offshore projects.
Firms who are considering moving IT projects offshore should take these risks into account and only offshore IT projects when they are sure that the promised benefits can and will be delivered. In many cases, traditional onshore or nearshore IT delivery proves to be an attractive—and reliable—alternative.
Offshore IT outsourcing has been a major business trend in recent years. The growth of outsourcing of this nature has been catalyzed by two major factors—infrastructure and workforce—thanks to which foreign countries (namely India, the Philippines, Poland, China and Romania) have created large and thriving IT outsourcing businesses.
The first trend, infrastructure, comes from the large amounts of reliable and affordable overseas communication infrastructure installed following the telecommunication and Internet expansion of the late 1990s. Combined with the digitization/virtualization of many services and the standardization of platforms and protocols, it became possible to shift the actual production location of IT services to low cost countries invisibly to end-users.
To take advantage of this infrastructure and launch offshore IT outsourcing businesses, the overseas countries needed large quantities of “cheap” programmers. Improved living standards and the ramp up of computer education in response to Y2K demand provided the required personnel and a new industry was founded.
The marriage of these two factors allowed for offshore IT vendors to promise comparable levels of service and greatly reduced cost—a promise that has driven adoption. IT projects can be very complex and labor intensive, and wage rates can have a significant effect on their feasibility. If a solution can be delivered from an offshore location for a fraction of the price of local delivery, why not look offshore? This “IT labor cost arbitrage” is even more important during economic downturns.
As recently as Q4, 2009, Gartner reports that the current economic crisis has pushed IT services buyers to accelerate their focus on both cost reductions and productivity increases in their sourcing decisions1. In this environment, many companies see offshore IT service solutions from low labor cost locations as a very attractive, cost-reducing option.
Conversely, some firms that were early adopters of IT offshore outsourcing solutions are shutting down their investments and returning development to North America. They have found that many of the promised benefits of IT outsourcing have not materialized. In fact, in some cases they have found that offshore IT projects were delivered at higher prices or not at all.
What drives these beliefs and shifts the pendulum either towards or against offshore IT outsourcing? What makes offshore outsourcing work for some companies but disastrous for others? What do organizations and businesses need in order to evaluate offshore outsourcing as an option?
The answers—while fundamentally intriguing—are unfortunately not simple. The intent of this paper is to examine the myths and realities of the offshore outsourcing model and provide some suggestions when outsourcing does or does not make sense.
Figure 1: The rapid historical growth of offshore outsourcing, multiple sectors
The current state of offshore outsourcing
The nature of the work serviced by offshore outsourcing has changed dramatically since its beginnings in the ‘80s, but the drive behind it has not: developing nations have ample supplies of inexpensive labor, ample natural resources, and legal and economic climates that welcome foreign investment. Unskilled labor is still a prime candidate for offshoring, but increasingly skills like programming, design, and knowledge-work are divorced from location and can be performed anywhere—allowing for a richly competitive, global offshore outsourcing market.
For consumers, it’s getting difficult to find a product or service that isn’t manufactured or supported overseas—from gaming consoles to clothing. But consumer-facing products and services aren’t the only place where businesses are looking to offshoring for savings. Cheap connectivity to overseas infrastructure is allowing European and North American companies alike to move significant portions of their IT infrastructure overseas—frequently to India, where firms are taking over IT infrastructure management with big, long-term bets by the likes of Nielsen media2, Citibank3, and General Electric4 —with little sign of slowing down5. But, just because everybody’s doing something, it doesn’t necessarily make it a good idea: while traditional IT service delivery models often have their share of headaches, sometimes the devil that you know is better than the devil you don’t.
Offshore outsourcing projects contend with a number of risks: implementation, if not handled carefully, can kill a project before it ever has a chance to come into its own and deliver results; differences in culture can lead to problems overseas while social risks amplify them at home; regulatory risks can add layers of red tape and penalize the enterprise for its efforts; and other financial risks can further undermine what at first seemed like an appealing strategic move. Any organization considering an offshore outsourcing solution will need to examine these risks and decide if an offshore outsourcing project is worth undertaking.
Figure 2: Growth of worldwide IT outsourcing spend
Risk—a challenge to the promise of IT offshoring
The offshore IT outsourcing business might have grown rapidly since its inception, but the field has not been without its failures. As the number of cases where expectations are not met has skyrocketed, it is worth taking some time to reevaluate the entire concept. As the universe of outsourced projects has become larger, the number of undelivered and over-budget projects has grown significantly. In fact, about 21% of IT executives surveyed by DiamondCluster International, a management consulting firm, said they had prematurely terminated offshore arrangements in the prior 12 months. The most common reasons given were that the provider had financial difficulties or the provider failed to deliver on commitments6.
This increased number of failures can be split into a number of categories, examined in this paper through a ‘risk’ lens. Risk categories include scope communication risk, logistical risk, hybrid governance risk, cultural and social risk, resourcing risk, compliance risk, regulatory risk, financial viability risk, privacy risk, reputation risk, intellectual property risk, legal risk and exchange rate risk.
Any one of the above risks has the potential to negatively impact the implied cost advantage of offshore IT outsourcing. When several of the risks manifest in concert, the aggregate burden can overwhelm and erase any potential labor cost advantages—and create a scenario where the offshore project is more expensive, takes longer to deliver, and does not meet specified requirements. In a nutshell, the projects fail.
The transfer of IT development projects offshore can (and probably should) entail significant startup costs. Contractual and communications requirements will be significantly higher than they would be for onshore projects. These requirements cannot be avoided, as both parties want to minimize regulatory and ongoing communication risks as the working relationship develops. Contractual costs include internal efforts as well as external professional services in both client and provider countries, while communication costs include due diligence trips and ongoing high SLA (service level agreement) bandwidth costs.
When IT projects are awarded to an offshore outsourcer there are often negative impacts to internal employment levels in the enterprise. After all, creating jobs overseas means cutting jobs locally. Remaining employees will likely find themselves ill at ease and may act emotionally in response to the offshoring decision. The success of an offshore project depends heavily on communication with IT project managers or owners in the enterprise. If those stakeholders feel alienated or unappreciated at the outset of the project, the outcome of the entire offshore project could be jeopardized.
Time zone disconnects
Communication is both a challenge for and cornerstone of IT offshore development. Time zone differences complicate an already difficult situation, and can cause communications breakdowns. The typical solution, adjusted work hours to provide some overlap between onshore and offshore locations, doesn’t address the inevitable concern that a question or issue will arise after one side or the other has gone home. The occasional day wasted waiting for a reply is an inconvenience, but repeated issues and delays results in project creep.
Project oversight and scope communication
Definition of scope, while seeming like a straightforward first step in a sourcing project, is often where the project goes imperceptibly off its wheels. Clients need to clearly and thoroughly set expectations about what services they will receive, at what level that service will be delivered and an agreed upon delivery timeframe. In an attempt to smooth this process, diligent managers go to extremes writing exact specifications for projects. These specifications are often onerous, especially when distance, culture and time zone come in to play. The project becomes burdensome and fails.
Additionally, scope can change. We clearly don’t live in a static world, sometimes scopes expand or contract due to changes in requirements and business needs. In this case, adjusting scope can be a good thing—assuming that the client firm can clearly communicate changing requirements and the IT outsourcer can deliver against the revised plan. Unfortunately, it is often true that offshore IT outsourcers are challenged to deliver against the new scope. Additionally, providers use changes in scope as opportunities to bill for ‘change requests,’ inflating the cost to the client.
Evolving development methodologies
The IT world is changing; traditional waterfall software development methodologies are being supplemented or replaced with new methodologies more aligned with the rapid changes in the workplace and global economy. These agile alternatives are built on iterative development, where requirements and solutions evolve through frequent, high-quality collaborations between self-organizing cross-functional teams.
While agile alternatives have proven to be very powerful options for modern IT projects, their core requirements expose the weaknesses of the offshore model. When your development method requires frequent, high-quality communication between team members who need to interoperate quickly and responsively, offshore resources will usually prove to be a bug, not a feature.
The traditional offshore model called for the offshore service provider to take responsibility for the entire enterprise functionality being replaced. The emerging framework, hybrid governance, is a strategically revised approach that emphasizes the client retaining overall organizational ownership of a project or a service.
Hybrid governance empowers organizations to outsource only certain components within a project or within phases of a project, thereby reducing risks and allowing organizations to continue their focus on ‘what they do best.’ The complexity required to orchestrate such a solution often requires retaining the services of a third-party consultant, who specializes in cross-cultural management7. While consultants do bring expertise and experience to the process, they can’t fully understand the processes that are ingrained in both firms, can’t communicate all needs, and can’t ensure that processes from both the client and the outsourcing provider are plugging in properly on both sides.
With multiple firms trying to work together to establish new processes between enterprises, where does ownership of the integration project ultimately rest? Who is accountable? With many risk areas where the transition can go awry, sharing responsibility often means diffusing accountability. Figure one examines the many areas where risk can poison the entire endeavor.
Figure 3. The Hybrid Governance Gap Table
Cultural and social risks
Language challenges can be a significant risk driver for IT offshore development projects and need to be kept top of mind on an ongoing basis. There is a lot said during even the informal chats between a project manager and the offshore team that can be misunderstood due to marginal or inconsistent language skills, unfamiliar accents or questionable interpretations and assumptions. Some of these challenges can be mitigated by backing up verbal communication with written documentation and emails but this of course takes time and is an indirect cost driver.
In the Western culture, employees and managers tend to see one another as equals: even in the face of differing levels of experience and compensation, there’s a general understanding that everyone has equal ability to generate ideas and should have their voice heard. The same is not true in all cultures: in countries like India, the Philippines, Russia and China, there are social stigmas against subordinates questioning or contradicting superiors. These different views towards social order and reporting relationships are dictated by a cultural phenomenon called “power distance.”8
Generally speaking, Western culture is characterized by low power distance. In United States, Canada, Australia, and many parts of Europe, it’s a simple matter of course for subordinates to engage freely with—and often challenge—their superiors. In countries characterized by a high power distance —like India, the Philippines, Russia and China—there is a pervading belief that superiors and authority are to be obeyed, not questioned. When organizations expand from a low power distance culture to a high power distance culture, many second-nature assumptions about how the business hierarchy functions need to be reconsidered.9
Figure 4: Power distance index visualized 10
Consider an organization that is expanding into high power distance geography. Not only will this business have to contend with obvious differences in culture, regulation, bureaucracy and situation, but they may also find themselves with employees with valuable insights about ideal modes of operation—employees that are simultaneously culturally restrained from sharing their insight. In his 2008 book Outliers, Malcolm Gladwell explores how power distance can cause negative consequences as catastrophic as plane crashes. For many organizations, the losses incurred from power distance related misunderstandings may never compare to the 158 passenger deaths from Gladwell’s example, but consequences can be disastrous and damaging.11
Executives charged with expanding into new territories with different cultures will need to keep these factors in mind and ensure that they surround themselves with trusted advisors who understand the cultural and political lay of the local land. Failure to do so could easily result in missed opportunities and a poverty of crucial information.
When outsourcing offshore, a company’s reputation faces risks both at home and overseas. At home, there is increased backlash against offshoring labor: citizens are opposed to the offshoring of jobs that would eliminate the jobs of locals—a concern that has only increased with the global economic downturn, and may increasingly be addressed by offshore-outsourcing taxes—and customers frequently find that the quality of service that they receive from outsourced service providers is lower than it was when the service was provided locally. While foreign English-speaking populations allowed many contact centers to be moved overseas, consumers are often frustrated, finding that they don’t have the same rapport with foreign customer service representatives that they had with their Western counterparts. Both of these concerns are easy fodder for competitors’ advertising campaigns, damaging the firm’s reputation and marketability of their products—thereby also creating a financial risk as there may be a decrease in revenue and/or an increase in the marketing expenses to counteract the attack.
Overseas, labor can usually be sourced so inexpensively because there is less oversight on minimum wage and working conditions. Offshore providers can make assurances that labor practices are above board, but they aren’t always true. If it comes to light that a company was profiting off of exploitative working conditions, even unknowingly, the damage to its reputation can take years to fix. While exploitation like the sweat shop frustrations of the early 90s are less likely with skilled labor involved with IT software development, the recent examples of employee suicides at Foxconn, a company extensively contracted to for the construction of high-tech devices, illustrates that any disorder in the supply chain can negatively impact the brand.
Multinational regulatory challenges
In times of economic downturn, companies rush into situations like offshore outsourcing, believing that it will speed up the delivery of solutions and/or reduce expenses. Sometimes, the rush to sign the contract may cause the client not to conduct the proper and complete due diligence or acknowledge the increase or magnitude of the risks that are being incurred. A badly written contract will often result in a lack of legal alternatives if the project does not produce the desired results (SLAs, penalties, accountability, etc). Depending on the laws that govern the contract, it may also result in a financial risk if the client must incur legal costs in the offshore country. The applicable country also may not have similar laws to those in the client’s country.
Certain types of software development and hosting are covered by regulations (the Sarbanes Oxley regulations, for example) which U.S. publicly-traded companies must comply with or face repercussions. These regulations are commonplace today in the U.S. and Canada but might not be fully understood or obeyed in offshore locations. Remote locations might have unexpected laws or regulations that complicate doing business there—and the enterprise needs to ensure compliance with two sets of laws. Audits of foreign facilities or processes may also be an additional cost to the client depending on contract wording. Further, some services or roles can be legally prohibited from being moved overseas. The offshoring client must ensure that they have done the due diligence to ensure that in their zeal to cut costs, they have not broken the law—this is a particular concern with data privacy, discussed below. At the very least, properly executed diligence slows progress and extends timelines.
Within the U.S. and Canada, there are privacy regulations in place that must be followed by companies on penalty of financial (settlements, lawsuits, fines) and/or legal risks. Offshore companies may not understand the complexity of these privacy laws and the risks involved. This concern is liable only to grow in-kind with the types and quantity of consumer data that are collected and warehoused. Consider the data from a social networking site: relationships, interests, and private communiqués are the types of information that consumers don’t want outside the hands of trusted entities. Financial institutions looking to warehouse consumer purchase histories and financial predictions have an extremely deep vested interest in keeping their data secure, and in compliance with local and international privacy guidelines. Unless otherwise stipulated by the SLA, the cost of the additional effort to ensure vendor compliance and security is usually incurred by the client, as the client will bear the burden for violations. In addition, there are some state or provincial privacy laws that prohibit the international transmission of certain information.
Intellectual property risk can be divided into two types: ownership of IP, and accidental/willful disclosure of trade secrets. Over the course of the outsourcing relationship, businesses and software processes will be amended and improved, and new intellectual property will likely be created. Ownership rights should be agreed upon before they become an issue; does the client have exclusive claim, or can the vendor take what they’ve created and use it for competitive advantage with other customers? Enforcement of intellectual property rights between nations is tricky at best.
The accidental/willful disclosure of trade secrets is also a large IP concern. As with privacy, there need to be transparent safeguards in place that provide the customer with the peace of mind that in addition to any customer data, proprietary software or other privileged information will be safe and secure while in use by the vendor.
Failures or breakdowns in either of these buckets require careful navigation of a foreign legal system in the search of remuneration/damages, a process usually burdened by immense costs.
National and transnational regulatory differences
Satyam Computer Services, founded in the late ‘80s, has grown to be one of the largest Indian IT outsourcing firms. Along with Tata, Infosys and Wipro, Satyam and its peers were enjoying the rapid growth of India’s IT outsourcing business. In January of 2009, Satyam Chairman Ramalinga Raju resigned after notifying board members and the Securities and Exchange Board of India that Satyam’s accounts had been falsified. Raju confessed that Satyam’s balance sheet contained inflated figures for cash and cash balances and understated liabilities.
Subsequently, Goldman Sachs Group Inc., Citigroup Inc., HSBC Holdings Plc, and Credit Suisse Group AG suspended coverage of Satyam, whose stock price slumped a record 78% in Mumbai, India after being exposed for the unethical financial practices. The National Stock Exchange removed Satyam from its main index after the benchmark slumped 6.2%. In subsequent analysis of the Satyam debacle, business analysts along with legal and accounting professionals surmised that regulatory standards in India were one enabler of the failure.
Globalization continues to be a powerful force for economic development and innovative firms from developing countries are disrupting traditional service delivery models and bringing value to many enterprises. It is clear however that the regulatory protections available in Western countries are not yet global and regulatory risk needs to be taken into account as offshore IT outsourcing decisions are undertaken.
Many offshore IT projects extend over several years. During the course of their lifetimes it is likely that regulatory environments in either home or delivery country will change. Something as simple as a change of government in a Western country can bring a radical change in how offshore outsourcing is perceived politically and with that change in perception can come new laws that change the ‘rules of the game’ for outsourcing. Firms need to be prepared to respond to these changing rules and need to plan for how they might adjust requirements and associated costs over the term of the contracts.
Financial stability/viability risk
The falsification Satyam’s books was damaging not only to the Indian stock market, but also the American markets. While offshoring projects of any number of midsized enterprises aren’t likely to cause an international financial incident, the recent global economic downturn showed that all national economies are linked together. When tough times come, they do not affect all economies equally; take for example the recent economic performance of Canada contrasted with that of Greece. It’s the nature of our economic system to have periods of contraction after periods of growth; countries that are prime candidates for offshoring frequently have economies with less inertia, and can be more seriously impacted by recessions and downturns. While any offshoring relationship clearly entails money flowing into the local economy, there are many other factors at play that could threaten the viability of offshore service providers.
Credit risk is associated with a firm’s failure to meet the terms of any contract with a financial institution or to otherwise perform as agreed. When an offshore IT outsourcer utilizes a foreign financial institution then credit information may not be as available or trustworthy as Western alternatives. The incremental risk associated with this reduced transparency should factor into decision making.
The war for talent and wage inflation
One of the social justifications for offshore outsourcing is that it injects money into the economies of developing nations, and in so doing raises income levels and improves quality of life. The disproportion between economies means that even by paying local workers a fraction of what their Western counterparts would make, they were still doing better than their local average. Wage inflation would gradually continue to improve the quality of life in developing nations, with outsourced labor being redistributed to other economies once the first batch has matured.
Unfortunately, there was a flaw in this plan. India was an ideal candidate for the offshoring of IT because of the high percentage of educated, English-speaking potential employees. Unfortunately, there are only so many countries with populations fluent in English, and demand for IT services in some categories is constrained on a global basis. A world-wide ‘war for talent’ has erupted which values skilled technology resources and is increasingly driving more standardized wages on a global basis.12 In effect, some Western enterprises have found themselves locked-in to their current offshore suppliers with minimal choice. As wages continue to increase, the largest perceived benefit of offshore outsourcing continues to erode.
A corollary of wage inflation risk, if overseas markets are supporting higher wages, it typically means that their overall economies are strengthening, which in turn means a less favorable exchange rate to investing enterprises. As the local economy strengthens, each invested dollar buys less than the last. Unlike wage inflation, exchange rate risk can be less predictable and therefore more damaging or volatile.
In China, the ruling party has been keeping the Renminbi artificially devalued to encourage foreign investment, if or when doing so no longer fits with China’s agenda, there could be a rapid increase in valuation, resulting in severely decreased international purchasing power.
Offshore outsourcing has been presented as an attractive strategic alternative for some businesses. IT specifically has been seen ideal candidate for outsourcing, and in fact there are scenarios where technical support, upgrades, patches and ongoing maintenance can be pushed entirely out of sight and out of mind, replaced instead by a solution that works when and where it needs to. What’s more, because cost effective connectivity that gives immediate access to inexpensive labor, this service might be offered at considerable savings. In terms of immediate savings represented on paper, some offshoring projects may well hit their mark.
It is clear however that when projects become more complex with tighter timelines and more fluid scope, then the risk categories outlined in this paper enter the equation and ‘paper labor cost savings’ can be quickly frittered away.
At the outset, the communication of scope needs to be done carefully but not onerously, or the service created may under-deliver or see crucial facets lost in translation, and ownership and governance of responsibility and intellectual property need to be assigned—with due respect for the regulatory climate both domestically and abroad. Once the solution is implemented, ongoing compliance with regulations must be assured, and stakeholders from both organizations need to overcome cultural differences and logistical difficulties to develop an effective, efficient working relationship. The service vendor needs to fully understand and respect the position of the client as a global citizen, and behave accordingly—consumers won’t always differentiate between the behavior of a supplier and the behavior of the company. Reputations are difficult to build and easy to lose, and should not be gambled on short term savings. Finally, while the financial angle is appealing, the prospects of wage inflation and exchange rate volatility undermine its security as a long term appeal. The accumulation and confluence of these factors should give any manager considering offshore outsourcing cause to pause and critically evaluate goals and approach.
As a reality, the numbers encourage skepticism towards the long-term value of offshoring projects: according to a Cisco study, enterprises typically realize the hidden costs of offshore outsourcing two years into a contract with their provider.13 The study also found that the areas that primarily suffer are those of innovation, risk-based process management at an enterprise level, and a lack of shared standards at the vendor level. Already, some companies are “reverse offshoring” and bringing jobs and services back home, where costs might appear to be higher, but they have fewer systemic and potentially brand-damaging issues to contend with. Ultimately, each company will need to do a piece of personal calculus to decide what amount of potential short term savings is worth navigating a potentially tricky landscape for questionable long-term outcomes.
Figure 5: Most Frequent Cause of Relationship Failures in Outsourcing 14
The nearshore alternative
Attractive alternatives to offshore IT outsourcing have emerged with the nearshore or onshore models that are now being more broadly utilized.
Near-shoring is the sourcing of IT services to a foreign, somewhat lower-wage country that is relatively close to the home country. Near-shoring is attractive because it brings some of the wage advantages of offshore outsourcing without many of the risks described elsewhere in this paper. For instance, Canada is often identified as a good example of an ideal nearshore location for U.S. based customers. Canada’s proximity to the United States, large community of IT expert professionals, and legal and regulatory similarity uniquely positions Canada as a preferred provider of nearshore sourcing services. Close proximity to service providers enables, a company to develop intimate working relationships, which translates into better communication and control of day-to-day project management, quality of service, and quality control.
Dan McLean, a research director at IDC Canada has said “Canada is a highly attractive outsourcing source region for many U.S.-based companies. Among the key advantages Canada provides are strong language, regulatory and cultural similarities to the U.S., plus comparable technological adoption and skill. These factors position Canada as a potential powerhouse for outsourcing to foreign markets, particularly those with which Canada shares cultural similarities.”15
Resource availability and low IT labor costs in offshore locations are on the surface powerful incentives to move IT projects to offshore locations. It has become clear however that labor costs are only one of the components of successful IT project delivery and can be overwhelmed by unanticipated implementation, cultural and social, legal and financial risks. Any one of these risks can reduce the cost advantage of offshore IT outsources but an aggregation of multiple risks can skyrocket costs and cause the outright failure of offshore projects.
Firms that are considering moving IT projects offshore should take these risks into account and only offshore IT projects when they are sure that the promised benefits will be achieved. In many cases, traditional onshore or nearshore IT delivery alternatives will be the superior choice.
11 Gladwell, Malcolm, Outliers : the story of success, Penguin Book, Camberwell, Vic. 2009.
13 Strategic Out Tasking – a new model for outsourcing; Cisco 2006.
15 IDC whitepaper, “Global Sourcing Trends Necessitate Considerations of Nearshore Sourcing in Canada”