The ongoing recession is likely to profoundly influence global offshoring activity, according to a survey conducted by the Centre for International Business Education and Research’s (CIBER) Offshoring Research Network (ORN) at the Fuqua School of Business at Duke University and PricewaterhouseCoopers (PwC). Although the recession will slow overall economic growth it will also compel companies to outsource in order to reduce costs and stay afloat, observed the leader of the study team.
Arie Y. Lewin, Professor of Strategy and Business and Executive Director, CIBER, who headed the study team which surveyed over 1,600 companies in the U.S. and Europe, told The Hindu that “Half of the new offshoring activity in 2008 is in the area of product development.” “Offshoring”, he said, “is not about shifting to ever lower wage countries — from India to Vietnam or Sri Lanka.”
Although the survey showed wage cost arbitrage still remains the prime motive for companies to outsource, Prof. Lewin said “outsourcing is also increasingly about high value addition and about business strategy.”
Asked whether the political climate is likely to influence outsourcing, Prof. Lewin said “the risk of a political backlash is likely to increase dramatically after Barack Obama takes over.” The survey was followed by a “flash survey” of 100 companies conducted in early November, in order to make a re-assessment of the demand for outsourcing from companies in the U.S. after the outlook for the global economy worsened significantly.
“China,” Prof. Lewin said, “is emerging as a major competitor to India in the outsourcing of software development.” He warned Indian service providers against “underestimating the tenacity and ability of Chinese outsourcers.”
The perceived advantage of having a large English-speaking workforce in India might not be as great as suggested in some quarters. He said the recessionary conditions might set the stage for “the consolidation of the service provider space.”
Prof. Lewin says China has an edge over India in the product development outsourcing business. “This is happening because companies realise they can do product modifications by co-locating engineering capabilities right next to the factories in China.”
Pressure on margins
Outsourcing companies from China has a 45 per cent market share in the product development outsourcing market, compared to 22 per cent market share of Indian companies. Since the nature of demand is likely to rebalance in favour of Asian and other markets, which are relatively immune to the economic crisis, this might require greater modification of products, which China-based outsourcers might be better-positioned to deliver. This, he said, was particularly relevant in the white goods sector.
Prof. Lewin said clients in the U.S. are likely to demand cost reduction, which will impose a pressure on the margins of Indian service providers. Nearly one-tenth of potential offshoring companies surveyed in November wanted service providers to finance the projects. Prof. Lewin said Indian service providers are likely to face increasing pressure to dip into their cash reserves to extend financial support to companies outsourcing to them.
Hari Rajagopalachari, Executive Director, PwC, said the recessionary conditions would result in clients demanding “price re-negotiation, contract rationalisation and more stringent enforcement of contracts while focussing closely on governance of contracts.” Pricing models would rely on a closer association with productivity increases, he said.
What do Indian service providers need to do in the changed situation? Mr. Rajagopalachari said the Indian service providers had hitherto relied on “reducing the average experience profile of their employees in order to reduce costs.” Although this reduces the price, this also has an impact on quality of service. “As long as the client is following an input-price model, this can work reasonably well. But when clients move over to output-based pricing, linking price to the quality of work done by the service provider, it will start impacting margins.”
Mr. Rajagopalachari said offshoring was now “a strategic priority” for companies, led by the top leadership of major companies across the world. Global companies are likely to seek outsourcing from larger-sized companies rather than smaller players, he added. This is also driving the process of consolidation in the global service provider space.