Nonlinear Thinking

The Only Constant is Change: Addendum

When it rains, it pours, or so it seems.  On the heels of a recent Forrester report on the future of IT services which I wrote about here, management consultant A.T. Kearney weighs in with their own, very similar view on that future.  This recent op-ed in Businessweek by Arjun Sethi and Olivier Aries sees most of the same external drivers highlighted in the Forrester report  but offers a different and altogether more interesting futurescape for IT services.

“ In the next five years outsourcing as we know it will disappear.  The legion of Indian service providers will be sidelined or absorbed. U.S. and European companies that pioneered this corner of the high tech industry will suffer similar fates if they don't wake up.  Who will emerge as the new leaders?  Google and Amazon.com , brands that we associate with search and retail, will become better known for outsourcing."

Longtime readers of this blog will know that I have been harping on the threat that Amazon and Google, in particular, present to the old guard of IT service providers as I have written about it here, here and here. SaaS/cloud technologies, under any name, have been a game changing disruptive force for the past 10 years. When IBM acquired Corio five years ago, that should have, de facto, been some kind of canary in the coal mine.

In their commentary Sethi and Aries also conjure up a vision of what the new outsourcing model will look like.

“In the new model, outsourcers provide standard, off-the-shelf software on a "pay-per-drink" basis. For that, they will leverage so-called cloud technology, which lets users tap into computing power available via the Internet, rather than on a desktop or computer server housed locally. The appeal is scale, flexibility, and efficiency: Thousands of server computers can attack a task more quickly—and cheaply—or handle a patchwork quilt of different technologies that companies use to run their businesses. This approach will let businesses outsource entire tasks such as the tracking of inventory, paying only for the information accessed or used.”

The commentary also mentions who might be the losers in this new model (mid-tier Indian outsourcers), possible winners (SAP, Oracle, Microsoft, Salesforce), and a several major players that are not moving fast enough (Accenture, Xerox, Dell, HP).  

I am guessing that this commentary and the Forrester report will be far from the last discussions regarding the changing IT services landscape.  I would also imagine that we will see more and more discussion of the death of the internal IT department beyond the many books and reports already written.  Fasten your seatbelts.

Outsourcing India

I have been talking about the end of the India offshoring tsunami for several years.  With wage inflation annually running between 15% and 20%, the delta between the U.S./Western Europe was bound to shrink to the point that the raison d'etre for offshoring to India no longer applied.

Now, it has come to this: India is outsourcing outsourcing.

To Mexico, because Indian workers are just too expensive these days.

Tata Consultancy Services (TCS) opened a software development center in Guadalajara, providing about 5,000 jobs to Mexicans over the next 5 years.

New Delhi-based IT firm Genpact (G), self-described as “a world-class” alternative to India for IT outsourcing, opened a 125,000-square-foot facility in Ciudad Juárez, employing 2,500 people.

Bangalore’s Infosys (INFY) set up shop in Monterrey last year - 150 miles south of the United States border.

This is the new paradigm: A company in the United States pays an Indian vendor 7,000 miles away to supply it with Mexican engineers who work within driving distance of America.

It’s what happens when a country’s companies are trying to cope with wage inflation hovering around 15% annually.

Global Economic Slowdown - Broken Glass

As someone whose genealogical roots extend back to Ireland, this is, indeed, saddening.

Iconic Irish company Waterford Crystal (WATFF) will lay off most of its workforce and shift production elsewhere, having already contracted most of its production to Slovenia.

At its height in 2002, Waterford employed 3,200 people, but that number will soon drop to approximately 125.

The company’s plant will remain in Dublin, though it will become primarily a tourist attraction, rather than a manufacturing plant. Waterford, which manufactures the ball dropped each New Year’s Eve in Times Square, draws about 300,000 tourists each year.

The decline of the dollar is partially to blame, as about half of the company’s revenue comes from American consumers. Also to blame are the living wages paid Western European workers; Eastern European laborers can produce high-quality goods for far less pay.

Global Economic Slowdown - Pink Slips in Bangalore

It looks like the global economic turmoil and the dramatic Wall Street meltdown is beginning to hit Bangalore.

The collapse of top US financial firms will cause a dramatic slowdown in hiring among outsourcing companies. The banking, financial services and insurance sectors account for 40 per cent of revenues for India's $52 billion outsourcing industry (as of 2007-2008).

Firms such as now-bankrupt Lehman Brothers and bought-out Merrill Lynch were big customers and provided millions of dollars worth of lucrative contracts to Indian technology services companies.

For tech employees, jobs no longer come with a lifetime guarantee. Companies are shedding people in small numbers and keeping their actions under the radar. The dreaded pink slips have arrived in Bangalore.

The biggest indicator of the slowdown is the salaries and raises. It used to be acceptable to have lateral hires ask and get 30 per cent increases on their previous salaries. Annual hikes have varied between 15 to 40 per cent in the good years. All that is now a thing of the past. Wage increases are now down to more realistic, single-digit numbers.

It may not all be bad news, though.

Some outsourcing companies see a bright lining to the cloud--lower attrition rates. In the last few years, Bangalore firms have averaged attrition rates between 20 to 40 per cent, the highest in any Indian city. 

Some analysts seem to think that, as the fall of financial firms leads to business slowdowns for the Accentures and IBMs in the US and Europe, they may move more work to lower-cost offshore locations such as Bangalore.

Three Horseman of the (Outsourcing) Apocalypse

Having charted the rise, and warned of the potential, of the India-based pure play service providers, over the past eight years, this warning from Gartner doesn’t really surprise me.  I do believe Accenture is a cut above the other members of their peer group and will thrive along side the “India-3” going forward.

According to analysts at Gartner, the US outsourcing giants will be knocked off their throne by the emerging Indian powerhouses by 2011.

Infosys, Tata Consultancy Services (TCS) or Wipro will augment, or in some cases surpass, "mega-vendors" Accenture, EDS and IBM by revenue in the strategic services market, it says.

Gartner says the India-3 have used their success at meeting client needs to achieve record revenue growth - of about 40 per cent - over 30 quarters and have enjoyed growth rates almost three times that of the incumbent mega-vendors.

Partha Iyengar, regional research director at Gartner, said in a statement: "The emerging mega-vendors have made dramatic progress in the past few years and have more than doubled their revenue in a four-year period, with the 2007 revenue being 2.6 times the 2004 revenue."

Gartner says the India-3 have achieved this by demonstrating process excellence, world-class HR practices, providing high quality services at a low cost and by winning significant "mind share" compared to their size.

But Gartner warns the India-3 will have to continue to evolve to reach true mega-vendor status, in particular they will have to achieve similar levels of revenue per employee to the US big three.

A Kinder, Gentler Rupee

The Financial Times reports on the U.S. dollar/India rupee dynamic:

India’s information technology outsourcing sector, which has been struggling this year with the growing slowdown in the US, has received help from an unexpected quarter – the country’s currency, the rupee.

Satyam Computer Services, India’s fourth-largest software outsourcing company, said on Tuesday a sharp depreciation in the rupee against the US dollar this year was expected to provide a direct boost to margins if it proved sustainable.

“The rupee has been very kind to us . . . it has depreciated almost 8 per cent in one month,” said Vadlamani Srinivas, chief financial officer at Satyam.

The rupee, which in 2007 appreciated about 12 per cent against the dollar, was the bane of India’s outsourcing companies last year – one of the country’s most crucial industries, generating more than $40bn a year in export revenue.

The industry incurs most of its expenses in rupees but makes the bulk of its revenues in dollars and other hard currencies, meaning that every rise in the value of the rupee squeezes its margins in India.

If the decline of the U.S. dollar has negatively impacted the India-based outsourcing industry, has it been beneficial to providers with a largely U.S.- centric workforce?

Offshoring Digital Advertising

Does this surprise anyone?  From the Wall Street Journal:

Outsourcing has hit Madison Avenue.

Until recently, Web ads were produced mostly by creative types in downtown lofts in places like New York City or San Francisco. But big marketers are now increasingly shipping off that work to little-known businesses in places like Costa Rica and Bulgaria.

The outsourced jobs at this point still only account for a fraction of the total digital-production work by U.S. companies, but U.S. ad executives say it is an increasingly vibrant and important service. It comes as marketers are devoting bigger portions of their budgets to digital-ad campaigns, which in turn are becoming increasingly sophisticated. Instead of creating a single Web site with a handful of display ads, marketers are designing intricate promotions that include a series of Web sites, emails, search ads, display ads, videos and games. And each of these different formats can have thousands of variations of colors, text and graphics, so that the ads are tailored to a consumer's likely interests.

The Coming Death of Indian Outsourcing

Came across an interesting commentary in Forbes on the above-referenced topic which touches on an earlier post of mine. Sramana Mitra leads with the incredible story of growth for the IT and business process outsourcing industry in India (7% of India’s GDP in 2008) and then digs at the foundation of that success

However, the reality is that wages are rising in India. The cost advantage for offshoring to India used to be at least 1:6. Today, it is at best 1:3. Attrition is scary.

One of the key assumptions regarding the sustainability of the India explosion has been their ability to ultimately move up the services value chain. From Mitras’s perspective, that just hasn’t happened in any meaningful way.

Yet, India, for all its glory, is still the world’s back office. India's tech industry is a "services" industry. The Indians don’t do the thinking. The customers do. India executes.

And as I have discussed before, Mitra suggestst that there may be a time in the near future when North America becomes an attractive offshoring destination.

As the 1:3 cost structure becomes 1:1.5, it will soon become inefficient to use Indian labor. Why not Oklahoma or British Columbia? For many Europeans, Eastern Europe has already become more compelling than India. The pure labor arbitrage equation will no longer balance.

While still other dynamics come into play.

The software as a service (SaaS) megatrend in technology also plays against India.

But initially, and perhaps ultimately, this is an issue of basic economics.

Forbes recently published some scary statistics on wage inflation in India. Salaries rose 15.1% in 2007, up from 14.4% the previous year. The 2008 forecast: 15.2%. This would be the fifth consecutive year of salary growth above 10%.

Add to that the appreciation of the rupee against the weakening dollar, and its impact on the labor arbitrage market.

Assuming a 15% year-to-year salary hike rate, and a 2007 cost advantage of 1:3 in favor of India, if U.S. wages remain constant, India’s cost advantage disappears by 2015. Then what?

Then, global service providers and India pure plays move operations to other ports where the economics are still meaningful (Bulgaria, Guatemala, Vietnam, Mississippi?)

North America As the Low Cost Offshoring Option?

Though it likely will not happen tomorrow, after years of wage inflation in India and other traditional offshore locations and the coincidental decline of the dollar against other currencies, at what point does the realized cost delta not cover the risk premium in offshoring?

At the same time, how much risk premium deflation will become manifest as the global delivery model is perceived to have been “tried and tested”?

As this Marketwatch story attests, the environment in India is getting more and more challenging.

Here's a unique twist: the high cost of doing business in India is pushing some smaller technology companies to relocate elsewhere in Asia.

Soaring wages and rentals there are having a significant impact on mid-sized companies, many of which blossomed for several years amid a vast pool of well-educated workers and comparatively lower operating costs.

Having more than tripled in size in just four years, the $52 billion software industry -- arguably India's best known overseas -- is now confronted with multiple challenges.

The economic slowdown in the U.S., the single largest market for outsourced orders, has cast a shadow over near-term business prospects.

It's being exacerbated by local issues such as an appreciating currency, rising fixed and operating costs, a growing shortage of skilled manpower and the prospect of a sharp tax increase.

While outsourcing has become truly a many-shores operating model, India obviously remains the epicenter of offshoring. If this trend continues, and the U.S. dollar continues to weaken, will U.S. companies begin to demand that outsourced services be provided indigenously? And might European companies begin looking at the U.S. as a low-priced offshoring destination?

Without question the services provided from India have benefited tremendously from process improvements and the value proposition is no longer solely about cost, but the combination of geo-political and macroeconomic dynamics has the potential to wreak havoc on the best laid plans of many providers and customers of offshoring.