As corporate interest in the cost savings and benefits grows, CIOs prepare to manage the risks and pitfalls of offshore outsourcing.
Several years ago, a CIO from a large financial-services institution began outsourcing a hefty portion of his legacy-programming resources to an overseas provider. And with expected savings of 40% to 50%, who could blame him? But strangely, this early adopter's savings never fully materialized. After replacing his onshore programmers with an offshore staff, he had to hire managers to maintain the engagement, adding costs. Then the CIO realized he'd need a larger percentage of onshore programmers than originally projected, further reducing his expected savings. In fact, after he accounted for the turnover from the offshore teams, his anticipated windfall of 40% to 50% had shrunk to less than 20% in all.
This CIO is in good company. Corporate interest in offshore outsourcing is huge, as the size of the market attests. But the reality doesn't always live up to the hype. Many companies that have embraced the practice haven't realized the promised savings; they're now wondering if and when they'll see the real value from their offshore investments.
For some companies, offshore outsourcing's initial appeal lies purely in the numbers. Success is measured by the ability to reduce costs as much as possible. It's not hard to see that by paying $20-plus per hour in India versus $80-plus in the United States a company's savings can be at least $60 per hour for every position outsourced. That math can be misleading, however. Instead of the 80% cost savings that those hourly rates suggest, companies are reporting far lower numbers. According to a recent AMR Research report, companies using offshore resources for development projects can see no savings at all or up to 50% savings. The majority report savings in the neighborhood of 25% to 30%.
What happened to the rest of the anticipated savings? As many CIOs are beginning to realize, outsourcing decisions based solely on hourly rates don't necessarily result in real cost savings. Hidden costs arise when a company doesn't first build a strong engagement-management experience, outsourcing industry expertise, technical knowledge, and a method for overcoming cultural and communication barriers.
By all accounts, outsourcing is a long-term investment, and it requires a serious commitment in order to reap the maximum benefits.
A December 2003 report from Forrester Research said most companies go through a four-stage migration period that can last from 24 to 60 months. Those expecting a quick, six-month project with few to no challenges would do well to rethink their strategy.
In their search for savings, many companies mistakenly assume that a single offshore provider can be successfully deployed on any and all IT projects. Instead, CIOs need to first analyze their IT-application portfolio based on business criticality, user interaction, complexity, and maturity. Only then will they have the knowledge to outsource their projects to a provider with the right skills and expertise to deliver successful results.
There are several types of offshore-outsourcing companies (see Indian Market Booms, But Changes Loom). The most prominent are the traditional offshore providers, such as Indian companies Infosys Technologies, Tata, and Wipro Technologies. Many offshore pure-play companies have narrow portfolios of services.
Then there are the large global integrators, such as IBM and Accenture, which recently developed offshore capabilities. These companies don't yet have large presences offshore, but they've developed experience managing engagements between U.S. companies and the offshore businesses and are quickly hiring staff offshore. Other consultancies have gone for a more hybrid approach, creating large divisions offshore.
Matching the right segments of work to the appropriate provider is the best approach to realizing the maximum savings from offshore outsourcing. We recommend that companies choose at least one provider from each category.
Managing IT projects successfully has always been a struggle for IT organizations, as the alarming rate of IT-project failure attests. A 2003 Standish Group survey found that 66% of outsourced projects are either canceled or materially off-target due to poor program execution, leading to additional costs in areas such as lost-opportunity costs, unrealized benefits, increased labor costs, and increased vendor costs. Unfortunately, outsourcing your IT initiatives doesn't make these problems go away. Using offshore programmers--who may lack business acumen and methodologies to extract accurate and detailed requirements--possibly can result in significant costs downstream. The repercussions can range from adding more--and expensive--local management to overcome the offshore team's lack of business experience, to late delivery, lost functionality, and fewer benefits realized from the investment.
Offshore outsourcing sometimes creates additional requirements and program-management challenges. Effective management is critical to improving the odds of success and overcoming the risks associated with IT-project failure. These risks--lack of clear business objectives, executive support, user involvement, and scope management--become exacerbated when the users and programmers are up to 8,000 miles and multiple time zones apart. Poor program management costs 25% to 35% in the concept-to-design phases, and 15% during the implementation phase. These costs reflect the additional management resources required to fix the problems.
There has always been an inherent conflict between the IT-services provider and the company contracting for services. This conflict stems from how the client pays for services--whether the contract is time and materials (T&M) or fixed price.
The issue is risk as one side tries to push most of the risk to the other. The vast majority of the revenue for major Indian offshore providers and integrators is derived from T&M contracts. These companies prefer a T&M contract because the risk shifts to the client, on which any project-overrun costs fall.
On the other hand, a fixed-price delivery model puts the onus on the service provider to get the right requirements, manage scope, and estimate and manage the project. This helps to insulate the client against the risks that can erode savings.
The fixed-price model also makes the service provider a better partner, as it's in the provider's best interest to get the project done--and done right. The provider's methodology and experience are critical.
Sophisticated clients look for providers that not only offer fixed-price contracts, but also attach results to fees. Measurable business results are replacing metrics such as service levels as a way to ensure that companies achieve real business value.
Defining measurable business results isn't easy. However, the benefits of defining them up front are high. Consider this example: If a company ties some portion of the contract to a 20% reduction in the cost of servicing customers using online channels, the provider will be motivated to achieve that result, as long as both risks and rewards are tied to the objective. The client wins because the provider is aligned with its business goals and hires the best people who can bring the greatest level of industry knowledge and business processes, as well as creativity and innovation--something clients have complained that many offshore businesses lack.
Don't bank on immediate payoff, however, and do bank on some heavy lifting when switching to offshore. CIOs must factor in significant ramp-up time for offshore projects, during which costs can actually increase. According to Meta Group, lags in productivity can add as much as 20% in costs to the offshore contract.
Part of that lag lies in the need for staffing overlap as the home team hands off to the offshore programmers. But there's more: All offshore providers have two rate schedules: offshore, which is the rate charged for work done overseas, and onshore, meaning the rates charged for the consultants that must come on-site during the transition period. The onshore rates are significantly higher and usually rival internal IT costs.
We've found that clients invariably underestimate the number of onshore staff required to make a project successful. This leads to inflated expectations of savings at the onset of a project. More than half of the revenue generated by the large Indian offshore companies is derived from onshore-staff augmentation.
Managing The Contract
To ensure the outsourcing engagement's success, companies must build an oversight organization to manage the process, a reality that's bound to add money to the mix. The oversight organization can account for as much as 5% to 16% of the overall engagement costs. Why so much? Typically, the oversight staff earns higher salaries. Managers often serve as business liaisons to the offshore provider and as quality-assurance officers to the overall engagement. In addition, somebody has to be in charge of sourcing and contracting personnel and managing the project from the client side. This facet of outsourcing is lucrative enough to generate a new business niche.
While moving specific functions and departments offshore can help save money on labor, the cost of reducing onshore staff must also be considered. It costs money to move displaced personnel to other departments. However, the most significant costs spring from layoffs. Companies must factor in the cost of severance and job-search support for its displaced workers.
Furthermore, your intellectual property goes out the door, too, when you replace in-house staff with an offshore provider. With offshore outsourcing, some of your go-to people may now be gone and any survivors will probably need time to adjust to the changed landscape.
What's more, outsourcing an application can have enormous impact on a multitude of supporting systems, hindering a company's ability to adhere to certain standards of customer service and regulatory compliance. Other hidden costs are generated as a result of compensating people with higher salaries--key IT-management staff, for example--as they oversee the transition.
Offshore outsourcing is the wave of the future for IT. Done right, it can result in tremendous savings and add significant business value. However, a bit of due diligence up front and a better understanding of how to avoid common obstacles can make a huge difference. Understanding the true total cost of ownership, segmenting your IT-application portfolio, and sourcing appropriately against those needs will let CIOs achieve real savings and help further business goals. And that, after all, is the true bottom line.
Sheeroy Desai is executive VP and chief operating officer at Sapient, a business-consulting and technology-services company based in Cambridge, Mass.