META Report: Offshore Outsourcing Fueled By IT Budget Pressures

By CIO Update Staff

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By Meta Group Staff

Situation Analysis: During the economic downturn of the past 12 months, efforts by Global 2000 organizations to reduce IT costs have added a counter-recessionary impetus to the long-term trend toward increased use of offshore outsourcing service providers - especially vendors based in India (which currently control 85%+ of the market). Offshore outsourcing services range from business processes (e.g., customer service call centers) to software application maintenance and support, new application development, contract R&D, and systems integration (though only application services and call centers are well established).


The business case for offshore outsourcing is based on the lower cost of skilled IT labor (30%-50% of that in the US) in India and other nations where outsourcing firms are proliferating (e.g., China, Mexico, Hungary, Poland, Russia, the Philippines). Leading Indian outsourcers (e.g., Tata, Infosys, Wipro) have earned a reputation as high-quality service providers, enabling their customers (predominantly US and European firms) to receive equivalent results, at a lower cost, versus in-house or domestic outsourced services.

Meanwhile, to co-opt the economic advantages of offshore outsourcers, traditional systems integrators (e.g., CSC, Perot Systems) have developed subcontracting relationships with offshore vendors. Similarly, major outsourcing vendors like EDS and Accenture have developed their own offshore capabilities; rather than trying to sell clients on a pure offshore outsourcing model, however, they state that they will selectively use an offshore division as a less-expensive delivery engine for fulfilling outsourcing engagements. None of these "domestic" vendors has yet established a practice of selling commodity, cost-cutting offshore capabilities; instead, they use offshore resources to reduce the average "blended rate" for application services.

Some offshore outsourcers are attempting to sustain their sales growth by developing consulting arms that can reassure prospects about the feasibility and ROI of sending business processes and IT projects halfway around the world. However, lack of the "hand-holding" typically provided by traditional outsourcing firms (e.g., Accenture, PwC) is not the key factor keeping many enterprises from exploiting offshore service providers. Our research indicates that Global 2000 IT organizations must achieve a sufficient level of internal process maturity and develop specific sourcing competencies to accurately evaluate and successfully exploit offshore outsourcing alternatives.

Careful assessment is essential to understand which tasks and services are suitable for offshore outsourcing. For example, few organizations outsource their internal help desk functions - to either domestic or overseas outsourcers. In fact, several META Group clients who tried outsourcing their help desks have brought those functions back in-house. The reasons cited are quality and, more importantly, process integration. Providing adequate help for employees with specific questions or problems about internal applications requires in-depth knowledge of the organization's implementation of the application and the overall business and IT environment. Process efficiencies and cost containment of problem management analysis is difficult when the help desk function is outsourced, and this is compounded when the outsourcer is offshore. Outsourcing call centers of other types have been much more popular - especially customer service call centers and HR call centers that answer questions from employees concerning benefits. Companies originally outsourced these functions to domestic outsourcers (for instance, both EDS and IBM Global Services have successful call center divisions). More recently, companies have been turning to Indian and other overseas service providers, which often provide equivalent service levels at lower cost.

Offshore outsourcing has also become increasingly popular for application maintenance processes, as well as for basic custom application development and application integration. It is most appropriate for maintaining mature, stable applications requiring low levels of change/update and for large development projects with specific design specifications (Y2K was perfect) that facilitate mass production in code factories. However, for projects relating to specific vertical-industry applications (e.g., financial services, insurance), offshore providers must be carefully evaluated for their subject-matter expertise. Although mature, stable applications provide an ideal fit for offshore outsourcing, other functionality such as speed of deployment (offshore provides true 24-hour days for development) can be appealing to specific IT projects.

Once an organization identifies a set of processes that it might outsource to an offshore vendor, it must assess its internal readiness. Offshore outsourcing means more than simply continuing current operations with less expensive labor. To gain cost savings from outsourcing significant processes to offshore code factories, companies must have a sufficiently mature internal process orientation and management capability. In fact, user organizations typically must make changes in their own operations to effectively exploit offshore outsourcers (and these changes will consume time and resources). Therefore, although offshore outsourcers are cheaper than traditional outsourcers (e.g., Accenture), the costs of using these services are higher than a straight labor-rate comparison might indicate. In fact, our research indicates that most offshore outsourcing efforts save only 15%-20% when all costs are considered. Best-practice firms achieve 25%-30% savings, which is still lower than the 30%-50% labor-only savings previously cited.

META Group research indicates that organizations operating at a low level of process maturity (i.e., Capability Maturity Model [CMM] Level 1) would require 18-24 months to achieve a sufficient process maturity level for successful exploitation of offshore outsourcing. On the other hand, for organizations that already have fairly mature standard processes for developing, deploying, and managing their applications (i.e., CMM Level 2 or Level 3), the risk of outsourcing is much lower, and the time required to obtain a return on investment is greatly reduced.

Outsourcing of operations activities (e.g., database administration, systems management/monitoring, call centers, help desks) also requires a sophisticated level of process maturity that most companies have not yet achieved. Before moving forward, user organizations considering outsourcing these types of activities must evaluate their level of process maturity as well as the consequent impact of proposed outsourcing arrangements on their current processes.

To obtain hoped-for economic benefits from offshore outsourcing, user organizations must allocate at least 5%-7% of the outsourcing budget to internal management of the outsourcing relationship. In addition, because the value of an offshore outsourcing engagement depends on the lower cost of labor, the terms and conditions of the contract should protect the customer from abrupt shifts in that relative cost during the term of the contract (sufficient to yield a good ROI). For example, we are now seeing rapid salary inflation in major Indian IT centers (which may lead to a shift in the types of projects performed by Indian outsourcers, with more mundane tasks shifting to China or other nations).

User Action: Global 2000 organizations should rigorously evaluate offshore outsourcing possibilities for IT and related services and projects for possible inclusion in their overall portfolio of sourcing options. The potential rewards of an outsourcing engagement should be weighed against the possibility that those rewards will not be realized, and in light of the costs that will be incurred as well as the risks contingent on variable political and economic conditions that may affect offshore outsourcing providers.

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Organizations must thoroughly evaluate the capabilities of any firm proposing an offshore delivery model. Capabilities vary widely among different offshore vendors (as do the offshore practices of US-based outsourcing firms). Also, it should not be assumed that offshore providers will always propose lower pricing than traditional outsourcing firms. Competitive bidding should include a mix of offshore providers, domestic providers with offshore delivery capabilities, and providers proposing domestic delivery.

META Group analysts Dean Davison, Michele Hudnall, David Scott Lewis, David Cearley, Steve Witkowski, John Brand, Stratos Sarissamlis, Chuck Johnston, Ashim Pal, Jeffrey Mann, and Chris Byrnes contributed to this article.