November 24, 2009

The Days of Easy Labor Arbitrage are Over. Look for Value in Outsourcing

A short history of outsourcing

In the 1990’s organizations spent a lot of energy looking for ways to reduce their costs so they could put more focus on their core business. Service firms sprang up to meet this demand to cut costs – human resources, accounting, security, internal mail distribution, catering and of course, information technology services.

As companies searched for the lowest cost providers of these services and as telecommunication costs plummeted, it wasn’t long before U.S. companies were contracting for support services in other countries – India, China, Eastern Europe, and the Philippines. Initially the prices were so low, especially in India and China, that labor arbitrage was the primary motivator. Sometimes even at the expense of quality. Or with lots of management frustration stateside as they tried to make these relationships work.

Most people would agree that the days of outsourcing internationally only to achieve lower labor costs are over. As more companies entered the business in each country and began to compete with each other for labor, costs began to rise. Now companies can achieve some cost benefit from outsourcing, but it is more modest than it was five or six years ago.

From low-cost-provider to strategic partner

In the meantime, outsourcing companies have improved the quality of their work and their ability to serve clients, so they can continue to make a convincing case for their services – slightly lower costs, higher service quality.

In a 2008 CIO article, Arpit Kaushik pointed out another feature of offshore outsourcing. The focus of the article is a caution to customers of offshore IT outsourcing to beware of exaggerated cost reduction claims by outsourcers. He advises the reader to make appropriate comparisons, to look for hidden costs, and to make the distinction between theoretical and real impact.

Towards the end of the article, Kaushik makes a comment that reveals the direction of offshore outsourcing. He cites a recent paper from a “leading offshore outsourcer” which revealed this tidbit: The “bulk of the benefit actually comes from revenue improvement rather than tangible cost savings.” This comment reveals that the current stage of offshore outsourcing is defined more by the desire to seek strategic partnerships than cost savings alone. Cost savings will only get you so far; at some point companies have to improve long-term profitability by finding opportunities for growth and by increasing their revenue.

Certainly we’ve seen that’s the case in our business, software development outsourcing. When we first started, customers were mainly focused on labor rates.

Today they mostly ask us what we can do to improve the software they are developing and shorten their time to market. Customers want much more than skilled engineers at a lower rate. They want to know how we manage large, distributed projects, how we manage project risk, how easy it will be to do business with us.

This is a challenging but exciting direction for software development companies. Challenging because it’s more difficult to be a strategic partner than a commodity service provider. Exciting because the projects are more interesting for our engineers and foster closer relationships with our customers.