Market ripples

Motorola is to form two two separate joint ventures with Indian IT outsourcing groups, Tech Mahindra and Wipro respectively, to create mobile phone software and telecoms networks for other companies.

The move emphasizes both the transition in the role of the Indian firms from low cost service providers to partners in sophisticated ventures that requires complex industry expertise as well as the burgeoning growth in India's domestic IT market (Motorola's venture with Tech Mahindra, which will be called Canvas M, will serve Indian telecoms companies that want to outsource development of mobile phone software ).

In support of the Dell model

Another earnings disappointment from Dell. Clearly, as technology advances and falling component prices render lean supply chains and falling PC prices a pervasive reality in the PC world, the strategy of cutting prices and daring other market players to follow does not seem to be working too well for Dell. Competitors like HP have been able to cut their costs in the last year, thereby diminishing the traditional cost and price advantage that Dell used to enjoy.

Industry analysts also point to Dell's falling customer service that is affecting sales, and the higher costs that the company faces as it expands customer service centers in the United States and Canada. The direct sales model, they warn, precludes the outsourcing of customer service and support costs to retailers and other front-end supply chain partners, resulting in a cost disadvantage with regard to customer support.

However, as the support function turns from being a necessary overhead to being a strategic lever that contributes to competitive advantage, I think organizational ownership of the customer support function presents potentially significant opportunities. Several companies are realizing the significant business potential of the function and increasingly subjecting it to management discipline and process improvement initiatives. The service organization not only delivers customer value but also feeds into other business functions such as product design and marketing to provide valuable insights and increase overall earnings. For example, analyses by Bain Consulting suggest that:

• Some companies have turned their support divisions into profitable businesses, increasing earnings by as much as 10 to 30 per cent
• An increase in customer renewal rates of between 1 to 2 per cent can engender a 10 to 12 per cent increase in revenue.
• In one instance at Cisco, customer feedback on a new voice over IP product was fast delivered to the product design team, who implemented five critical changes to the next generation product, resulting in a 17 per cent decrease in support calls and a sharp increase in sales.

So, it seems the problem at Dell is not the high costs of customer service; it is the inability to embrace the challenges of customer service and deliver business benefits that make such investments worthwhile. Perhaps, low-end support functions may be outsourced but largely, the flexible and adaptive nature of the function, as it turns into a strategic customer touchpoint, may be best served in-house. More important, as customer service agents become increasingly involved in mining data, proactively solving customer problems, and translating customer data into actionable information and innovation directions for other organizational departments and business groups, they must be acutely tuned to business needs and strategies. This too renders the in-house servicing of the function advantageous. Especially as new product lines are added and scale economies are asked of.

The road ahead? Dell needs to check communication lines between customer support and the executive order. If they don't exist, segments of support must be identified followed by analyses of drivers of profitability for each segment. The firm must then invest (yes!) in training, diagnostics and process improvements for the strategic support functions. And then somewhere before the end of the fourth quarter, it must check communication lines between customer support and the executive order again. It may well find its direct sales model somewhat of an advantage.

More on outsourcing and wage inflation

An article in today's Financial Times, "Are India and China up to the job?", emphasizes the point in my earlier post - although only 10% of the $300bn market for global offshoring is currently being tapped, labor shortages in India and China are kicking in. With the industry struggling with annual employee turnover rates approaching 40 per cent, wage inflation is rising. Wage increases in India were the highest among Asia-Pacific countries. In the IT sector, pay inflation this year is expected to reach nearly 20 per cent.

The result is more expensive managers, a phenomenon that has put paid to the localisation strategies of many multinationals. Localisation was meant to save money by replacing expatriates on large packages with cheaper locals, but good
Chinese managers now command a similar premium. "There are some very alented Chinese leaders coming through," says Mr Mullinjer. "I have done a number of management searches where these guys are getting paid no differently to western expats. In some cases they're making more. It is a huge jump over what we saw five to six years ago."

With India and China both still enjoying spectacular growth, their shallow talent pools have yet to cut into headline GDP numbers. But such shortages are chipping away at their emerging economic strengths. The talent crunch will threaten India's knowledge-based and services-driven growth story. In China's case, it undermines Beijing's aim to re-tool its economic model to build the domestic service sector and wean itself off reliance on manufacturing exports. For both, capturing the demographic dividend may prove far harder than they expected.

India has over a billion people and will soon have the world's largest number of young people. However, many of the country's population is still engaged in low-income activities. It is imperative that the country work toward providing education to its young people and invest in their capabilities. It must also extend its position as a skilled service provider to develop a more broad-based employment model that effectively leverages the education and skills of the majority of its population.

Of Wage Inflation and Outsourced Jobs

Information Week attempts to explain why India's wage inflation won't bring outsourced tech jobs back to the U.S. in this article. Example, Cognizant Technologies. Like many Indian outsourcers, Cognizant is growing fast and hiring aggressively. Its revenues in the most recent quarter jumped 57%, and the firm increased its head count last year by 49% to house more than 28,000 employees. Narayanan, CEO of Cognizant, offers perspective:

Seventy-five percent of Cognizant's workers are based in India, but those workers account for only 20% of its labor costs. Conversely, Cognizant workers based in the West, mostly in the U.S., account for 80% of the company's wage expenses even though they're just one-quarter of its total staff.

Because wages paid to workers in India represent such a small percentage of total costs for companies that operate there, a 15% increase in salaries results in no more than a 2% rise in prices charged for IT services, says Narayanan.

And that's precisely the problem. Given that supply is limited, wage inflation represents a growing concern (no pun intended). Narayanan describes the scenario over the next year. So, an annual wage inflation of 15% translates into an average annual increase of 2% in prices. Ceteris paribus, of course. Given that the supply of skilled labor to sustain the torrid growth of the outsourcing firms remains limited, the estimate for wage inflation can only rise over time, engendering further price inflation.

For example, this article in yesterday's Financial Times (subscription required) discusses how Chinese exporters, in the face of rising input costs, including growth in manufacturing wages, and raw material and intermediate costs, are increasingly confronted with the choice to either accept lower margins or raise prices. Export data points to evidence of both. Goldman Sachs expects Chinese annual consumer price inflation, currently 1.4 per cent, to reach 3 per cent by the end of 2006. If this increase were replicated in import prices from China, Goldman estimates the impact on US inflation could be 25 basis points.

Indian service providers are not immune to similar inflationary risks. Clothes and consumer durables account for only 15 per cent of US consumer price inflation; 60 per cent is from services. However, globalization is not widespread in services and this should help the Indian service providers offset inflationary impacts of higher priced services. The (new) services that they replace will still be cheaper than the American counterparts. Increased volume of business will help preserve margins and prices. Of course, both these solutions assume a constant supply of quality labor, which is clearly not the case. Perhaps, the Indian firms could leverage their expertise in service provision to transition into a skilled systems integrator that coordinates service providers in other emerging low cost countries. Coordinating work across firm and national boundaries is a distinct competitive advantage that the Indian firms have come to acquire over the past decade.

Finally, the Indian service providers will have to invest in innovation and providing more value-add services. Innovation is the latest management mantra, especially in a growing number of large, established firms that have long focused on reducing costs and budgets. Executives are working on becoming more creative to capture customers in the global market. As mentioned in my previous post, firms will look to offshore providers who can transition from being a strategic service provider to being a business unit that develops and delivers products to the firm's customer in the region where it is located. This calls for increased flexibility, responsiveness and vision.

And if the providers fail to deliver, Narayanan may well need his U.S. workforce to cover. So, India's wage inflation may not bring outsourced tech jobs back to the U.S. but it might just engender a cross border war for managerial talent which brings forward U.S. workers to India and at the forefront of new international paystakes.

Tapping the Brakes

An article in today's Wall Street Journal reports on the results of a recent offshoring survey conducted by DiamondCluster International Inc. DiamondCluster interviewed 153 buyers of outsourcing services in the U.S. and U.K. and 188 providers in about 10 countries. The survey focused on information technology, because it is one of the most popular services that is outsourced. Key findings:

• 64% of the buyers of offshore outsourcing services and 50% of buyers of onshore services planned to increase their use of such services in the next 12 months, a much lower figure than in previous years. Last year, 74% of the survey respondents said they planned to increase their outsourcing overall.
• About 8% of the buyers of offshore services and 9% of the onshore buyers said in the latest survey they planned to decrease their use of outsourcing in 2006. In last year's survey, 5% of offshore-service users and 7% of onshore-service users said they were poised to terminate contracts.
• U.S.-based companies are increasingly looking into Canada for outsourcing needs. While the cost isn't low, buyers are comfortable with "near-shoring" because of the proximity and common language.

Last week, I had blogged about how boundaries between various forms of outsourcing - nearshoring, offshoring, onshoring, etc. - are blurring as is the erstwhile distinctive role that each had in the manager's toolkit. The survey findings are further evidence of blurring boundaries and point to some interesting directions in the field.

As the Journal points out, there will be fewer successful new entrants. Further, slower growth rates raise the likelihood of consolidation amongst the service providers. U.S. based service providers, who are looking to be part of the vision of a "globally integrated enterprise," will likely leverage such consolidation to integrate offshore resources and cut costs.

Further, if the decrease in outsourcing to third party service providers is accompanied by a concomitant increase in the establishment of captive offshore centers, the findings might well point to the role of outsourcing and offshoring as organization design strategies that play an important role in catering to international markets. For example, in this article in the McGill International Review, the authors point out that very few of the Fortune 500 firms have the ability to sell products and services around the world. They urge companies to think global but act and strategize regional, implying that a focus on regional strategies should become central to strategic planning. Captive offshore centers might well have a better understanding of the focal firm's operational and strategic contexts and customers. Therefore, as companies turn to fast growing international markets as an important source of revenue, their offshore centers can transition from being a strategic service provider to being a business unit that develops and delivers products to the firm's customer in the region where it is located. A.k.a Dell?

So, this is not tapping the brakes in the race to outsource. This is a whole new race.

Debunking Myths

I like this article by Pankaj Mishra in today's New York Times on "The Myth of the New India".

A Theory of Evolution

Andrew Hill pens an interesting piece in the Financial Express on how outsourcing and offshoring continue to evolve as an increasingly important part of good business practice:

About 10 years ago, I visited a nut factory in Italy and learnt something astonishing about pistachio production. Closed nuts, the bane of the pistachio-eater, were being shipped to China where they were cracked open by hand, exported back to Italy, packaged and sold on.

Here, I thought, was the irreducible kernel of outsourcing: a basic task that would always be done in the country that could supply the cheapest labor force. Nut-cracking would move around the world, shifting from country to country as workers' standards of living, expectations and skills improved. How long would it be before China grew out of pistachio-opening and developed higher-value manufacturing and services companies, while other countries took on this menial job? Could even the US or Britain, if they lagged too far behind in a global skills arms race, eventually turn into nations of nutcrackers?

Well, of course not. Because, as Hill points out, outsourcing decisions are no longer dominated by cost considerations alone. Firms are increasingly leveraging outsourcing to realize complex value equations and a wide range of strategic business objectives. An allied shift is occurring in supplier offerings as well. As cost objectives are realized in the first or second year of a seven year outsourcing contract, suppliers are increasingly feeling the need to innovate and reconfigure traditional service offerings. This, in turn, has resulted in a blurring of boundaries between different service provider groups and the outsourcing forms that they represent. While low-cost offshore service providers such as Infosys and TCS grapple with business needs to retrain staff and offer value added services at low costs of process ownership, the Accentures and McKinseys are looking to make the shift to a "globally integrated enterprise" and reduce costs of operation.

This suggests that it's not the business case for outsourcing that is eroding. Apple's decision to shut down its offshore operations and Powergen's decision to move its customer service operations back are reflective not of the firms' failure to realize cost savings but of their decision to structure operations based on a combination of efficiency and available skills. They're also reflective of the blurring of boundaries between various forms of outsourcing - near-shoring, offshoring, onshoring, etc. and the erstwhile distinctive role that each had in the manager's toolkit. Hill concludes:

The nut factory I visited - New Factor, near Rimini - looked at the time like many family-owned Italian import-export businesses, run from the centre by savvy entrepreneurs who tended a network of distant suppliers and customers. It now has an "offshore" operation - in Ukraine - where walnuts are cracked by hand. Nut-cracking, in this case, is not the lowest rung of the outsourcing ladder but an important way of improving a product harvested nearby: workers extract the flesh by hand, because unbroken kernels are more use to cakemakers and confectioners than walnuts broken open by machine.

As for China's pistachio-openers, they disappeared a few years ago. According to Alessandro Annibali, New Factor's boss, Californian farmers have developed "a fantastic automated system to open the nuts". Was that an advance or a reversal for outsourcing? Neither - just a good, old-fashioned example of business innovation.