The profits and perils of international outsourcing

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D

omestically, outsourcing is used by many corpo- rations to convert the fixed cost of payroll to a variable cost through temporary and contract staffing. Moving offshore for manufac- turing advantage has also increasingly been a mantra for cost savings over the last few years.

However, the current trend is to export international outsourcing work as the source of cost savings in more service-related industries. Major employers such as Bank of America, Dell Com- puter, and Merrill Lynch, as well as many smaller companies, are riding this new globalization wave that is transforming everything from call centers and medical transcription to processing credit card transactions, digitiz- ing mass collections of documents, and developing software.

In fact, Forrester Research, Inc. of Cambridge, Massachu- setts, estimates that 3.3 million white-collar jobs (including 473,000 computer-related jobs) and $136 billion in wages will shift from the United States to low-cost countries by 2015

(Nowlin, 2003; Engardio et al., 2003). Geographically, these outsourcing providers are locat- ed primarily in India, but solici- tations from Thailand, the Philip- pines, Jamaica, Bulgaria, Russia, China, and other countries are on the rise.

WHAT IS INTERNATIONAL OUTSOURCING?

According to Bierce (2003), international outsourcing can take a number of different forms. These include:

• The “out-tasking” model—

direct or subcontracted exportation of particular tasks or functions to a foreign enterprise for perfor- mance “offshore” and use in the customer’s home coun-

try after completion offshore.

• A subset of the

“out-tasking” model—

incorporates only par- tial exportation of a task and accelerates the business design by using two interdepen- dent teams in different time zones for a 24/7 business process.

• The “foreign local sub- sidiary” model—relies upon a foreign external enterprise to support a foreign subsidiary of the U.S. customer.

This is typically part of a

“global outsourcing” (across territorial boundaries), but could equally be done country-by-country and managed by in-house headquarters staff, in the home country or regional centers.

• The “shared services”

model—establishes a jointly- owned subsidiary for the provision of shared services to affiliates.

• The “global multilateral out- sourcing” model—relies upon a multinational enterprise to support a multinational customer’s operations in multiple countries and More and more companies are outsourcing work

abroad. This trend is transforming everything from call centers to credit cards. But there are both benefits and dangers for your company. The author investigates how companies are using this strategy today and gives some solid advice to help you choose the right outsourcing model for your particular company. © 2003 Wiley Periodicals, Inc.

LuAnn Bean

T he Profits and Perils of International Outsourcing

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includes cases involving

“private label” services by the outsourcer to create foreign business infrastructures rapidly. Private label outsourcing is expanding rapidly, particularly with regional telephone call centers for

“customer care,” and poses significant challenges to the more outmoded foreign local subsidiary model.

Petersen and Prinsley (2002) caution that choosing the right model is very important from a contractual standpoint. Selection of the model that is right for your company should consider both internal processes such as enterprise

resources planning, as well as core competencies in the entire supply chain.

Key issues for successful and advantageous contract compliance in these global models must consider many things: foreign legal systems and jurisdiction; how dispute resolution might proceed in courts and/or through arbitration; risks of data protection and privacy regulation abroad; multinational labor, employment, and real estate lease law; access and security; global treatment of intellectual property rights;

taxes; and termination. Experts also advise that the best way to set up a coordinated approach arrangement is to develop legal teams in each country to make sure all local issues are considered in core contracts.

ADVANTAGES TO CONSIDER What advantages can be gained from international outsourcing? Although the benefits vary with the type of company and work being farmed out, the general benefits include: (1)

price/cost reductions, specifically in support services and research and development (R&D), (2) program flexibility, (3) enhanced attention to critical customer service, (4) interna- tionally savvy talent and bigger foreign markets through economic investment, and (5) lower turnover rates.

Price/Cost Reductions and Cutting Research and Development Costs

There is some confusion between industry vendors and analysts as to how savings are passed onto the consumer. Ven-

dors, reluctant to admit how international outsourcing has impacted pricing models, generally argue that the savings are passed on in service cost benefits—particularly in bundled services of supporting and main- taining products. Analysts, on the other hand, point to price reduction phenomena, such as IBM Web servers, that have shown price drops of more than 40 percent over the last few quarters (Mishra, 2003).

Another big advantage of international outsourcing occurs in direct costs, by reducing total cost of ownership (TCO) for the end-user. The word on overall cost cutting, according to Read (2002), is that, on average, cost savings across all types of services are about 5 percent to 8 percent when done in Canada, 10 percent in Mexico for Span- ish-speaking Americans, and 20

percent to 40 percent when outsourcing to India, the Philip- pines, and South Africa. In fact, the number two executive in Microsoft’s Windows unit, Brian Valentine, has urged others to take advantage of the “two- workers-for-the-price-of-one sale” in India, where quality work costs only 50 percent to 60 percent of U.S. rates (Engardio et al., 2003).

As more product-driven companies face pressures on R&D budgets, they are increasingly looking to international outsourcing as a way to make big cuts in costs. For example, companies like i2 outsource 60

percent of their global R&D to India and propose to increase that to over 80 percent in the coming years. Likewise, Baan outsources almost 40 percent of its global R&D to development centers in Hyder- abad and Mumbai, while SAP has a Bangalore facility that is projected to account for 15 percent of the company’s total development expenses during the next two years (Mishra, 2003).

Program Flexibility

International outsourcers indi- cate that this strategy allows them to expand or shrink programs in less time. In addition, because direct costs are low, they are able to govern critical investments in fluctuating customer care operations without the adverse publicity of layoffs and downsizing. Read (2003) points to the advantage posed by globally outsourced call centers. In cases where CFOs won’t approve new or expanded in-house call centers, many companies find that their corporate investment payback threshold is generally cut in half through outsourcing options. Flexibility

Another big advantage of internation-

al outsourcing occurs in direct costs,

by reducing total cost of ownership

(TCO) for the end-user.

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through global outsourcing of non-core services becomes part of a beneficial cycle of cost savings and value-added service benefits, allowing many firms to streamline operations and improve quality through more efficient and effective technological procedures.

Enhanced Service Benefits According to Mishra (2003), as the software products industry has matured, it has been faced with a changing revenue shift in the service-to-license spending ratio, which is currently about 3 to 1. In other words, for every dollar spent on licenses, $3 are spent on external services, with still more spent on internal services.

According to the Gartner Group (2003), this

increased service-to-license ratio is occurring because of lack of new license sales and a large number of customers who are satisfied with their current systems. Gartner recom- mends that companies treat this market with innovation as a new playing field of greatly modified buying patterns and strong value propositions for customers, rather than work with the same old tired strategic plan. In light of this change, many vendors have benefited by using international outsourcing arrangements that allow them to produce more feature-rich products in terms of service, take advantage of lower labor rates and pools of IT expertise around the world, and expand geographic markets.

Finding International Talent and Growing the Global Market

The prime targets for companies in what Read (2003)

terms a buyer’s market are countries loaded with college gradu- ates who speak Western lan- guages. One example is the Philippines, where nearly 380,000 students graduate each year and a record number of the oversupply are accountants trained in U.S. accounting standards. Trade specialists, such as Robert Lipsey, see international outsourcing as a way to shift America’s comparative advantage through economic development in nations such as India, which will give U.S. companies the opportunity to have bigger foreign markets for their goods and services This impact is enor-

mous, as predicted by a joint study by McKinsey & Co. and Nasscom, an Indian software association, who estimate that IT work and other service exports will generate $57 billion in rev- enues, employ 4 million people, and account for 7 percent of gross domestic product in India by 2008 (Engardio et al., 2003).

Lower Turnover Rates In the United States, the annual turnover rate at outsourced call centers is about 50 percent to 100 percent as com- pared to just 5 percent to 10 percent in India and the Philippines (Read, 2002). The product of reduced turnover in international outsourcing can translate into reduced staffing and training expenses, limited productivity lags, and less hiring. As many have found, some of these cost

savings can then be capitalized on to incorporate other types of revenue-enhancing activities that have previously been unthink- able, like contacting more customers on outbound calling lists or incorporating more strategic data mining with the goal of increasing sales potential. How- ever, cost is not everything in global outsourcing. As Read (2003) notes, although Canada is not the lowest cost country for international outsourcing opportunities, many firms value their strengths, which lie in workers with a strong work ethic, low turnover, better education, and familiarity with Americans.

MORE INTERNATIONAL OUTSOURCING SERVICE EXAMPLES AND

GEOGRAPHIC/POLICY TRENDS

Dramatic forces are changing the way that all companies, both in the United States and globally, think about knowledge work. Outside of the United States, British banks like HSBC Securities, Inc. have huge back offices in China and India, while Philips, a Dutch consumer- electronics firm, has shifted R&D for most televisions, cell phones, and audio products to Shanghai. Likewise, French companies maintain call centers in Mauritius, and German multina- tionals such as Siemens and roller-bearings maker INA- Schaeffler outsource to Russia, the Baltics, and Eastern Europe (Engardio et al., 2003).

It seems that the list goes on and on, and the possibilities are only limited by the corporate imagination. The following sec- tion explores some of the cre- ative and more diverse services applications currently outsourced by U.S. companies.

Dramatic forces are changing the way

that all companies, both in the Unit-

ed States and globally, think about

knowledge work.

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India

A large percentage of international outsourcing is related to global access to high-speed data networks and the Internet and the ability to digitize. As such, much of the IT-related services can be parceled out to India. However, in the face of a protracted economic slump, outsourcing is not necessarily occurring because of shrinking demand in the Ameri- can economy. Rather, it is due to cost shifting and associated cost reduction. The following list identifies some of the more com- mon and uncommon activities that highlight service diversity currently performed in India (Engardio et al., 2003; Ribeiro, 2002; Scott, 2003):

• Massachusetts General Hospital outsources the reading of approximately 30 CT scans per day to a Bangalore office of Wipro, Ltd.

• Greenpoint Mortgage of Novato, California, outsources home loan processing to Infosys Technologies, Ltd. staffers in Bangalore.

• SurePrep, a California-based company, is offering U.S.

and multinational companies the ability to scan source documents and have their taxes prepared by Chartered Accountants in India.

• Bank of America in Char- lotte, North Carolina, will outsource 1,100 jobs this year (primarily IT-related) to Infosys Technologies, Ltd.

and other Indian companies, with dramatic 80 percent reductions in costs.

• Texas Instruments, Inc. is designing third-generation mobile-phone chips in their outsourced Bangalore facility.

• Hewlett-Packard Co. outsources work to approximately 3,300 Indian software engineers and has moved their key accounting functions to Bangalore-based Global e-Business Opera- tions.

• Brokerage houses like Lehman Brothers, Inc. and Bear, Stearns & Co. use financial analysts in India to do some of the more tedious number-crunching. Similar data mining positions on Wall Street command seven times the salary of the Indi- an analysts.

• Wipro Spectramind Ltd. in New Delhi has branched out to process insurance claims for a major U.S. insurance company, provide help-desk support for a major U.S.

Internet service provider, and employ seven Ph.D.’s in molecular biology to sift through scientific research data for Western pharmaceu- tical companies.

Jamaica

The Jamaican government established an initiative in 2000 to create a knowledge-based society driven by increased foreign investment in information technology services over a five- year period. As part of this effort, they have sweetened the pot for more call centers and back-office operations with low- cost telecommunications, Eng-

lish-speaking workers, training in customer service skills, and free trade zones with high-end office space at a 35 percent reduction from comparable U.S.

costs. Currently, U.S.-based Sitel maintains call centers in Jamaica and encourages others to consider these and other benefits.

Other U.S. companies taking advantage of the Jamaican initiative include: Apple Vacations, a Pennsylvania-headquartered company; Teleservices Direct, based in Indianapolis, Indiana;

OverDrive, the Ohio-based world leader in digital publish- ing; and Satellite Imaging Sys- tems from Dallas (Beatty, 2002).

Budapest, Manila, and Beyond

Some of the most interesting applications of international outsourcing can be found in Budapest and Manila. In Budapest, real estate developers, such as San Francisco-based David Marlatt, have found a glut of architects willing to design 3D computer models and blueprints for dream homes at about ¹⁄⁴the cost of domestic talent. Other firms have also found this sur- plus of architectural talent in countries like Poland and Chile.

Likewise, the firm known as SGV & Co. provides accountants that do the backoffice work for many of Ernst & Young International’s audits. The Manila connection has been such a good outlet for financial information processing that even Procter & Gamble Co.

(P&G) employs 650 employees there, with business and finance degrees, to assist in preparing P&G tax returns around the world (Engardio et al., 2003).

Another firm, IntegMT, in Manila, has opened up a niche

A large percentage of international

outsourcing is related to global access

to high-speed data networks and the

Internet and the ability to digitize.

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market for medical transcription.

With their service, Hilo Medical Center in Hawaii integrated the radiology department’s dictation system with medical records.

Quality medical transcription services were provided within a 24- hour turnaround time window.

Tremendous savings are expected to continue in the U.S. market for this health care service, which is specifically required for insurance reimbursements and liabili- ty issues and is estimated at $7 billion and $40 billion per year (Sarmiento, 2002).

The Philippines

Larger scale architectural designing is also being outsourced to the Philippines through companies like Fluor Corporation of Aliso Viejo, California.

This company employs approximately 200 young Filipino engineers at less

than $3,000 each per year to col- laborate on specs and blueprints of industrial facilities via the Web with U.S. and British engineers, who earn average salaries of $90,000 annually (Engardio et al., 2003).

Other firms like America Online, American Investment Group (financial services company), Citibank N.A., P&G, LexisNexis, and Barnes and Noble have transferred accounting, customer service, document digitization, search, engineering design, human resource services, medical transcription, and telemarketing to local Filipino operations. Even the Bush administration supports the outsourcing of non-core government services to the Philip- pines. Under this arrangement, it is estimated that the U.S. government will “back office” fed- eral data applications via the

Internet to the Philippines, creating approximately 335,000 Filipino jobs (Gonzales, 2003;

Overby, 2003).

China and Russia

Surprisingly, the Chinese government, after many years of creating trade barriers, is pro- moting policies to enhance its IT services sector by setting up software parks and offering tax breaks. As Overby (2003) notes, IBM and Nortel Networks have already entered the race in China to grab up the best and brightest.

However, with a good technological education system and a pop-

ulation of 1.3 billion, there are plenty of opportunities for other firms, and predictions are that China will surpass India’s lead in global outsourcing.

By 2007, Gartner (2003) estimates that Russia will have captured a 5 percent market share of offshore services revenue in North America and Western Europe. Currently, Moscow-based Luxoft has attracted outsourcing from Boe- ing, Citibank, and Dell. Russia’s glut of ex-rocket scientists and other laid-off technological talent is now being promoted by an agency known as the National Software Development Associa- tion (Overby, 2003).

RISKS ASSOCIATED WITH INTERNATIONAL OUTSOURCING

Risks can be significant in the global outsourcing market.

The following points illustrate some of these and present sug- gestions on minimizing them:

• In countries with inherent political risk, many outsourcers are opening centers in multiple countries to min- imize single-location risks.

That way, bureaus can accommodate their program in another country in the event of political turmoil, terrorism, or war. More bureaus are incorporating phone switches and application servers on U.S. soil to guard against data theft, particularly in call centers. In

fact, Read (2003) indicates that companies should carefully scrutinize Indian- owned and Indian-operated outsourcers, who typically underestimate the com- plexities of security con- cerns and vendor viability in operating a center. Cul- ture risks related to confi- dentiality of critical information and loss of control are especially important when accounting functions are to be outsourced (Man- abat, 2003).

• Companies must address the risks of losing control of core competencies and/or coordinating them. In a recent Gartner, Inc. survey of 900 big U.S. companies that outsource IT work inter- nationally or offshore, a majority complained of the difficulty communicating and outsourcers’ inability to meet deadlines (Engardio et al., 2003).

• Companies must consider the legal ramifications of global outsourcing arrangements.

For example, Cisco, which has set up its own development center in Bangalore,

Companies must address the risks of

losing control of core competencies

and/or coordinating them.

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mainly outsources product research and development to its Indian partners—Wipro and HCL Technologies. The company has already filed for about 50 patents from India (Anonymous, 2003).

What are the legal challenges presented by intellectual property right laws, as well as labor laws, and potential management change issues in this environment?

• Despite the fact that the genie is out of the bottle on international outsourcing, the unemployment backlashes are a risk associated with this global movement. Already faced with this, New Jersey legislators are pushing a bill that would block the state from outsourcing public jobs over- seas. Likewise, Boeing, which currently has a new 350-employee R&D center in Moscow, faces tricky negotiations with an anxious union trying to stop the loss of jobs through international outsourcing. In Boeing’s case, the current short-term savings per engineer at the new center are nearly 90 percent for each worker in terms of salary expenses (Engardio et al., 2003). What does the long-term cost/benefit analysis of this center show with all factors considered?

• When technology companies were flying high in 2000, the U.S. Congress expanded the H-1B “guest worker” visa program. This program allowed technology firms to bring in foreign workers if they couldn’t find enough qualified workers. The year- ly cap was bumped up to 195,000 H-1B visas in 2000.

This cap, due to expire on

September 30, 2003, is being supported for exten- sion by some technology industry lobbying groups (Nowlin, 2003). If extended, how will this impact a company’s risk analysis with respect to a new outsourcing venture? As Grieves (2002) notes, some companies have made the mistake of outsourcing to a low-cost country without giving considera- tion to the long-term labor market trends and programs, such as the H-1B, only to find that staff costs rise and supply problems occur in the outsourcing environment.

ADVICE BEFORE CONSIDERING INTERNATIONAL OUTSOURCING

Corporate executives should consider the following checklist when initiating or expanding any global outsourcing agreement.

Considerations adapted from Novak (2001), Guerra (2003), Manabat (2003), and Bierce (2003) include:

1. Review individual opportunities and needs. What types of projects should be sent offshore—mission-critical functions, such as trading applications, or just ancillary processes, like human- resources-related functions?

Are they new application development processes or the maintenance of existing systems? What is the level of dependency upon the out-

sourcer for delivering any important level of services?

Include in this evaluation:

(a) the time investment and resources in-house versus global outsource and (b) the status of technological innovation that can occur in- house versus an outsourcing arrangement.

2. Does the outsourcing company you have chosen have the experience to do what you need done and can you identify its core competencies, as well as your own?

3. Beyond identifying core competencies, run an in- depth background check on

the stability of the company you have chosen. Find out if they have they been around for a while, what international standards and credentials they possess, and their history, as well as any other clients that they have worked for in the past or are working with now.

Are these clients happy with their work? Do ongoing rela- tionships with current clients create risks for your company? Will they share your company’s vision of the outsourced process?

4. Plan a site visit and interview their staff. Do they have a high degree of proficiency in English or whatever language fulfills your company needs?

(For example, MsourcE is opening a 300-workstation call center in Tijuana, Mexi- co, to serve Spanish-speaking Americans (Read, 2003).

5. Nail down a contractual agreement of what you expect and what you are buying. This will require establishment of a solid statement of work with clear roles and responsibilities for your company as well as the

Despite the fact that the genie is

out of the bottle on international

outsourcing, the unemployment back-

lashes are a risk associated with this

global movement.

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responsibilities of the provider. Do you want a vendor/consultant relationship, like Infosys or Wipro offer, or are you going to establish a new center, similar to what Bearing Point (formerly KPMG Consulting) did in China? What permits and licenses are required to con- duct the potential operations? Are there any conditions of such permits and licenses that are prohibitive?

Are there any restrictions that might apply to transbor- der flows of data, personnel, goods, and other products of the foreign services?

6. Be sure to include a service level agreement (SLA), with any penalties associated with missed service levels. Can outsource providers demon- strate flexibility and adapta- tion to evolving and chal- lenging scenarios? Does foreign local law limit the enforceability of the customer’s rights under the outsourcing contract, particularly with respect to payment conditions, limitations of lia- bility, covenants to perform services, the right of termination, post-termination covenants, and contractually selected methods of dispute resolution?

7. Remember, nothing can be taken for granted, even with very reputable and established organizations. Include checks of things like power source backups and security, as well as other basic business infrastructure. Look into “friendly laws” in the geographic domain you pick.

Are there any sources of laws, such as multilateral organizations, free-trade unions, or bilateral treaties that might govern the con-

tracts including the Euro- pean Union or Mercosur?

What are the special legal risks arising from the application of U.S. and foreign laws and how do you plan to manage them?

8. Develop a joint participation management program that will incorporate building of the program and handling of emerging issues of new technology, potential disputes, and future planning processes. For global outsourcing to succeed, it must have the support of executives and man- agers within the company.

Grieves (2002) emphasizes that resistance to change can be a deal breaker and any per- ceived risk to domestic staff positions must be communi- cated as early as possible.

9. Despite cost savings in international or offshore arrangements, do not scrimp on support, because you get what you pay for. There is plenty of low-balling of companies with poor capabilities, according to Read (2003).

A MAINSTREAM PRACTICE International outsourcing is no longer considered a com- modity. It is now a mainstream business practice in manufactur- ing, technology, and service industries. Companies considering the move toward global outsourcing must examine the risks associated to avoid strategic fail- ures in their core business.

While international outsourcing can redirect some responsibility, firm focus is still key in facing its many challenges.

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LuAnn Bean,Ph.D., CPA, CIA, CFE, is professor of accounting at the school of management, Florida Insti- tute of Technology, Melbourne. She has published articles in many professional journals and is actively involved in several professional organizations, including the American Accounting Association and the American Society of Women Accountants.