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Explosive growth, the political debate in the United States, and a limited track record have combined to generate a hype around the topic of offshore outsourcing that is hard to penetrate. This article is the first of a three-part series that will aide executives tasked with investigating offshore options. This first article sheds light on the most talked-about aspect of offshoring: cost savings.

This article answers three pressing questions:

1. What is the range of savings reported?
2. Why do reported cost savings vary so widely? What are the key drivers?
3. How do I explore the potential cost savings inherent in offshore?

The Range of Savings Reported

Most of the Fortune 500 companies are now outsourcing at least one business process or Information Technology application development and maintenance (ADM). For example, Everest research indicates that, of the top quartile of banks, 94 percent have one or more offshore relationships.

Given such widespread use of global resources, one might expect that it would be easy for senior management to clearly define and quantify expected cost savings and benefits. In Everest's experience, the opposite is in fact true. For many reasons, there is little agreement or clarity in published sources as to the scope of savings and other benefits. For example, CIO Magazine (in its September 2003 article titled "The Hidden Costs of Offshore Outsourcing") cited Meta Group and others when estimating that hidden costs range from 15 percent in the best case to 57 percent in the worst case. It was unclear which costs were onetime costs versus an ongoing offset to the expected savings. On the other hand, Deloitte estimated savings from offshore spanning 15 percent (its typical case) to 47 percent (its best possible case, though apparently the best realized was 24 percent) in a 2003 report titled "Offshore Outsourcing: Is it the TCO Slasher It Promised To Be?" Meanwhile, Booz Allen & Hamilton states that companies should target a 30-35 percent cost reduction in its "2001 BPO Survey of 100 U.S. Companies." Imagine presenting a business case predicated on achieving a range of savings somewhere between 0 and 47 per cent.

The fact that these reports are all true in some way probably does little to comfort the senior executive having to make a decision. Exhibit 1 shows the results of Everest's own analysis of 24 case studies drawn from a survey of 20 leading suppliers.

Exhibit 1

Reasons for the Wide Variance in Reported Savings and Key Drivers

To start at the most basic level, labor arbitrage drives the majority of savings. So how big is the "raw" labor arbitrage? According to the World Bank, in 2001 gross national income (GNI) per capita in the United States (~$34,300 per year) was approximately 68 times the GNI per capita in India (~$500 per year).

The gap narrows considerably, however, when one considers the total compensation of workers in similar positions. In the case of programmers (and most other professional positions), professionals in developed economies make roughly eight-to-ten times what similar employees in a developing economy earn. Finally, most offshore relationships involve a supplier rather than a captive operation. Due to increased overheads and supplier costs (and margin), the delta drops to roughly two times. For example, a programmer in the United States may make ~$80,000 per year including benefits and other overhead costs. The billing rate for a similar programmer in India would be roughly $22/hour for 1800 hours per year or about $40,000 per year. This billing rate generally includes all overheads including telecom costs, training, space, etc. Thus, the pure labor arbitrage often runs around 50 percent.

This huge variance (from 2x-68x) is probably the single greatest reason why companies report such a large range of savings. Gross savings of 60 percent+ are possible, especially through captive operations. However, net savings will always be lower unless the supplier makes substantial productivity improvements.

This leads to the second reason: there are many factors that drive cost savings, and comparison of savings across multiple deals is only meaningful if done on the same basis. For example, savings on different deals would be comparable if computed net of investments amortized over a five year period and excluding all productivity based gains.

The following section explores the mathematical relationship between the various drivers and the savings achieved. This is critical in that companies offshoring a function should understand these drivers and design an offshore solution that maximizes returns given its risk profile.

Cost savings = Function (labor arbitrage, percent of services offshored, potential productivity improvements, length of contract, percent reinvested, setup costs, governance cost, inflation.)

Labor arbitrage generally ranges from 50 percent (through a supplier given a tightly negotiated contract) to 65 percent (through a captive operation). Savings are lower if the operation being offshore was originally located in a low-cost region such as Canada or the US Midwest.

Percent of services offshored is a critical for two reasons: (1) Labor arbitrage can only reduce costs for services sourced offshore, and (2) the scope of services offshored is by far the most important factor under the control of the buyer. While the labor arbitrage is important, the range of potential results is much narrower. Two variables typically drive the percent of services offshored: the process offshored and the company's sourcing strategy. The result typically ranges between 20-90 percent offshored.

Potential productivity improvements depend primarily on the existing organization's performance level and thus opportunity to further reduce cost through automation, etc.

Length of contract drives the schedule over which the buyer or supplier amortizes capitalized costs or the period over which net present value/internal rate of return (NPV/IRR) is calculated. More subtly, it also drives percent reinvested.

Percent reinvested is a factor in that many companies choose not to take all potential savings to the bottom line. Instead, they reinvest savings in some combination of increased capacity, increased quality, and retraining of affected employees.

Setup costs vary widely but generally range from 15-30 percent of the annualized spend before outsourcing. They include the cost of knowledge transfer, the cost of the procurement process (external legal counsel, third party consultant, travel), software, etc.

Governance cost is the cost of the retained organization that manages the outsourced relationship.

Inflation is a hotly debated topic at the moment and subject of an upcoming Everest White Paper. In short, even though wage inflation in offshore destinations is substantial (e.g., according to the 2003 NASSCOM--Hewitt study, compensation increases ranged from 12-15 percent), Everest believes that billing rates will not exceed domestic inflation over the next five years. The fact that most recent offshore deals signed limited cost of living adjustments (COLA) to domestic indices such as the US consumer product index (CPI) is significant evidence that suppliers also forecast manageable offshore inflation.

A simplified version of the cost savings calculation is shown below:

Gross savings = (percent of services offshored^* labor arbitrage) + percent productivity improvement

Net savings = Gross savings - percent reinvested -- (setup costs / length of contract) -- governance costs as a % of original costs

Everest believes the financials behind offshoring are almost always compelling. Whether savings are 20 percent, 40 percent, or 60 percent, most executives would agree that the savings are significant enough to warrant further investigation.

As shown below in Exhibit 2, most companies are also finding the quality and on-time delivery of offshore offerings to be compelling.

Exhibit 2

Given these facts, the following questions become prevalent:

1. What are my competitors doing? What results have they had? What strategy shall I adopt (leader, fast follower, etc.)?
2. What are suppliers' current capabilities? Who are the leaders in my industry and in this business process? What is the best way to engage with them?
3. Given the wide range of savings, how do I ensure a better than average result? How do I avoid the pitfalls that others have encountered?

While questions (a) and (b) vary widely by industry and function under consideration, (c) is the focus of the next two articles in this series.

Do you find analytic articles like Harnessing the Full Power of Offshore Outsourcing useful? Very useful Somewhat useful Too complicated View Results Other Results

In December, Article 2 will ask "What decisions do companies make that limit savings before transition even starts? Article 3 in the December 15 Journal will answer the question, "How can companies most effectively utilize the offshore lever?"

Publish Date: November 2004

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Copyright © 2004 - Everest Partners, L.P.

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