Globalization and Offshoring of Software

Understanding Offshoring from a Company Perspective

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4. Understanding Offshoring from a Company Perspective

Instead of examining offshoring by country, it is also possible to examine offshoring by the type of company. We will consider five types of firms. The first are large, established software firms headquartered in developed nations that make and sell packaged software. Examples include Adobe, Microsoft, and Oracle. As a general rule, the largest and most successful packaged software firms are headquartered in the United States; the notable exception is SAP in Germany.

Most large packaged software firms have global operations. In many cases, their offshore operations are for localization work for the local domestic market. However, particularly in the case of India, and also to some degree in Russia, the work is for development of their worldwide software packages. Locating in these low-wage countries enables these firms to have access to lower-cost programmers, many of whom are comparable in skill levels to the company’s workers in the developed nations. This is not the only benefit. Having operations in other time zones can speed up production by facilitating round-the-clock production. These opportunities are encouraging major packaged software firms to expand their workforce in India and other lower-cost nations.

Offshoring will have a complicated effect on the packaged software firms. First, it might and likely will put employment pressure on developed nation software firms to decrease employment in the developed nations. On the other hand, the lower cost and faster production could allow the development of new features in old software and could contribute to the creation of new, well-priced software products, which would in turn increase income for these firms and perhaps lead to greater hiring.

Next we consider large, established software firms headquartered in developed nations that are large providers of software services. These companies may also provide packaged software, though not all of them do so. Examples include Accenture, EDS, and IBM. Software service firms have been among the fastest growing firms in the IT sector, and in general they are far larger than the packaged software firms. Firms coming from the software side (e.g., Hewlett Packard or IBM) and from the service side (e.g., Accenture) are converging. In the case of IBM, this has been through both direct hiring and its recent acquisition of the Indian service firm Daksh (with its approximately 6,000 employees). Hewlett Packard has built its global non-IT services to over 4,000 persons in the last three years, largely through in-house hiring.

Software services is in most respects a headcount and labor-cost business; these companies grow their revenues by hiring more persons. The multinational software services firms have been experiencing increasing pressure on costs due to competition from developing nation producers, particularly from the Indian service giants such as Infosys, TCS, and Wipro. This has forced the multinationals themselves to secure lower-cost offshore labor. Service firms such as Accenture, ACS, EDS, IBM, and Siemens Business Services operate globally, but only in the last five years have they found it necessary to have major operations in developing nations to decrease their labor costs. Today, the larger service firms, including Accenture and IBM, are rapidly increasing their headcount in a number of developing nations, particularly India. At the same time, these firms are holding steady on their developed nation headcount or gradually drawing it down. Given the ferocious competition in software services, there is little possibility that prices will increase substantially. This suggests that, for the large multinationals, the offshoring of services will continue to increase in both absolute numbers and percentages of their global workforce.

Next we consider firms headquartered in developed nations that have software operations but are not part of the software industry sector. This is the enormous and eclectic group of companies that provide all the non-IT goods and services in the economy. Software is now at the heart of value creation in nearly every firm, from financial firms such as Citibank, to manufacturing firms such as General Motors. Customizing, maintaining, and updating IT systems has become an increasingly significant expenditure for businesses in developed countries, and thus firms are actively trying to lower these cost. One way to lower them is to offshore the work to nations with lower labor costs.

It is difficult to estimate the amount of software work that is offshored by these companies. Businesses often do not break out this particular kind of expense, and if work is transferred to an overseas subsidiary, this is considered an internal transfer and may not be reported at all. However, it is clear who does the work. If it is not an overseas subsidiary of the company, then it is likely to be one of two other kinds of firms that provides the service: a large service firm from a developed nation (e.g., Accenture, CapGemini, IBM, and Siemens Business Services) or a firm from a developing nation (e.g. Infosys or TCS in India, Luxoft in Russia, or Softech in Mexico).

It is not certain whether offshoring will lead to a decline in the number of software service employees employed in the developed nations. In the current economic recovery, existing firm headcount throughout the IT sector in the United States appears to be stagnant. In other sectors, limited data are available. For example, in financial services it is unknown as to whether the increasing headcount in developing nations has had any impact on employment in the developed nations. The most that can be said is that non-IT firms are increasing their IT employment in developing nations to serve the global market, and this trend is underway across many different firms, including industrial firms such as General Electric and General Motors.

Next we consider software-intensive small firms, particularly startups, based in developed nations. For small startups, offshoring is often a difficult decision, although more recently a number of firms in the United States have been established with the express purpose of leveraging lower cost offshore skilled engineers. For many smaller firms, an offshore facility can be demanding on management time. This is especially true in India because hiring and retaining highly skilled individuals is difficult. The protection of intellectual property, which is typically the most important asset that a technology startup has, is problematic in India and especially China. There is substantial anecdotal evidence that, despite these challenges, under the pressure from their venture capital backers and the need to conserve funds, small startups are establishing subsidiaries abroad, particularly in India, to lower the cost and increase the speed of software development.

A pattern is emerging for US startups. They may initially use outsourcing to, say, an Indian firm as a strategy, but many soon establish a subsidiary in place of the Indian firm. They do this for a variety of reasons, including worries about intellectual property protection, control of the labor force, and management efficiency. The minimum size of an offshored operation is reportedly as few as 10 persons. If this report is accurate, then it may be possible for many more small firms to establish subsidiaries in developing nations than have done this so far. Unfortunately, data on the scale and scope of offshoring by startups are unavailable.

It is tempting to view offshoring by startups (whether to an Indian firm, say, or to their own overseas subsidiary) as an unmitigated loss of jobs for US workers. Nevertheless, the real situation is more complicated. Lowering the cost of undertaking a startup could mean that the barriers to entry are lowered, thus encouraging greater entrepreneurship. The jobs created by this entrepreneurship should be counted against those lost by offshoring. So, correctly estimating employment net effect of offshoring in the case of startups is very difficult.

Finally, we consider firms in developing nations providing software services to firms in the developed nations. The availability of capable software programmers in developing nations provided an opportunity for entrepreneurs and existing firms to offer programming services on the global market. It was in India where this practice first began in a significant way. Because telecommunications links were not so sophisticated, the Indian programmers initially were placed in the US customer’s premises. This practice was profitable and gradually expanded to include remote provision of services – often to do Y2K work—when telecommunication improved and demand heated up in the late 1990s. These developments created an environment within which major corporations were willing to experiment with overseas vendors, and a sufficient number of these experiments were satisfactory. The result was that offshore vendors, particularly Indian firms, were validated as candidates for software-related projects. These projects also allowed offshore vendors, again particularly Indian firms, to grow in headcount, experience, and financial resources, so that they could undertake larger and more complicated projects.

Software services firms from a number of the developing nations have become players in the global economy. The large Indian firms (HCL, Infosys, Satyam, TCS, and Wipro) are at present the global leaders. However, in China, Mexico, and Russia there are growing software service firms that employ between 1,000 and 5,000 people. Currently, the firms from other nations are not large enough to compete with either the multinationals headquartered in developed nations or the large Indian firms. Medium-sized firms in other geographies can, however, reduce the risk for customers of having all their offshore work done in one country, where it might be interrupted by a natural disaster or by political or military problems. The larger multinationals and Indian firms are also establishing facilities in other geographies, particularly Eastern Europe and, more recently, Mexico.

Firms are leading a global restructuring of the geography of software and software services production. They are experimenting with a variety of strategies meant to utilize workers that have become available in the global economy. This is true of software product firms as well as multinational and developing-nation software service providers. The impact of firms outside the IT sector with large internal software operations transferring some of the software operations to lower-cost environments has been less remarked upon; however, should the current trend continue, this will have a substantial effect on IT employment. These firms have already relocated a significant amount of work from high-cost to lower-cost environments, and this process appears likely to continue, and possibly accelerate, as firms become more comfortable working in developing nations. The offshoring of startup employment bears particular observation because the US high-technology economy in particular is dependent upon the employment growth that small startups provide.

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