The Hidden Costs of Offshore Outsourcing

Moving IT work overseas can be a much more expensive proposition than you may think.

The current stampede toward offshore outsourcing should come as no surprise. For months now, the business press has been regurgitating claims from offshore vendors that IT work costing $100 an hour in the United States can be done for $20 an hour in Bangalore or Beijing.

If those figures sound too good to be true, that's because they are.

In fact, such bargain-basement labor rates tell only a fraction of the story about offshore outsourcing costs. The truth is, no one saves 80 percent by shipping IT work to India or any other country. Few can say they save even half that. As just one example, United Technologies, an acknowledged leader in developing offshore best practices, is saving just over 20 percent by outsourcing to India. (For more, read "Inside Outsourcing in India.")

Thats still substantial savings, to be sure. But it takes years of effort and a huge up-front investment. For many companies, it simply may not be worth it. "Someone working for $10,000 a year in Hyderabad can end up costing an American company four to eight times that amount," says Hank Zupnick, CIO of GE Real Estate. Yet all too often, companies do not make the outlays required to make offshore outsourcing work. And then they are shocked when they wind up not saving a nickel.

In this article, we will explore a new TCOthe total cost of offshoring. We will uncover all the hidden costs of outsourcingareas in which youll have to invest more up front than you might think, places where things such as productivity and poor processes can eat away at potential savings, and spots where, if youre not careful, you could wind up spending just as much as you would in the U.S. of A. (For more on how to calculate your own TCO, see the worksheet "Do the Math" on this page.)

"You cant expect day-one or even month-six gains," Zupnick says. "You have to look at offshore outsourcing as a long-term investment with long-term payback."

The Cost of Selecting a Vendor

With any outsourced service, the expense of selecting a service provider can cost from .2 percent to 2 percent in addition to the annual cost of the deal. In other words, if youre sending $10 million worth of work to India, selecting a vendor could cost you anywhere from $20,000 to $200,000 each year.

These selection costs include documenting requirements, sending out RFPs and evaluating the responses, and negotiating a contract. A project leader may be working full time on this, with others chipping in, and all of this represents an opportunity cost. And then there are the legal fees. Some companies hire an outsourcing adviser for about the same cost as doing it themselves. To top it off, the entire process can take from six months to a year, depending on the nature of the relationship.

Vice President of Program Solutions and Management Ron Kifer spent several months on vendor selection before contracting with Bangalore, India-based Infosys to handle a whopping 90 percent of development and maintenance work for DHL Worldwide Express, a shipping company. "Theres a lot of money wrapped up in a contract this size, so its not something you take lightly or hurry with," Kifer says. "There has to be a high degree of due diligence making sure that the [offshore] company can respond to your needs."

Even when there is an existing tie between customer and offshore vendors, the expensive and lengthy step of vendor selection is a must-do for successful outsourcing. The chairman of Tata Consultancy Services (TCS), a Mumbai, India-based outsourcer, sat on the international advisory board of Textron, a manufacturing company that owns such brands as Cessna Aircraft and E-Z-GO Golf Carts, for several years. However, when David Raspallo, CIO of business unit Textron Financial, began exploring offshore outsourcing in 1999, he still spent five months doing what he calls "the usual Betty Crocker Bake-Off" with service providers Covansys, ITS, TCS and Wipro. Ultimately, he went with U.S.-based Covansys, which has three development centers in India. Selecting the vendor took 500 hours in total, involved Raspallo and three senior managers, and cost $20,000 in additional expenses.

At this stage, travel expenses enter the picture as well. A trip overseas helps CIOs get comfortable with their choice. After all, offshore vendors can send their best and brightest over for a dog and pony show, but checking out the company on its home turf provides more insight. John Dean, the CIO of Steelcase, an office furniture manufacturer, spent several thousand dollars to send one of his IT executives to Intelligroup Asia in Hyderabad, India, for a week before signing on the dotted line.

"You can read everything you want to read and ask for advice as much as you want, but you have to make it a fact-based decision," Dean says. "So it was important to visit India to validate our thinking."

Bottom line: Expect to spend an additional 1 percent to 10 percent on vendor selection and initial travel costs.

The Cost of Transition

The transition period is perhaps the most expensive stage of an offshore endeavor. It takes from three months to a full year to completely hand the work over to an offshore partner. If company executives arent aware that there will be no savingsbut rather significant expensesduring this period, they are in for a nasty surprise.

"You have to bring people to America to learn your applications, and that takes time, particularly if youre doing it with a new vendor for the first time," explains GE Real Estates Zupnick, who maintains a handful of three-year contracts with offshore vendors, including TCS and smaller vendor LSI Outsourcing. In GE Real Estates case, the transition time for each vendor was three months at the very least and up to a year in some cases, in addition to the money-draining vendor selection period of several months.

Zupnick, who has seven years of offshore experience, says most of his peers dont appreciate the time and money it takes to get a relationship up and running. "The vendors say you can throw it over the wall and start saving money right away. As a result, Ive heard of CIOs who have tried to go the India or China route, and nine months later they pulled the plug because they werent saving money," Zupnick says. "You have to build in up to a year for knowledge transfer and ironing out cultural differences."

CIOs must bring a certain number of offshore developers to their U.S. headquarters to analyze the technology and architecture before those developers can head back to their home country to begin the actual work. And CIOs must pay the prevailing U.S. hourly rate to offshore employees on temporary visas, so obviously theres no savings during that period of time, which can take months. And the offshore employees have to work in parallel with similarly costly in-house employees for much of this time. Basically, its costing the company double the price for each employee assigned to the outsourcing arrangement (the offshore worker and the in-house trainer). In addition, neither the offshore nor in-house employee is producing anything during this training period.

But it has to be done. "We made a mistake in the beginning of just packing up the specs and shipping them over, looking at it from a pure cost standpoint," says Craig Hergenroether, CIO of Barry-Wehmiller, a packaging manufacturer that has its own development center, Barry-Wehmiller International Resources, in Chennai, India, and works with other offshore vendors. "Silly mistakes were made because we didnt take the time to have them come over. Its a false savings to keep costs down by communicating only by phone."

During the transition, the offshore partner must put infrastructure in place. While the offshore partner incurs that expense, the customer should monitor the process carefully. Often it can take longer than expected. "It took an awful lot of time to bridge the Pacific [networking our company to the Indian vendor] and getting that to work correctly," remembers Textron Financials Raspallo, who spent six months and $100,000 to set up a transoceanic data line with Infosys in 1998 for Y2K work. It also cost an extra $10,000 a month to keep that network functional. "You have to know hands down that the technology infrastructure you put in place is fully functional and will operate at the same performance level as it would if you were connecting to someone on the next floor. Otherwise, youll have a lot of costly issues to deal with."

DHLs Kifer had similar problems. Long lead times for acquiring the necessary hardware in India delayed development work, he says. The hardware holdup put off the start of offshore work for several months, requiring DHL to continue to keep vendor workers employed onsite at the more expensive rate.

During the transition period, the ratio of offshore employees in the United States to offshore employees working at the vendors overseas headquarters is high. But after the transition is complete, CIOs have to get those employees out of the office if offshoring is to be a money-saving move. "Its got to be 80 percent or 85 percent working offshore or the numbers just dont work," explains GE Real Estates Zupnick.

It makes sense for offshore service providers to place as many of their employees in the United States as possible. The providers marginsalready quite decent for offshore work (Indian companies charge U.S. companies $20 an hour for an employee they pay around $10)really skyrocket when theyre on American soil. "They make more money and often the client feels better having them close," says Praba Manivasager, CEO of Minneapolis-based offshore adviser Renodis. "But the customer immediately loses all of the bill-rate savings." If not included in the original contract, additional travel and visa costs also must be figured in. Tally it all up and you will pay as much as you would for one of your own employees.

Its a difficult area for CIOs to manage. Work is much easier to do with offshore workers onsite, but to cut costs they must push as much overseas as possible. Conversely, the more manpower based offshore, the more project problems and delays. Barry-Wehmillers Hergenroether says the amount of workers you can reasonably send offshore depends on the type of work being done. Industry- or company-specific system development requires more developers onsite. Legacy maintenance or simple upgrades may not require a soul.

"On some of our projects, up to 50 percent of offshore workers are onshore; on others its closer to 10 percent," Hergenroether says. In some caseswhere specific skills are the reason for offshoringhe may even bring in offshore talent over long term. "But if youre going to do that, your cost savings diminish dramatically," he says. In fact, there may be no savings at all.

Bottom line: Expect to spend an additional 2 percent to 3 percent on transition costs.

The Cost of Layoffs

Laying off American employees as a result of your offshore contract poses other sometimes unanticipated costs. To begin with, you have to pay many of those workers severance and retention bonuses. "You need to keep employees there long enough to share their knowledge with their Indian replacements," Zupnick explains. "People think if they give generous retention bonuses it will destroy the business proposition. They cut corners because they want quick payback. But then they lose the people that can help with the transition and incur the even bigger cost of not doing the transition right."

Layoffs can also cause major morale problems among in-house "survivors," in some cases leading to disaffection and work slowdowns. Companies with experience in offshoring factor productivity dips and potential legal action from laid-off employees into the cost-benefit analysis.

"You can never underestimate the effect these issues will have on the success of [your offshore venture]," says Textron Financials Raspallo. CIOs must take time to communicate with their staffs, being "brutally honest," he says. "If your intention is to lay off some workers and move work offshore, let them know. If you want to move legacy systems offshore and retrain staff for other systems, tell them that. And constantly reinforce what the vision is."

Raspallo sets aside time for a monthly meeting with all staff (offshore included) by video. "In the beginning, we spent the whole time talking about the offshore proposition," he says. "If you dont spend that time doing that, your staff is going to make up stories about whats happening themselves."

Without this kind of effort, offshore endeavors are doomed.

"Internal people will refuse to transition to the offshore model because they have a certain comfort level, or they dont want their buddy to lose his job," Renodiss Manivasager says. "There has to be a mandate. Trying to build consensus can take a very, very long time." Manivasager has seen some relationships take as long as three years to get off the ground because the strategy was neither shared with nor embraced by employees.

Bottom line: Expect to pay an extra 3 percent to 5 percent on layoffs and related costs.

The Cultural Cost

One of the biggest impediments to offshore savings is productivity. "You simply cannot take a person sitting here in America and replace them with one offshore worker," GE Real Estates Zupnick says. "Whether theyre in India or Ireland or Israel."

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