Myth of vanishing advantage in IT offshoring

Word is going around in some IT and vendor circles that the cost advantage of leading offshore locations is rapidly declining. This speculation is based on news of rapid wage increases in key countries, such as India, especially for IT capability.

A.T. Kearney's close examination of the factors underlying offshore cost and price trends reveals that the offshore advantage is likely to continue well into the next 10 to 15 years and beyond. Although our predictions factor in an anticipated slow-down in wage increases and a migration into lower cost locations, it focuses on the advantages of performance improvement.

First, let's temper the myth of the vanishing wage differential. Through 2010, increases are more likely to be in the 5-10 percent range, as compared with the past year's 10-15 percent in some locations, such as India's hot markets. Plus it's important to remember that wages account for only 45-50 percent of the total cost of services, with infrastructure and facilities making up most of the rest. Then add in the cost benefits of relocating to Tier II cities, which have been recruiting and developing IT capabilities. These Tier II cities can offer cost advantages of 35-50 percent over mature locations, in India and also other regions across the globe. While the location gap will close over time, Tier II and III locations will continue to provide a strong counterpoint to wage increases.

The missing element in offshoring has been a concerted focus on performance improvement. When companies focus on performance, they realize significantly higher value from offshoring than just a one-time wage arbitrage. In IT-related services, performance improvement of 30-35 percent over the first three years, and up to 40-50 percent over 5 years, is possible and has been realized by a number of A.T. Kearney clients across a range of industries. These improvements are driven by:

• Increased productivity (including longer work hours)
• Improved performance quality
• Improved processes and tools
• Leverage of a broader set of expertise across the offshore organization
• Spillover effects of improved processes and quality into the retained organization

While some companies have leveraged improved performance into lower cost or improved capacity to meet business needs, the potential, in most cases, has been limited to vendor marketing materials, benchmarks, and presentations. Translating improvements into reductions in the cost base are primarily achievable though negotiated year-on-year performance improvement commitments, which are backed by contracts and realized by focus on targets and implementation plans.

Done right, it is entirely possible that the offshore advantage increases over time. We may be on the cusp of a new phase of offshoring, where the traditional wage arbitrage equation is replaced by a more strategic consideration of performance improvement. Realizing these benefits will require a shift in mindset and a new way for companies to look at the value offshoring offers.