IT Offshore Outsourcing: Benefits and Risks - Term Paper Example

ABSTRACT This research was undertaken to evaluate the impact of offshore outsourcing in the IT sector. The concept of offshore outsourcing was reviewed and the reasons that prompted the sector to offshore jobs were looked into. Globalization and the need to focus on core competencies, apart from the economic considerations compelled the organizations to turn to low-cost nations. Fortunately, these developing countries such as India and China have a large pool of skilled and talented, educated engineers. This proved to be a boon for the IT companies as they invested and reaped benefits. Risks and challenges in the sector have also been evaluated in the paper. The risks can be combated through the right strategy of vendor evaluation and cross-cultural training. The fear that offshoring adversely impacts the US economy has been undermined because in the long run, the economy stands to gain. The displaced IT workers have been compensated with jobs in other sectors. Overall, the initial decision to offshore IT jobs has proved to be the right strategy considering that US would face labor shortages when the baby boomers retire. Table of Contents 1. Introduction 1 2. Concept of IT outsourcing 2 3. Reasons for businesses moving towards offshore outsourcing 4 4. Benefits of outsourcing 5 4.1 Economic benefits 6 4.2 Transfer of risks 6 4.3 Time Zones 7 4.4 Agility and Flexibility 7 4.5 Core competencies 7 5. Risks in outsourcing 8 5.1 Client-vendor communication 8 5.2 Client’s internal management 9 5.3 Vendor capabilities 10 6. Impact of IT outsourcing 11 6.1 On the US economy 11 6.2 On the IT workers 12 6.3 Social impact – impact on people 13 7. Conclusion 14 References 16 1. Introduction Internationalization, globalization, fundamental changes at the work place, corporate restructuring and downsizing exerted pressure on the organizations to reduce costs. Outsourcing was considered the way out and outsourcing has been a part of the American regime for decades. Most marketing personnel are of the opinion that outsourcing is good for the world economy but as far as America is concerned, it became a politically sensitive issue. Shifting of jobs to low-wage countries, known as offshore outsourcing, became a popular practice among US businesses, as it helped to cut operating costs (Otterman, 2004). The presidential candidates described it as unfair international trade and its costs for US workers. Outsourcing has become an emotional issue for several years now because of the debates and diverse viewpoints that it has attracted – it leads to layoffs and dislocation of jobs for the US workers while the economists say that it will strengthen the economy. While all agree that relocation of jobs and services are definitely cost-effective, many point to the risks involved. Moreover, outsourcing certainly impacts people and the nation as well. The Information Technology Association of America (ITAA) also agreed that even though jobs had been lost, the trend will ultimately lower inflation, lead to more job creation and boost productivity (MSN Money, 2004). This is because savings from outsourcing allows companies to create jobs. While initially people believed that it has adversely impacted the US economy, a report by Evalueserve suggests that for every $100 of work sent overseas by the US companies, about $135 to $140 would be reinvested in the US economy (Braun Consulting Group, 2004). At the same time, 30% of the companies according to Gartner did not find any cost savings in offshoring work. It thus becomes very interesting to research and look into the reasons and justification of outsourcing, its benefits and pitfalls. 2. Concept of IT outsourcing “Offshoring” according to the US Government Accountability Office, refers to an organization replacing services produced domestically with imported services (Chakraborty & Remington, 2005). Offshoring firms can imported goods and services from its foreign affiliates and sell it in the domestic market. Outsourcing and offshoring are two different concepts. Outsourcing refers to a buyer contracting with an outside supplier for services. It is possible to offshore without outsourcing if the jobs are relocated to a different location at its own captive unit (Scott, Ticoll & Murti, 2005). Offshoring hence is the relocation of production or services to another country (Garner, 2004). Offshoring refers to the location of the work while outsourcing refers to who does the work. Offshore outsourcing occurs when a third party delivers outsourced work from a lower cost destination. The offshore company (the service provider) and the company that outsources jobs, work across time, space and corporate boundaries. Hence, their agreement or contract should be well defined and the relationship must be well-governed. Offshore IT outsourcing has been able to harness the power of information technology from distant locations. It has enabled to achieve economies of scale and cost competitive operations (Knapp, Sharma & King, 2007). Offshore IT outsourcing has been defined as the contracting of various information systems’ sub-functions by user firms to external vendors. Organizations turn over part or all of the IT functions to external service providers to achieve the corporate goals. Variety of business processes have taken to outsourcing their business functions. The sectors that use offshore outsourcing include retail, banking and financial services, insurance and telecom industries. Based on the statistics provided by Forrester Research Inc., by 2015, 3.3 million jobs would move overseas. Offshore outsourcing has become the dominant trend in the IT services industry. The offshore outsourcing industry has been in existence for over 16 years (Braun Consulting Group, 2004). In 2001, the Offshoring industry was valued at $27.75 billion and expected to grow at a rate of 35-40 percent per year. About 65% of the American and European countries use offshore providers for application development (Iacovou & Nakatsu, 2008). The current most active players in the market are India, China, Russia, Philippines and South Africa, with India being the leaders. India has been the main attraction because of its large educated, English speaking workforce and the low labor costs. It is also the most employer friendly nation. According to Juniper (n.d.), offshoring operations are generally conducted through three different models: Transactional BPOs handle one aspect of business process only Niche BPOs carry out three or four aspects of a business process Comprehensive BPOs handle both transactional and administrative tasks and accept 70% responsibility for the task. Failures in Offshoring operations have also been found and the reasons most cited include wrong location, lack of staffing and funding, improper planning from the beginning and the wrong purpose with which he offshore operations started (Braun Consulting Group, 2004). Failures in domestic outsourcing are also possible but offshore outsourcing is more prone to failure. 3. Reasons for businesses moving towards offshore outsourcing Core competency has been the back bone of decision on offshoring jobs. It enabled the firms to focus on their strong areas and outsource routine and repetitive business functions (Chakraborty & Remington, 2005). While cost reduction has been the main reason for considering outsourcing in the first place, it also enabled the firms to focus on core sectors and function while the routine jobs could be outsourced (Knapp, Sharma & King, 2007). This strategy also allowed them to gain access to scarce skills. Outsourcing frees up the skills in the US to be used elsewhere. Increased competition, rising business costs and competitive pressures forced organizations to seek innovative ways to gain competitive advantage in order to survive (Juniper, n.d.). Thus economic reasons were the drivers in offshore outsourcing. Offshoring outsourcing picked up because of the availability of the low cost, educated and technically competent labor pool available in India (Braun Consulting Group, 2004). The American economy was under extreme pressure to reduce costs at this time and the companies found it attractive to outsource work at significantly lower costs. Another reason that prompted America to offshore work was the shrinking pool of qualified labor. Vendors in developing economies cost one-third of domestic vendors and as they gained experience, their service quality also improved (Shao & David, 2007). They could add value to their clients’ supply chain. Clients could thus gain not only economic benefits, but improved services. Offshore IT outsourcing has enabled firms to remain competitive, reduce costs, improve cycle time and speed time-to-market (Knapp, Sharma & King, 2007). In the 1990s, the information systems played a key role in the US economy. Firms increased their investment in IT with a view to enhance competitive advantage. Gradually firms started feeling increased pressure to contain costs and to make profits. Information system budgets grew but they soon became targets to reduce investments. One of the major driving forces behind offshore outsourcing was the advanced information and communications technology (Shao & David, 2007). Advanced technologies of networking, digitization and storage have transformed IT operations. It has helped transform the routine tasks that can be converted into a utility-like service that can be managed from anywhere at any time. Hence distance does not matter and services can be delivered half way across the globe. Regulatory reasons also have compelled organizations to look overseas. Deregulation in many developing countries provided access to foreign service providers (Chakraborty & Remington, 2005). Many governments offered attractive incentives in R&D (Vedder & Guynes, 2008). Outside the US there are many highly talented researchers and technical workers. China, for instance, produces more science and engineering graduates than the US every year. US wants to recruit the best talent and leading US companies such as IBM, Microsoft and GE are investing heavily in emerging technology clusters like India and China. 4. Benefits of outsourcing Offshore outsourcing has several benefits such as low investment and enhanced productivity but these should be the long-term objectives of the company. Overnight cost savings should not be expected because initially the company that outsources has to invest in technology transfer and related expenses. 4.1 Economic benefits Companies and nations have been outsourcing work to low-cost countries for perceived benefits. The most important factor that has influenced and expedited offshore outsourcing has been the cost factor. It is believed that if work like computer coding, document scanning, customer-service call-center staffing and payroll processing could be outsourced to countries such as India, the savings could be as high as 20-25 percent (Braun Consulting Group, 2004). Outsourcing does not require organizations to maintain a huge labor force at all times. They can increase or decrease their workforce based on the demand. This again indirectly impacts costs because the investment is low on infrastructure and equipments. The work that is generally outsourced is repetitive work and it was believed that this could be automated. This again becomes cost effective to outsource. Cost savings are known to create value in the US economy which is the biggest benefit in engaging in offshore outsourcing. 4.2 Transfer of risks Offshoring business processes also result in transfer of risks associated with the process to the contracting company while the client gains substantial cost savings. The client or the outsourcing company also can manage with less investment in certain areas which are not its strongest, thereby enjoying greater flexibility. Outsourcing also eliminates distractions and enables the company to focus on its core strengths. When market conditions demand organizational changes, such as reductions in force, the company can afford to be agile. 4.3 Time Zones Offshoring helps to conduct work in different time zones which means that a normal work day is extended and the turnaround time is less (Vedder & Guynes, 2008). Hence, apart from the cost factor, efficient production is also an important consideration for offshore outsourcing. 4.4 Agility and Flexibility Offshoring IT work makes the company agile and flexible and one is able to respond quickly to the changing business environment. This is an important factor success. Offshore outsourcing provides the organization with a reliable and adaptable stream of workers which reduces the overall time taken for a project (Djavanshir, 2005). In addition, the developing countries have good universities and they provide educated engineers, skilled in problem-solving techniques. This is a very vital factor because the number of engineering graduates in the US is less than 10 percent. Core competencies of an organization depend to a large extent on the skilled and talent staff. 4.5 Core competencies Offshore outsourcing can free up assets and reduce costs in the immediate financial period (Harland, Knight, Lamming & Walker, 2006). Organizations are able to separate the business units and departments and the barriers between them. This helps the larger organizations as the hierarchical structure makes them more agile. Outsourcing started as a simple, remote code testing but has now progressed to application development and critical business processes. 5. Risks in outsourcing Offshore outsourcing has been growing at a steady rate of 20-25% with no signs of slowing down (MOFCOM, 2010). There is initial resistance within the organizations but they soon overcome the barriers as they are able to resolve the technical issues. The geopolitical risks are considered insignificant after careful evaluation. Nevertheless, MOFCOM cautions against certain potential risks that could reverse the benefits of offshore outsourcing. Risks in offshore outsourcing focus on three major areas – client-vendor communication, the client’s internal management of the project, and vendor capabilities (Iacovou & Nakatsu, 2008). 5.1 Client-vendor communication The client vendor communication could be impacted due to several reasons. Cultural differences are a major risk that could impede the operations and the benefits may not be achieved. This requires the manager to understand the cultural diversity. For instance, Indians require direction at every stage of operations as they are caste and family dependent. Their education system emphasizes rote learning over practical applications and independent research (Braun Consulting Group, 2004). Language and cultural barriers can lead to miscommunication as language is based on cultural assumptions (Iacovou & Nakatsu, 2008). Use of slangs and accents can create misunderstandings or even slow down communications. Even if the original set of requirements has been clearly laid down, due to long-distance communication and due to lack of face-to-face communication, certain assumptions are likely leading to miscommunication. Ineffective controls can also be a threat to projects. Physical distance can impact the change requests and the same sense of urgency may not be perceived by the vendor. However, to combat the cultural differences and to remove such barriers, high-tech firms like Intel, Adaptec, AMD, and Intuit offer optional training to their employees in the US, in Indian cultural nuances (Crainer & Dearlove, 2005). Some like AMD even flew teams of Indian workers to California and Texas for a month of cultural training with managers. 5.2 Client’s internal management The client’s internal management issues pose a threat to overseas outsourcing. The primary reason for outsourcing is cost reduction but organizations usually overlook the hidden costs and the differences in operating model. Against their expectations to save over 40% through offshoring operations, they are able to save just about 15-20% in the first year. This could rise as the learning curve of the company rises. However, the expected benefits are not achieved. The costs involved in setting up overseas operations that are overlooked, include the time and cost involved in selecting a vendor, cost of layoffs in the home company, the cost of transition, and the cultural costs (Braun Consulting Group, 2004). Layoffs in the home country could lead to major morale issues among the “survivors” and this could impact productivity. Besides there could be several communication-related, overhead and intangible costs that are overlooked (Iacovou & Nakatsu, 2008). This could possibly be due to inexperience of the clients in outsourcing. At times the offshore resources may need to be brought to the home country of the client and the time and money spent on such activities are not accounted for. Lack of top management commitment has been found to be a major risk in offshore outsourcing. This can lead to political battles, delays and even rejection (Iacovou & Nakatsu, 2008). Lack of technical know-how by the service provider can lead to delays. Inadequate user involvement is a critical threat to offshore outsourcing. The users have to be meaningfully engaged in all IT projects. Lack of offshore project management know-how by the client can cause delays and makes the client vulnerable as the vendors tend to run the show. The client must possess specialized project management know-how to be successful. Inexperienced and ill-equipped clients tend to face project delays. Inadequate knowledge transfer and miscommunication between the two groups can result in delays and overshooting the budget (Iacovou & Nakatsu, 2008). Eight of the ten businesses that have outsourced to India have experienced problems due to inadequate preparation and ineffectual management. Both the parties under the contact should have top management commitment and a consistent understanding of the requirements. 5.3 Vendor capabilities The third major area of concern in Offshoring projects is vendor capabilities. The outsourcing supplier needs to be evaluated before the contract is awarded. The service provider should have sufficiently robust security practices and they should be able to meet the security requirements internally (Braun Consulting Group, 2004). The chances of security breaks and theft of Intellectual Property (IP) is a major area of risk. Privacy concerns must be addressed. An uninformed vendor is more likely to miss things than an informed and experienced vendor. Hence it is better to work with a vendor who is familiar with the native business context of the client (Iacovou & Nakatsu, 2008). Most offshore vendors have been found to be adept in software development work. But if they do not have easy access to assigned resources and a clear understanding of the work patterns expected, delays are likely. 6. Impact of IT outsourcing Outsourcing decision may be beneficial for the organization but it does carry with it a social stigma, apart from the risks, uncertainties and challenges. 6.1 On the US economy Offshore outsourcing has existed in the United States for decades and it was believed to have a positive impact on the economy. For instance, when manufacturing was offshored, it destroyed two million blue collar jobs in the US but created 43 million white collar jobs in other service areas. In 2003, McKinsey Consulting estimated that for every dollar of corporate spending outsourced to India, US gains $1.14 and India retains only 0.33 cents (Chakraborty & Remington, 2005). It was also estimated that US GDP growth would have been 0.3 percent lower per year had offshore outsourcing of jobs not taken place. However, as people lost their jobs, they moved to other occupation or profession. In such cases, the manufacturing workers lost 12% and the non-manufacturing employees lost 4% from their previous earnings. These are the short-term losses but in the long run offshore outsourcing increases labor productivity, employment, real wages, GDP, lowers cost, and also improves the standard of living. However, these are not easily visible and hence there is a tendency to assume that offshore out has a negative impact on the US economy. IT jobs are highly skilled jobs and require formal training and education but workers in the IT sector fell in the low-skill category. Thus, job losses in the IT sector were in the low skill categories in 2003. The job losses quoted by researchers are in millions but these numbers are normal for a dynamic and flexible labor market. Moreover, in 2003, out of 1.2 million layoffs, only 6.6 percent occurred in the IT sector and the rest were in the manufacturing sector. Thus, job loss in the IT was not as significant as has been publicized. If import competition and offshoring are the main reasons for job losses, it should also reflect that import in the US had increased. It would also reflect in higher FDI and expansion of employment abroad. An analysis of US Trade in IT services between 1997 and 2003 showed that there was trade surplus for the seventh year in a row. FDI from the US also remained flat at less than 8 percent during 2002-03. All these demonstrate that the US economy was not negatively impacted by offshoring IT jobs. 6.2 On the IT workers According to the US Bureau of Labor Statistics, more than 500,000 people in the IT profession have lost jobs since 2001 (Knapp, Sharma & King, 2007). Initially this occurred due to laying off people in the US but soon, outsourcing to other countries led to the displacement of the IT professionals. The IT professionals should accept that routine tasks that require practically no client interactions will continue to be sent abroad. These include jobs like application development, detailed design, program coding and testing, and system maintenance and support (Shao & David, 2007). Other service like back office support, system administration and networking would also move abroad. IT workers involved in the non-core activities are more likely to be affected when jobs move overseas. This is a warning to the IT professionals to acquire training and gain new skills to ensure they contribute value to the organization. Demand will increase for security experts and confidential data protection as these pose hazards in sending overseas. In many instances, the domestic IT workers were asked to train the foreign workers and then they were asked to leave the job. This sends the wrong messages and the IT workers may not be very effective in their training or may deliberately impart ineffective training (Vedder & Guynes). Low morale and lower productivity under the circumstances are not unexpected. IT offshoring can endanger the future domestic supply of IT professionals which means that organizational knowledge could be at stake which is critical to the successful development and maintenance (Vedder & Guynes, 2008). Students are losing interest in IT-related careers which indicates that the future IT talent pool is shrinking. 6.3 Social impact – impact on people The BLS suggests that offshore outsourcing has at least a short-term negative impact on the IS professionals. Wages declined 1.3% between 2001 and 2003 (Knapp, Sharma & King, 2007). This in turn impacted the standard of living, the savings and retirement accounts. The professionals are concerned that unemployment would rise while there were also concerns about data security and privacy. There was also an increase in the planned retirement age. The negative impact are being perceived and experienced by the IS professionals. The IT professionals experience job insecurity, lower wages, possible unemployment and fewer benefits (Shao & David, 2007). Once jobs are sent overseas, it is difficult to get them back. This implies that the workers, who have lost their jobs in the developed countries, have remote chances of getting them back. This has prompted the IT professionals to form a labor union and this has also led to a political backlash against offshore outsourcing. The workers who lose their jobs fall down the economic ladder and most often lose their health insurance plan (Chakraborty & Remington, 2005). The government has not shown consideration for these workers who are adversely affected by trade. Transitional support for the displaced workers is essential. However, the baby boomers will soon retire leaving a wide gap between the demand and supply of labor. In the developing nations, the percentage of youth is increasing. In the new industrialized countries such as India and China, the share of GDP is increasing their share of GDP while the US is decreasing in relative economic power. Labor shortfall could cost the US economy $2 trillion if appropriate measures are not taken (Forge, Blackman & Bohlin, 2006). 7. Conclusion Offshore outsourcing in the IT sector has been the issues of debates and discussions for long. Competitive pressures and globalization were the main drivers of outsourcing as firms had to cut down costs to remain competitive. The benefits of outsourcing are recognized by the organizations as well as the nation but offshore outsourcing carries certain risks and challenges. The benefits of outsourcing include economic, technological, regulatory benefits apart from enabling the form to focus on core competencies. However, certain precautions have to be kept in mind. Evaluation of the vendor before awarding the contract is essential. The cultural and language differences could also create miscommunication and delay projects. However, as the vendors in the developing countries gain experience, such drawbacks are soon taken care of. It was believed that offshoring work adversely impacts the US economy. However, this is a short-term negative impact as in the long run, the economy stands to gain. The job loss in the IT sector resulted in employment increase in other sectors. In the IT sector too, the job loss was only in low-skilled jobs. The IT professionals have been impacted due to low morale and change of profession. The workers have faced loss of health insurance plans but the government can look into how to bring back such benefits. However, there are predictions that US would face labor shortages as baby boomers retire. Under the circumstances, offshore outsourcing would prove to be a boon in all respects. References Braun Consulting Group. 2004, 'Offshore Outsourcing: Impact on the American Workplace', Chakraborty, K. & Remington, W. 2005, '“OFFSHORING” OF IT SERVICES: THE IMPACT ON THE US ECONOMY', CCSC: Central Plains Conference, JCSC, 20 (4), pp. 112-125. 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