CHAPTER 19

Global Outsourcing

INTRODUCTION

Outsourcing as a business phenomenon has its roots in David Ricardo’s theory of comparative advantage and has been a major growth driver for countries such as India, Ireland and the Philippines in the 1990s.

The concept of outsourcing is a commonly used term in the context of economies such as India. Although there is no commonly accepted definition, it may be described as the transfer of a firm’s non-core functions and activities to an outside service provider in order to improve overall business performance.

The origin of the term may be traced to Ricardo’s theory of comparative advantage, where an organization transfers some of its repeated core and non-core business processes to an outside provider to achieve cost reductions, improve service quality and increase shareholder value. The organization is thus able to concentrate on activities in which it has a comparative advantage.

The growth of outsourcing is a phenomenon of the 1990s, attributable to the rebounding of the information technology industry, which had slowed down considerably after the bursting of the dotcom bubble in the 1980s. For countries such as India, the basis of the outsourcing phenomenon was the time-tested principle of comparative advantage, helped by factors such as developments in telecom and Internet facilities, the existence of a low-cost English-speaking skilled labor force and a geographical distance of 12.5 hours from the US, which was its principal outsourcer in initial years.

FORMS OF OUTSOURCING

The terms ‘outsourcing’ and ‘offshoring’ are often used interchangeably, although they are not quite identical. In order to understand the terms better, we may classify outsourcing into four main categories using location and control/ownership as distinguishing criteria¹:

1. Captive onshore outsourcing is a shift in intra-firm supplies to an affiliated firm in the home economy.
2. Non-captive onshore/local or domestic outsourcing refers to the shift in sourcing of supplies to a non-affiliated firm in the home economy.
3. Captive offshoring describes a situation in which future supplies are sourced from an affiliated firm abroad.
4. Non-captive offshoring is the fourth variant of outsourcing and refers to the case when the new supplier is a non-affiliated firm and located abroad.

From an international perspective, the latter two categories of outsourcing, namely captive and non-captive offshoring, are of particular interest. Table 19.1 illustrates the four concepts.

 

There are also uncertainties of outsourcing. The requirement of delivering an agreed quality and quantity of goods and services may be subject to the possession of a certain skillset, equipment and product development techniques in the outsourced destination. For example, BPO workers in India knew how to speak English, but had to learn the American accent to be able to service clients in the US. Alternately, a task may require a particular software. However, the software may then be rendered useless after it has been used if it is task-specific.

DRIVERS OF OUTSOURCING

The following factors have been the major drivers or factors facilitating the outsourcing phenomenon.

Theory of Comparative Advantage

The theories of comparative advantage and intra-industry trade together explain why a firm outsources certain operations abroad. Trade between countries, which are significantly different in terms of factor endowments, is driven by comparative advantage. Thus while trade between nations happens because of different factor endowments, trade between countries that are similarly endowed is motivated by a desire to obtain a wider variety of goods and services.

The process of offshoring enables countries to exploit competitive advantage as well as obtain a wider variety of goods and services. For example the offshoring of IT enabled services and business processes is an example of vertical trade within the same industry on the principle of comparative advantage. The offshored services are usually less skill-intensive and capital-intensive than those retained in the home country. Offshored services, whether low-skilled, such as payroll accounting or telemarketing, or high skilled, such as legal process outsourcing, are all sources of cost-saving and driven by desire to obtain comparative advantage. The use of these services may lead to the final production of commodities such as cars, computers or services such as banking and financial services, and helps to increase the variety of goods and services available for the final consumer.

Concentration on Core Competency

From the firm’s point of view, offshoring certain services helps it to concentrate on those functions that are responsible for its core competency. A total business process consists of a multitude of complex tasks and skills, all of which do not have equal strategic significance for the business firm. By outsourcing its non-core business functions, a firm is able to concentrate on those functions and processes that are of strategic significance and value. Outsourcing thus helps a firm to save on costs in terms of both time and managerial capabilities, enabling greater innovation and growth.

Developments in Technology

New networking technologies have made it possible for global companies to seek the lowest cost solutions from anywhere in the world for activities that can be digitized. Companies can outsource their non-core functions such as human resource, finance and management accounting, customer relationship management and IT services to a third party to be able to focus their resources on their core activities and hence reduce their operational costs. Developments in infrastructure and privatization of telecommunication services have further catalysed the outsourcing boom.

Existence of Low-cost and Skilled Manpower

The existence of an educated, low-wage seeking, language and technically proficient labor force has been a major growth driver for the outsourcing industry. India and Ireland’s success in attracting offshoring business from the US and the United Kingdom has been partly attributed to their English-speaking workforce. Outsourcing from the other leading industrial countries is much lower to these destinations, however it is more to countries that are closer to home geographically and/or culturally. A large share of German outsourcing contracts thus go to Central Europe, and a large share of Spain’s outsourcing contracts go to Latin America.

Changes in Regulatory Environment

Improvement in the regulatory environment, such as trade liberalization for imported inputs, lifting of foreign investment restrictions, favourable taxation and low-interest export credits have been the major driving forces responsible for the growth of the two largest IT traders, namely Ireland and India.

Infrastructural and Institutional Development

It should also be noted that institutional and infrastructural quality at the national level is also a relevant variable to look at. In some cases, notably in India, software technology parks and other special economic zones have excellent infrastructure and effective one-stop-shops for sorting out the legal formalities of establishing and running a business, even if the average quality in the country as a whole leaves much to be desired.

FACTORS BEHIND A DECISION TO OUTSOURCE

How do firms decide which activities to conduct in-house and which ones to outsource? The following parameters may help a firm to determine its make-or-buy/outsourcing decisions.

Technical and Institutional Separability

The ability to distinguish and separate functions and services is an obvious precondition for outsourcing. Recent innovations, particularly in IT, have made an increasing number of service tasks separable in time and space. Services that deal with the collection, manipulation or organization of information and can be codified, digitized and separated from other tasks within the firm can be outsourced. A number of entirely new information-based services and occupations have also emerged with the diffusion of IT. This includes software developers and IT consultants, search services, and also new types of media and content that have resulted in new opportunities for independent service suppliers.

 

Standardization and Automation

Once information-based services have been codified, digitized and separated, they can also be standardized and can be automated in some cases. Some can even be reduced to a set of instructions or tasks that workers can follow routinely. Examples of information-based services that can be codified, standardized and outsourced are accounting, billing, the payroll, booking and many more. These are typically non-core tasks, both in manufacturing and services companies, and are increasingly outsourced to specialized external suppliers. In addition, as computer software have become standardized, many IT services have also become non-core and can be outsourced.

Cost Minimization

The decision to outsource is essentially a make-or-buy decision for a firm and is based on finding the balance between fixed and variable costs that results in the lowest total costs. The relevant costs here are production costs and managerial costs.

Being independent of the production volume, fixed costs have an inverse relationship with the volume of production—they decrease as the volume of production increases. In the context of outsourcing, these are the costs of searching for a supplier and negotiating a contract, and are lower in the case of outsourcing than if production is an in-house activity. Variable costs such as monitoring and coordinating production are usually lower with in-house production, and make outsourcing less attractive.

Production Costs

If the outside supplier is located in the same country as the outsourcing firm, one would expect that production costs would be the same, since the factors of production are purchased in the same market. If the activity in question can be offshored to a low-cost location, there are additional gains in terms of lower production costs, but there are also additional managerial costs. These managerial costs depend on whether offshoring is through foreign direct investment (captive offshoring) or by entering a contract with an independent foreign supplier. In the case of captive offshoring, the costs of acquiring local knowledge about laws and regulations, the availability of non-tradable local inputs and so on have to be incurred in addition to the cost of setting up or acquiring the foreign firm.

Managerial Costs

Managerial costs can be considerable within large companies and probably increase more than proportionally with the complexity of the task and the number of tasks being conducted. Furthermore, many of these costs are independent of the production volume (they are fixed costs) and constitute a higher share of total cost when the scale of production is less. With outsourcing, such fixed managerial costs are limited to searching for a supplier and negotiating a contract, and can be considerably lower than setting up in-house production. This is the most important reason why outsourcing is attractive.

There are also variable managerial costs such as monitoring and coordinating production. These costs are usually lower with in-house production than with outsourcing, and make outsourcing less attractive. Variable managerial costs related to offshoring also arise due to differences between the two countries involved in terms of language, laws, government regulations, currency and usually also due to distance, as even digitized service provision requires some face-to-face communication between the contracting parties.

Fixed managerial costs differ between the four types of outsourcing as follows:

1. Captive offshoring
2. Local in-house production
3. Non-captive offshoring
4. Local outsourcing

Market Size

The relevance of market size for the make-or-buy decision is based on the need of a firm to break even. If firms must reach a minimum scale in order to break even, the number of firms that can operate profitably is limited by the size of the market. Likewise, within a firm, a minimum scale is needed in order to employ specialists in all tasks and keep them fully occupied.

But as firms grow, a larger administration is needed in order to coordinate activities and govern relations between divisions and individuals. At one point the cost of additional administration exceeds the benefits of additional tasks or components being produced in-house.

Outsourcing is thus a way of avoiding expanding unit costs, but the existence of a network of outside suppliers requires a sufficiently large market.

Market size is also related to the risks related to outsourcing. The outsourcing firm must be sure that the supplier delivers the agreed quantity and quality of inputs at the agreed time, whether it is a service or a component. If not, the production process can be brought to a halt and in an environment with just-in-time production systems this can be extremely costly. Furthermore, if quality is not as agreed, the value of the outsourcing firm’s brand name can deteriorate. If the market is large and a large number of alternative firms available, the chance of finding a good match is better and so is the chance of finding an alternative, if a supplier fails.

SOFTWARE INDUSTRY IN INDIA

The origins of an independent global software industry can be traced to IBM’s decision in 1969 to sell software separately instead of bundling it with hardware. This gave customers the option of buying their hardware and software from different vendors in the world computer market. A few years later, in 1972, Intel’s invention of the microprocessor led to the development of powerful mini- and micro-computers, challenging the dominance of the larger and more expensive mainframes that had been in use till then. The availability of more powerful and inexpensive hardware created a simultaneous huge demand for software, and was the beginning of the global software industry.

 

A basic characteristic of but software production is that it is a craft-like, labor-intensive affair unlike hardware which can be mass produced. This also implies that software production is prone to delays and cost overruns with uneven productivity and quality.

Over a period of time, software engineering has developed along the lines of industrial engineering. Software development is a process of structured programming aimed at achieving coordination and control over a team of programmers working on a large project. In recent times, the use of industry-wise certification norms has helped to strengthen the process of development. The growth of the industry therefore depended not only on demand generated for the development of new software, but also for the maintenance of older software. This resulted in the emergence of time-specific and labor-intensive demand that grew in magnitude in the 1990s into a full-blown software industry.

The emergence of the Indian software industry as a global leader requires an understanding of the macro environment in which it has grown and flourished. The globalization of the semi-conductor industry during the 1960s largely bypassed India, which was committed to self-sufficiency and self-reliance within a broader state dominated strategy of import substitution led industrialization.

The highlight of Indian computer policy in the 1970s was forcing IBM to shut its operations in 1978. There was no Indian software industry to speak of, despite development efforts in state firms as part of unsuccessful attempts to build a commercially viable computer; nor did efforts to promote exports by permitting the import of hardware in exchange for a guarantee to export a certain amount of software prove effective. There was essentially no government policy for the software industry till the 1980s.

A change came about during the early 1980s through a policy of cautious liberalization to encourage private investment and trade. There were two important initiatives taken by the state for the development of the software industry:

1. The Computer Policy of November 1984, besides easing the local manufacture and availability of computers, recognized software as an ‘industry’, making it eligible for investment allowances and other incentives. It also lowered duties on software imports, and made software exports a priority.
2. The Computer Software Export, Development and Training Policy of December 1986 explicitly aimed at increasing India’s share of world software production. This was done with a procedure known as ‘flood in, flood out’ feature, where firms in India were provided with liberal access to global technologies to encourage the development of thousands of small software companies.

This phase of industry development is known as body shopping, or the practice of providing inexpensive on-site (that is, at customer locations overseas) labor on an hourly basis for low value-added programming services such as coding and testing.

In 1988, the National Association of Software and Service Companies (NASSCOM) was formed to promote the interests of the software industry. Subsequent policy measures tried to promote the industry more pro-actively. The clearest instance of this was the establishment, in 1990, of the Software Technology Parks (STPs). As export zones dedicated to the software industry, the STPs offered data communication facilities, allowing firms to offer offshore services, that is, service provision from India, instead of having to work at customer sites overseas.

The shift to offshore services in a more liberal economic environment marked the beginning of a new relationship between the Indian software industry and the global market. The growth of the Indian software industry may be attributed to conscious policy changes in the context of the IT industry and certain hidden benefits which were incidental benefits which the industry got as a result of earlier policies. The Indian software industry’s comparative advantage emerged out of the following factors.

Large Skilled English Speaking Work Force

Despite widespread illiteracy, Indian education policies managed to create a large pool of skilled labor that suffered from under-employment and unemployment. This became a ready skilled resource for the industry since most of them were English speaking as a result of the colonial education policy of the government.

The exit of IBM’s, and the unsuccessful local efforts to build a commercially viable computer, led to a huge reliance on imports. Since high duties were a disincentive to import, mainframes never had a significant presence in India, and the few that were imported were of various vintages and from various sources. As Indian programmers had worked on a variety of platforms in the 1970s, it proved helpful in acquiring contracts to maintain various older systems in the 1980s.

Time Advantage

A geographical accident benefiting Indian firms is the 9.5 hours difference with the US, their main market, allowing them to undertake offshore maintenance and re-engineering after regular users there leave for the day. This meant lower costs and profitability as professionals in India are paid an Indian wage whereas, once abroad, they are also paid an overseas allowance. Offshore development also offers the advantage of having most employees under one roof, instead of them being scattered across customer sites, allowing the firm to build a repository of knowledge to compete for subsequent projects, and to move employees from one project to another in a critical situation.

It was against the backdrop of such conscious efforts and unforeseen benefits that the STPs helped transform the industry during the 1990s. Software factories emerged in India with the infrastructure, technology, training programmes, quality processes, productivity tools and methodologies of the customer workplace.

Location Advantage

Within India, software factories and development centres began sprouting in regions with skilled labor and communications facilities, both of which were available in the golden triangle of Bangalore, Hyderabad and Chennai. During the 1980s, prominent domestic firms such as Infosys, India’s second largest software exporter by 1999–2000 and the first Indian firm to be listed on the NASDAQ, was among the early trickle of TNCs to India located in Bangalore. They were attracted by the concentration of skilled labor in the region, initially in public sector manufacturing industries and laboratories in sectors such as aerospace, defence electronics and telecommunications, and subsequently replenished by the large numbers of graduates from the engineering colleges of Karnataka and adjoining provinces.

Thus, the IT industry in India began as a domestic industry and eventually spread to international markets, while the BPO industry started with a strong export focus. The changing policy environment with regard to foreign investment, rising quality of the offshore environment and improved management capabilities all led global firms to increasingly locate development centres within India. The mid-1990s saw the growth of new centres of software development in Hyderabad, Pune, Chennai, Mumbai and Kolkata and today there are a large number of big and small cities which are part of the IT industry’s map.

GROWTH DRIVERS OF INDIA’S ITES–BPO SECTOR

The factors driving the growth of India’s ITES–BPO sector are:

Abundant Talent

India’s young demographic profile is an inherent advantage complemented by an academic infrastructure that generates a large pool of English-speaking talent. Talent suitability concerns are being addressed through a combination of government, academia and industry-led initiatives. These initiatives include national rollout of skill certification through NAC (NASSCOM assessment of Competence), setting up finishing schools in association with the Ministry of Human Resource Development to supplement graduate education with training in specific technology areas and soft skills, and MOUs with education agencies like UGC and AICTE to facilitate industry inputs on curriculum and teaching, and to develop faculty development programmes.

 

Sustained Cost Competitiveness

India has a strong track record of delivering a significant cost advantage, with clients regularly reporting savings of 25–50 per cent over the original cost base. The ability to achieve such high levels of cost advantage by sourcing services from India is driven primarily by the ability to access highly skilled talent at significantly lower wage costs and the resultant productivity gains derived from having a very competent employee base. This is further complemented by relative advantages in other elements of the cost structure (for example, telecom) that contribute to India’s cost competitiveness, even when compared to other low-cost destinations.

Continued Focus on Quality

Demonstrated process quality and expertise in service delivery has been a key factor driving India’s sustained leadership in global service delivery. Since the inception of the industry in India, players within the country have been focusing on quality initiatives to align themselves with international standards. Over the years, the industry has built robust processes and procedures to offer world-class IT software and technology-related services.

World Class Information Security Environment

Stakeholders of Indian BPO recognize fool-proof security as an indispensable element of global service delivery. Individual-firm-level efforts are complemented by a comprehensive policy framework established by Indian authorities, which has built a strong foundation for an ‘info-secure’ environment in the country. These include strengthening the regulatory framework through proposed amendments to further strengthen the IT Act 2000, scaling up the cyber lab initiative, scaling up the National Skills Registry (NSR) and establishing a self-regulatory organization.

Rapid Growth in Key Business Infrastructure

Rapid growth in key business infrastructure has ensured unhindered growth and expansion of this sector. The BPO sector has been a key beneficiary with the cost of international connectivity declining rapidly and service level improving significantly. The growth is taking place not only in existing urban centres but increasingly in satellite towns and smaller cities. Critical business infrastructure such as telecom and commercial real estate is well in place; improving other supporting infrastructure is a key priority for the government. STPI infrastructure available across the country and the magnitude of investments shows government support to the industry.

Enabling Business Policy and Regulatory Environment

The enabling policy environment in India was instrumental in catalysing the early phases of growth in this sector. Policy-makers in India have laid special emphasis on encouraging foreign participation in most sectors of the economy, recognizing its importance not only as a source of financial capital but also as a facilitator of knowledge and technology transfer. The Indian ITES–BPO sector has benefited from this approach, with participating firms enjoying minimal regulatory and policy restrictions along with a broad range of fiscal and procedural incentives.

PROBLEMS AND PITFALLS OF THE ITES–BPO INDUSTRY

The IT industry has boasted annual growth rates of nearly 30 per cent in the past ten years, with revenues now nearing USD 88 billion. The following are some of the problems faced by the industry today.

 

Changing Value of the Rupee

The most immediate difficulty faced by the industry is the constant change in the value of Indian rupee against the dollar. As a predominantly export oriented industry a depreciation in the value of the rupee against the dollar helps to increase export earnings, and an appreciation works against the interests of the industry.

Poor Infrastructure

Poor quality of infrastructure continues to be a problem in cities like Bangalore, where workers can spend four hours a day in traffic. Although state-of-the-art technology was used for telecom networks, getting a connection can still take as long as three months. The problem of erratic power supplies forces units to use their own back-ups.

Increasing Demand for Trained Manpower

Indian engineering schools award around 200,000 diplomas each year, and produce around 250,000 graduates, but only half are employable by the IT industry. Employees have learnt to switch jobs for better pay, but that only leads to increasing costs for the industry.

Employee Dissatisfaction and High Attrition Rates

Call centres and other outsourced businesses such as software writing, medical transcription and back-office work employ more than 1.6 million young men and women in India, mostly in their twenties and thirties, who make much more than their contemporaries in most other professions. They do, however, face sleep disorders, heart disease, depression and family discord. Most call centre jobs involve responding to phone calls through the night from customers in the US and Europe, some of whom can be angry and rude. It is monotonous and there is little meaningful personal interaction among co-workers. That can also be true of other jobs such as software writing and back-office work. All these factors have led to an increasingly dissatisfied workforce, especially at the lower end of the job pyramid, which is increasingly viewing work in the IT industry as a job more than a career.

Intensifying Competition

IT industries in other parts of the world, such as Central Europe, may never match India in size, but they can still pick off valuable contracts. Meanwhile, foreign IT firms have been beefing up their Indian subsidiaries. In 2002, the six biggest—including Accenture, IBM and HP—had fewer than 10,000 employees in total in the country. Their combined Indian workforce now exceeds 150,000. This enables them to rival the Indian firms in scale and cost, while exploiting their stronger brands and international scope.

Future Threats

In the longer term, Indian firms must keep abreast of technological changes. Many of the services they now provide will eventually be automated; this is already starting to happen, for example, in software testing. Western firms, meanwhile, increasingly want Indian providers to do more than just keep systems running; they want help in developing new solutions to business problems—something few Indian firms are set up to do.

CHAPTER SUMMARY

• Outsourcing as a business phenomenon has its roots in David Ricardo’s theory of comparative advantage. It is the process of transferring recurring business activities to a low-cost supplier outside the business.
• The major drivers of outsourcing have been a low-wage-seeking English-speaking workforce; developments in technology; changes in the regulatory environment and institutional and infrastructural developments.
• A firm’s decision to outsource certain business processes depends on its ability to standardize and digitize certain functions, cost considerations and market size.
• The Indian Software Industry came into existence with the passing of the Computer Policy of November 1984, the Computer Software Export, Development and Training Policy of December 1986 and the establishment of NASSCOM in 1988.
• In India, Bangalore, Pune, Hyderabad, Chennai and Gurgaon have been important centres of the IT industry; however, smaller satellite towns are also becoming increasingly important.
• Key growth drivers of Indian ITES–BPO exports are a talented workforce, sustained cost competitiveness, continued focus on quality, world-class information security environment, rapid growth in key business infrastructure and an enabling business policy and regulatory environment.
• Major problems of the ITES–BPO industry are an appreciation of the rupee, intensifying competition, insufficient trained manpower, poor quality infrastructure, rising employee dissatisfaction and high attrition rate.

KEY TERMS

• Outsourcing
• Captive onshore outsourcing
• Non-captive onshore outsourcing
• Captive offshoring
• Non-captive offshoring
• IT value chain

DISCUSSION QUESTIONS

1. What does the term ‘outsourcing’ mean? Discuss the different forms of outsourcing in the global economy.
2. Enumerate the different factors that play a key role in a firm’s decision to outsource certain business operations.
3. List the factors that have acted as drivers in the process of outsourcing in the global economy.
4. Write a short note on the growth of the software industry in India.
5. Discuss the contribution of the software industry in the context of the Indian economy.
6. What are the key growth drivers of India’s ITES–BPO industry?
7. Discuss the main problems faced by the IT industry in India today.

EXAMINATION QUESTION

1. What is outsourcing? Discuss the importance of outsourcing in the context of the Indian economy. (7, 8)

   [B.Com (Hons.), 2010]

2. What is the significance of outsourcing for the modern global business? (8)

   [B.Com (Hons.), 2007, 2009]

3. What is outsourcing? Discuss the different factors which play a key role in a firm’s decision to outsource certain business operations. (5, 10)

   [B.Com (Hons.), 2011, 2012]

4. What is the role of IT in international business? (8)

   [B.Com (Hons.), 2014, 2015]

5. What is e-commerce? Briefly explain the factors responsible for the growth of e-commerce in the last few years. (8)

   [B.Com 2018]

6. Explain the factors for growing e-commerce. (7.5)

   [B.Com 2018]