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Is Offshoring Demand Sustainable?

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Offshoring has become a proven business strategy because of its profound effects on both buyers and suppliers. Buyers are seeing dramatic savings by offshoring. Our May 2005 analysis found that buyers typically achieve over 30 percent net savings when they send work to a lower cost location.

At the same time, suppliers of offshore services are gaining dramatically in terms of revenue growth, margins, and cash flow. In a May 2005 report, co-authored by Everest Research Institute and Sanford Bernstein, our analysis showed that revenues of the top six Indian offshore services suppliers had grown at an annual rate of nearly 40 percent in 2004, while the top six traditional outsourcing suppliers registered only a three percent growth in revenue.

The Indian firms also benefited from increased cash flow. The top six Indian players combined generated $953 million in free cash flow last year, which was nearly equal to the aggregate cash flow of the six major players ($992 million) excluding Accenture, which generated $1.3 billion in free cash flow itself.

Indian suppliers have further managed to maintain their net margins while registering such strong growth - a truly impressive achievement. The top six Indian suppliers averaged a net profit margin of 21.7 percent in 2004, with Infosys reporting the highest net margin at 25.6 percent. On the other hand, the top six major traditional outsourcing suppliers achieved an average net margin of only 4.3 percent, with ACS leading at 9.2 percent.

How Much Demand Can Offshore Suppliers Support?

Today, the question is no longer how much offshore demand can grow. Rather, the relevant query is: How much demand can offshore suppliers support? Our recent analysis showed that the IT offshore market can easily sustain a 30 percent annual growth rate, with the nascent BPO market capable of sustaining even higher growth.

It's time to ask these types of questions because a number of signs are emerging that point to supply-side constraints in offshore markets. We focused on India, one of the most developed offshore locations, as a representative market. But we believe supply-side constraints are showing up in every offshore locale.

In India, suppliers are now talking about new challenges. In June 2005, human resources (HR) issues dominated this year's National Association of Software and Service Companies' (NASSCOM) annual BPO conference. Of the many discussed issues, the two most important ones which are clear indications of the supply side concerns are attrition and wage inflation:

• Attrition. Attrition rates are high in India because a growing number of global suppliers are chasing a limited supply of people. We found attrition rates for Indian IT workers range between 15-20 percent per year. For firms doing business process outsourcing, the attrition rates can reach, and even surpass, 60 percent annually.
• Wage inflation. A 2004 Hewitt Associates study of IT-services employees found Indian wages rose 14.5 percent in 2004 over 2003. This year the supplier predicts some top managers could receive salary increases of 22.4 percent. Read "India Sees Performance-Linked Salary Hikes for Outsourcing Staffers in 2005."

Indian suppliers have already begun to address these issues. They are considering opening locations in Tier 2 cities instead of expanding in their traditional centers like Bangalore, Delhi, and Mumbai. Many talented workers who live in Tier 2 cities like Chennai, Hyderabad, Kolkata, and Pune do not want to relocate to Tier 1 cities. Suppliers are beginning to open offices in these cities in order to tap these resources, who are both talented and less expensive.

Suppliers will have to take other strong measures to be able to meet the burgeoning demand. They include:

• Moving to new locations. This includes new cities within their home country as well as opening offices in other countries.
• Tapping new educational pools. Currently Indian suppliers are hiring primarily from the pool of engineering and computer science graduates. They will have to expand their reach to college graduates in other fields to keep up with demand.
• Reviewing their overall business models, including markets, pricing, and margins.

Whether suppliers will be able to cope with growing demand will depend on how well they can adapt to and overcome these challenges.

Publish Date: July 2005

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Copyright © 2005 - Everest Partners, L.P.

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