Do Indian Tier 1 Service Providers Run the Risk of Losing Their Cost Competitiveness? | Sherpas in Blue Shirts

An international private equity client recently asked whether Indian service providers’ cost competitiveness was eroding and, if so, whether they would be able to protect its cost advantage over multinational corporation (MNC) players. While we gave our directional point of view, this question was worth following up with a quantitative answer. And as expected, a few days (and nights!) of serious number crunching turned up interesting insights. Let me share a few.

First, let’s establish the current differences in costs and the drivers. Pricing for standard IT services (say ADM) has been under pressure due to a number of factors such as economic headwinds, maturing buyers, and intensifying competition. However, at a marginal deal level MNC Tier 1s continue to price at a 20-30 percent premium (average price per blended FTE) over Indian peers. This can be attributed to underlying differences in cost structures that translate into a 30-35 percent lower blended operating cost of the Indian Tier 1s compared to MNC peers at a marginal deal level. Key operating cost levers that result in this difference include location mix, project pyramid, employee tenure, and salary differential for the same talent profile. Across each lever, Indian Tier 1s command a competitive advantage given different starting points in arbitrage leverage and talent practices (e.g., full offshore pyramids versus partial pyramids, new versus lateral hires) compared to MNCs. In addition, the gross margin expectations differ. A key driver of gross margin difference is the SG&A spends. Indian Tier 1s on average have ~50 percent lower SG&A spends than their MNC peers due to lower corporate overhead and smaller investments in sales and support personnel.

Let us now turn the clock back a few years. The cost gap at a marginal deal level has closed by ~50 percent between 2005 and today. So, what changed in favor of the MNCs? They have improved cost competitiveness along all the drivers, particularly location mix. While the Indian players were busy expanding their overseas headcount and investing in higher skilled talent during 2007-2010, the MNCs steadily pushed the offshore lever hard, while quietly rationalizing their U.S/U.K. headcount. Over the past few years, the MNCs struck marginal ADM deals with an offshore component closer to that of Indian benchmarks though falling short by 10-15 percent. As a result today, 40-50 percent of MNCs’ services delivery headcount is global, predominantly in low cost locations. In comparison, Indian Tier 1s have ~73 percent of their headcount in India.

Going forward, which levers will experience greater convergence? And to what extent will the gap close?

Although MNCs have covered significant ground on offshore leverage, they have a lot more to cover on the rest.

Among arbitrage levers, MNCs have limited room to increase offshore leverage. For instance, achieving even 60 percent offshore leverage at a portfolio level would require them to structure all incremental work at the marginal deal level identical to the offshore-onshore mix of Indian Tier-1s. On the other hand, Indians will continue to have a head start in driving arbitrage through extensive use of Tier 2 and 3 offshore locations that are 20-40 percent cheaper than established ones. However, the Indian Tier 1s expanding location footprint into high-cost onshore markets will marginally offset some of these arbitrage gains. Pyramids differences are easier to fix through investments in offshore project managers.

Among the talent model levers, the MNCs have a lot of ground to cover, and the near-medium term opportunity for impact is high. They have already stated intentions to aggressively ramp up new graduate hiring in India. This will help reduce tenure difference to some extent, but will not erode the differential completely. For instance, even if they were to bridge the tenure difference to Indian Tier 1 levels for all new deals, the resultant impact on the average experience years at a portfolio level will be limited. Salary differential is likely to experience some erosion on the back of new visa/immigration legislation in the United States. We expect the dependence of Indian players on H1B/L1 visas – another source of cost advantage – to reduce as they look to scale up local hiring from the current 30-40 percent to ~50 percent of total onshore headcount.

The journey from here for MNCs is going to be more challenging as achieving operational efficiencies involves driving more structural changes (e.g., talent model) and associated investments (e.g., training and strategic bench). Another important driver is the impact of inflation, which MNCs will be more exposed to as they grow in offshore markets.

So, the question then becomes, can MNCs bridge the cost gap at a portfolio level to enable them to reduce the price differential to a level at which they can justify a premium of, say ~15 percent for plain-vanilla ADM work? Highly unlikely, for three key reasons:

  • Bridging the current cost differential to even sub 20 percent (through 2015) at a marginal deal level will require them to maximize all cost levers at the same time
  • The current cost differential at a portfolio level is wider than that at a marginal deal level
  • The Indian Tier 1s are increasingly playing head-to-head with the MNCs in terms of capabilities on deals, and getting entrenched in the IT services vendor portfolios of large buyer organizations

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