While cost arbitrage for global services delivery is impacted by numerous factors, e.g., wage and rental cost inflation, currency fluctuations are often the ignored wild card.
Most currencies have varied significantly in the past few years (see the graphic below). For example, in Asia-Pacific, the Indian rupee has depreciated considerably compared to the U.S. dollar, with an average yearly decline of 5.4 percent in the last three years. On the other hand, the Philippine peso has appreciated substantially against the dollar, recently reaching a four-year high. The currencies from major outsourcing locations in Latin America and Europe have also been volatile in recent months.
While one would have expected the large currency variations to have a big impact on delivery costs, a closer analysis reveals that the relative cost rankings of locations in 2013 have remained nearly the same as in 2010 (see the graphic below). This counter-intuitive result is because the currencies in most global services delivery destinations have depreciated over the last few years. In addition, all these locations have experienced moderate-to-high wage inflation, thus having a similar net impact on cost across locations.
Further, the interplay of wage inflation and exchange rates is leading to interesting trends in absolute value of operating costs among locations. Let’s look at two extreme examples to understand this phenomenon:
It is important to note that these cost changes among competing locations for similar type of work has not resulted in changes in work distribution. For example, India has not gained greater share of contact center voice work relative to the Philippines. This is because while cost is an important factor, location selection and work placement decisions are dependent on several other factors, e.g., talent availability and scalability, niche skills, risk considerations, and the organization’s existing footprint. Short-term currency changes may result in companies optimizing some work among locations in their portfolio, but this alone is not likely to significantly change the role and standing of locations in their portfolio.
For readers who are not sports fanatics…the U.S. National Football League (NFL) – and many other professional sports leagues around the world – must abide by a rule called a salary cap that places a limit on the amount of money each team in the league can spend on player salaries. Every year, this results in the team owners dismissing still productive players, in part due to expected changes in future performance, but largely because they must cut players with salaries above what they can afford in order to stay under the league-mandated salary cap for the entire cost of the roster. Invariably, this means changes to the teams’ make-up from year to year, as their rosters are rebuilt to compete in the new season.
So, what does this have to do with global services (and how can you justify reading about football while at work)?
Looking at the salary cap as a cost benchmark – which for each NFL team sets in motion a range of forces that define which teams are successful – provides some interesting lessons for the global services industry.
1. Talent models: build through the draft
The price of experienced talent in the NFL limits the teams’ ability to use that talent while still staying underneath the salary cap. Although a team could build itself entirely with 6+ year veterans, it would have to do so with almost all of them being average or below average performers. It simply could not afford to have higher paid, above average performers. And, while few top-notch players are important to each team, they’re not necessary in every spot on the roster.
Entry-level players provide teams the opportunity to find high-potential talent and utilize it before a market develops to buy it away. They also enable teams to experiment with larger volumes of comparatively cheaper talent. And, of course, once a player gains experience and can test the open labor market, the highest bidder wins, so the player is automatically paid above what the average bidder felt was the market value.
So, entry-level talent helps fulfill key roles because the diamonds in the rough are beginning to emerge, and because the market is not able to overpay for this talent in the earlier years of their careers. In the NFL, the winning teams are built based upon key talent that is found in the draft and supplemented with signings of select players from other teams.
Global services face a similar dilemma: entry-level talent is comparatively affordable, whereas experienced talent that is known to perform above average comes with a high price tag.
Implication for global services: sourcing talent from colleges and other education programs is essential to building a competitive cost structure.
2. Management: coaching matters – a lot
Since teams are experiencing greater than ever churn in their roster of players, it is becoming increasingly apparent that a good coaching staff is critical and can rapidly change the performance level of its team. In most cases in the NFL, whether a new coaching staff will be successful is evident quite quickly – generally within two years.
In order to be competitive, a coaching staff must both develop the entry-level talent from the draft and help mold together the entire team to perform at or above their collective level of capability. This often means pushing newly drafted talent (which they must be able to identify early on) into bigger roles than what seems ideal at the time.
As a result, teams with a capable and stable coaching staff are often able to sustain above average performance over multiple seasons – and members of these coaching staffs become prime candidates for bigger roles on other coaching staffs which are looking to turn around performance.
Implication for global services: ensure a management model that can rapidly develop new talent, (invest in the right training, etc.), and increase the overall performance level…operational expertise may not be enough.
3. Culture: it must endure beyond changes in players and coaches
With expected change in players and coaching staffs, the longest-term success comes from establishing and nurturing a culture that can both sustain itself over time and help raise the performance of players above what may be their natural, individual ability.
As hardcore fans of the NFL know, many of the high priced veterans that sign with other teams fail to live up to the expectations and may be cut in only a few years. Why? Some is due to physical decay or inability to step up to fill bigger shoes. However, the change in team culture – expectations, offensive/defensive schemes, attitudes…the way things are done – can also limit a player’s ability to perform at a high level.
By contrast, teams with strong cultures can often find average players and attain above average results – assuming the average players were correctly identified as being a good fit with the “system” (or culture).
Implication for global services: build a culture, (and supporting tools, processes, etc.), that relies not only on superstars, but rather on the ability of many team members to perform above their expected level – including that of the superstars.
So, draft smart, coach well, and build an enduring culture. And, if you’re seeking ways to refine your global services skills, you might want to spend some time watching the NFL teams’ strategies…the draft begins on April 25.
Note: apologies to our non-North America readers and those who don’t follow the NFL. We understand that calling our violent game “football” is an insult to all fans of FIFA, the World Cup, etc. – we simply can’t help ourselves.
Last Wednesday, we hosted a webinar on the cost competitiveness of global in-house centers and were privileged to have Kush Kamra (SVP of Global Operations for MetLife) and Charlie Roberson (Head of Enterprise Expense Management and Offshoring for Wells Fargo) join us as guest panelists. The analysis presented came from a joint study between Everest Group and NASSCOM earlier in 2012.
The webinar featured extensive discussion (thanks to our wonderful panelists) and got me thinking about two points in the aftermath of the webinar.
First, as those who attended know, the term “captive” is being replaced by “global in-house center” or “GIC.” In all honestly, I have been reluctant to confidently adopt this because change is hard (is it really worth it?) and “captive” is so simple to use in our reports (a mere seven characters!).
What suprised me is that in the two days after the webinar, three different individuals (two at the FSO event in NY, one during a phone interview) proactively corrected themselves after they said “captive” and replaced it with “global in-house center.” We laughed about it, but the point is that people are open to change and the word can get around pretty quickly. And not to be underestimated, it is much easier to replace a REALLY BAD idea when something better is consistently introduced into the market.
The second point that that I wanted to share is about labor arbitrage. As those familiar with the analysis we presented will recall, we analyzed the relative cost structure of offshore delivery vs. onshore and the sustainability of it under a range of scenarios. In many ways, the analysis simply helps rigorously document what those already close to situation know in their hearts – labor arbitrage is alive and well and not in danger of going anywhere soon.
The day after the webinar, the same topic came up in conversation with a senior solution design executive from a leading service provider. The individual mentioned that entry level positions continue to join at roughly the same salary level as five years ago and wage inflation is not nearly as dramatic as it may seem. However, she pointed out that the price for leadership is going up rapidly (luckily, this is a small sub-segment of the cost structure).
This underscores an important fundamental: supply and demand and how small changes in both can have big impacts. In short, demand for offshore resources is growing at a slower rate at exactly the same time that education systems are producing increasing amounts of resources. Further, training efforts aimed at increasing employability of graduates are slowly demonstrating impact. My prediction is that with the combined impact of slowing growth in demand and increasing supply of resources, we will see very little increase in the cost structure from offshore locations over the next 5 years (and this is before considering the impact of exchange rates). Yes, leaders (scarce resources – completely different supply-demand curves) will continue to become more and more expensive, but much of the cost structure will stay roughly the same.
Looking at this another way, the entire offshore/nearshore delivery ecosystem providing export services (India, China, Philippines, Mexico, Malaysia, Poland, etc. serving the United States, United Kingdom, Netherlands, Australia, etc.) is only a little over 4 million people on a global basis. In the grand scheme of things, this is a really small labor pool and the ability to create excess supply from the 6 billion humans across Asia, Latin America, and Africa is tremendous – we are not in a supply constrained situation, but rather a demand-constrained scenario. SaaS, cloud, BPaaS, etc. only further suggest the potential for moderated demand for offshore resources.
I understand why people are concerned about cost increases and indeed some costs are increasing and some have increased significantly, but we are a long, long, long way from fundamental shifts in cost structures.
For those tracking the global service market, reports of 10-15% salary increases in low-cost countries is almost expected. For executive management not familiar with the offshoring of services, seeing these headlines in the business press is unnerving.
But should it be?
I am not arguing that wage inflation in low-cost countries is equal or lower to high-cost countries, but it is clear to me that those in high-cost countries significantly lack perspective on how to interpret these numbers.
Let’s start with a simple exercise (yes, you can count this towards your daily mental fitness goals).
First, recall your starting salary out of college.
Second, recall your salary in the fifth year of being in the work force (the fifth year is fourth salary increase if you received increases annually). If your salary changed currencies or you jumped to business school, you are disqualified from further playing this game.
Two numbers…now divide the fifth year salary by the first year to get a ratio (this should be greater than 1.0 and generally less than 3.0).
Now compare against the table below to get the annual percent increase in your salary across those five years. For example, if the ratio is 1.5, then the average annual increase was 10.7%.
|Ratio||Annual % increase|
Most people find the annual percent to be higher than they expected. And often surprisingly close to the typical reported increase in offshore salaries.
Why? The perspective that most people miss is that the growth in salary for an individual is different than pure salary inflation. Salary growth of an individual reflects both pure salary inflation (what an entry-level developer will earn) and the impact of their career progression (being able to deliver more value). In other words, salary growth also reflects being paid more for playing a slightly more valuable role – even if that does not include a formal promotion.
This picture becomes even more skewed if you consider total compensation (salary and bonus), which tends to grow even faster early in a career.
Many of you are probably now thinking, “Wait, my salary has not been growing that fast recently!”
True – and salary growth in percentage terms slows as individuals reach 10, 15, and 20 years into their careers. Much of the growth in salary in the early portions of the career is due to steady progression in being able to play a more valuable role – taking greater ownership, requiring less quality review, increasing domain knowledge, and other factors. But the benefit of further increasing these skills diminishes beyond a certain point, and salary growth is then predicated on other factors such as impact, leadership, and overall labor market rates for fully developed skills.
These same things are at play in offshore labor markets and much of the labor force is in the first 5-10 years of their careers due to the labor pyramid – so much of the workforce should be seeing “high” salary increases. At more senior roles, salary increases tend to moderate on a percentage basis.
Give this exercise to others – and potentially to that executive who feels 10% salary inflation is far different than what happens in the United States.
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: