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INTERACTIVE WORK SHEET
You can figure out
your own best and worst case scenarios for going offshore when you
calculate the costs for yourself. Use our online calculators.
Detailed version:
Use this to include the individual amounts to be spent in each category.
Summary version:
Use this if you want to enter one overall cost for the entire contract.
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Talk to David Raspallo
Outsourcing is a
tangled, more expensive web than you think. What are the real costs of
going offshore? David Raspallo, CIO of Textron Financial, knows. Until
Sept. 15, go to ASK THE SOURCE
to query him on offshore issues—costly and otherwise.
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Doing Your Offshore Homework
Offshore
outsourcing may save you money; then again, it may not. Rather than accept
offshore vendors' claims, you need to calculate your own ROI. Here are some
tips to get started.
1. Know what your internal costs are. If you don't know what your
own real labor rates are for accomplishing tasks you plan to send offshore,
how can you know how much you'll really save?
2. Ask your peers. Organizations such as the Society for Information
Management and CIO conferences are great places to get the real information
from peers who are outsourcing offshore.
3. Contact vendor references. Ask these CIOs what unforeseen costs
they've encountered in their offshore engagements.
4. Estimate potential soft costs. As much as possible, figure in
factors such as lower morale and cultural changes.
5. Create a three- to five-year plan. Include your identified hidden
costs as well as anticipated scope changes.
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The current stampede toward offshore outsourcing
should come as no surprise. For months now, the business press has been
regurgitating claims from offshore vendors that IT work costing $100 an hour
in the United States can be done for $20 an hour in Bangalore or Beijing.
If those figures sound too good to be true, that's
because they are.
In fact, such bargain-basement labor rates tell only a
fraction of the story about offshore outsourcing costs. The truth is, no one
saves 80 percent by shipping IT work to India or any other country. Few can
say they save even half that. As just one example, United Technologies, an
acknowledged leader in developing offshore best practices, is saving just
over 20 percent by outsourcing to India. (For more, read "Inside Outsourcing in
India.")
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Hank
Zupnick, CIO of GE Real Estate, found that because of cultural differences
you cannot simply replace one American worker with one offshore worker.
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That's still substantial savings, to be sure. But it
takes years of effort and a huge up-front investment. For many companies, it
simply may not be worth it. "Someone working for $10,000 a year in
Hyderabad can end up costing an American company four to eight times that
amount," says Hank Zupnick, CIO of GE Real Estate. Yet all too often,
companies do not make the outlays required to make offshore outsourcing work.
And then they are shocked when they wind up not saving a nickel.
In this article, we will explore a new TCO—the
total cost of offshoring. We will uncover all the hidden costs of
outsourcing—areas in which you'll have to invest more up front than you
might think, places where things such as productivity and poor processes can
eat away at potential savings, and spots where, if you're not careful, you
could wind up spending just as much as you would in the U.S. of A. (For more
on how to calculate your own TCO, see the worksheet "Do the Math"
on bottom of this page.)
"You can't expect day-one or even month-six
gains," Zupnick says. "You have to look at offshore outsourcing as
a long-term investment with long-term payback."
The Cost of Selecting a Vendor
With any outsourced service, the expense of selecting a
service provider can cost from .2 percent to 2 percent in addition to the
annual cost of the deal. In other words, if you're sending $10 million worth
of work to India, selecting a vendor could cost you anywhere from $20,000 to
$200,000 each year.
These selection costs include documenting requirements,
sending out RFPs and evaluating the responses, and negotiating a contract. A
project leader may be working full time on this, with others chipping in, and
all of this represents an opportunity cost. And then there are the legal
fees. Some companies hire an outsourcing adviser for about the same cost as
doing it themselves. To top it off, the entire process can take from six
months to a year, depending on the nature of the relationship.
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Ron
Kifer, VP of program solutions and management at DHL Worldwide Express, ran
into delays and additional costs in shifting jobs offshore when it took
longer than expected to install the necessary hardware in India.
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Vice President of Program Solutions and Management
Ron Kifer spent several months on vendor selection before contracting with
Bangalore, India-based Infosys to handle a whopping 90 percent of development
and maintenance work for DHL Worldwide Express, a shipping company.
"There's a lot of money wrapped up in a contract this size, so it's not
something you take lightly or hurry with," Kifer says. "There has
to be a high degree of due diligence making sure that the [offshore] company
can respond to your needs."
Even when there is an existing tie between customer and
offshore vendors, the expensive and lengthy step of vendor selection is a
must-do for successful outsourcing. The chairman of Tata Consultancy Services
(TCS), a Mumbai, India-based outsourcer, sat on the international advisory
board of Textron, a manufacturing company that owns such brands as Cessna
Aircraft and E-Z-GO Golf Carts, for several years. However, when David
Raspallo, CIO of business unit Textron Financial, began exploring offshore outsourcing
in 1999, he still spent five months doing what he calls "the usual Betty
Crocker Bake-Off" with service providers Covansys, ITS, TCS and Wipro.
Ultimately, he went with U.S.-based Covansys, which has three development
centers in India. Selecting the vendor took 500 hours in total, involved
Raspallo and three senior managers, and cost $20,000 in additional expenses.
At this stage, travel expenses enter the picture as well.
A trip overseas helps CIOs get comfortable with their choice. After all, offshore
vendors can send their best and brightest over for a dog and pony show, but
checking out the company on its home turf provides more insight. John Dean,
the CIO of Steelcase, an office furniture manufacturer, spent several
thousand dollars to send one of his IT executives to Intelligroup Asia in
Hyderabad, India, for a week before signing on the dotted line.
"You can read everything you want to read and ask
for advice as much as you want, but you have to make it a fact-based
decision," Dean says. "So it was important to visit India to
validate our thinking."
Bottom line: Expect to spend an additional 1 percent to
10 percent on vendor selection and initial travel costs.
The Cost of Transition
The transition period is perhaps the most expensive stage
of an offshore endeavor. It takes from three months to a full year to
completely hand the work over to an offshore partner. If company executives
aren't aware that there will be no savings—but rather significant
expenses—during this period, they are in for a nasty surprise.
"You have to bring people to America to learn your
applications, and that takes time, particularly if you're doing it with a new
vendor for the first time," explains GE Real Estate's Zupnick, who
maintains a handful of three-year contracts with offshore vendors, including
TCS and smaller vendor LSI Outsourcing. In GE Real Estate's case, the
transition time for each vendor was three months at the very least and up to
a year in some cases, in addition to the money-draining vendor selection
period of several months.
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"The vendors say you can throw offshore jobs over the
wall and start saving money right away. You have to build in up to a year
for ironing out cultural differences."
—HANK ZUPNICK, CIO OF GE REAL ESTATE
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Zupnick, who has seven years of offshore experience,
says most of his peers don't appreciate the time and money it takes to get a
relationship up and running. "The vendors say you can throw it over the
wall and start saving money right away. As a result, I've heard of CIOs who
have tried to go the India or China route, and nine months later they pulled
the plug because they weren't saving money," Zupnick says. "You
have to build in up to a year for knowledge transfer and ironing out cultural
differences."
CIOs must bring a certain number of offshore developers
to their U.S. headquarters to analyze the technology and architecture before
those developers can head back to their home country to begin the actual
work. And CIOs must pay the prevailing U.S. hourly rate to offshore employees
on temporary visas, so obviously there's no savings during that period of
time, which can take months. And the offshore employees have to work in
parallel with similarly costly in-house employees for much of this time.
Basically, it's costing the company double the price for each employee
assigned to the outsourcing arrangement (the offshore worker and the in-house
trainer). In addition, neither the offshore nor in-house employee is
producing anything during this training period.
But it has to be done. "We made a mistake in the
beginning of just packing up the specs and shipping them over, looking at it
from a pure cost standpoint," says Craig Hergenroether, CIO of
Barry-Wehmiller, a packaging manufacturer that has its own development
center, Barry-Wehmiller International Resources, in Chennai, India, and works
with other offshore vendors. "Silly mistakes were made because we didn't
take the time to have them come over. It's a false savings to keep costs down
by communicating only by phone."
During the transition, the offshore partner must put
infrastructure in place. While the offshore partner incurs that expense, the
customer should monitor the process carefully. Often it can take longer than
expected. "It took an awful lot of time to bridge the Pacific
[networking our company to the Indian vendor] and getting that to work
correctly," remembers Textron Financial's Raspallo, who spent six months
and $100,000 to set up a transoceanic data line with Infosys in 1998 for Y2K
work. It also cost an extra $10,000 a month to keep that network functional.
"You have to know hands down that the technology infrastructure you put
in place is fully functional and will operate at the same performance level
as it would if you were connecting to someone on the next floor. Otherwise,
you'll have a lot of costly issues to deal with."
DHL's Kifer had similar problems. Long lead times for
acquiring the necessary hardware in India delayed development work, he says.
The hardware holdup put off the start of offshore work for several months,
requiring DHL to continue to keep vendor workers employed onsite at the more
expensive rate.
During the transition period, the ratio of offshore
employees in the United States to offshore employees working at the vendor's
overseas headquarters is high. But after the transition is complete, CIOs
have to get those employees out of the office if offshoring is to be a
money-saving move. "It's got to be 80 percent or 85 percent working
offshore or the numbers just don't work," explains GE Real Estate's
Zupnick.
It makes sense for offshore service providers to place as
many of their employees in the United States as possible. The provider's
margins—already quite decent for offshore work (Indian companies charge
U.S. companies $20 an hour for an employee they pay around $10)—really
skyrocket when they're on American soil. "They make more money and often
the client feels better having them close," says Praba Manivasager, CEO
of Minneapolis-based offshore adviser Renodis. "But the customer
immediately loses all of the bill-rate savings." If not included in the
original contract, additional travel and visa costs also must be figured in.
Tally it all up and you will pay as much as you would for one of your own
employees.
It's a difficult area for CIOs to manage. Work is much
easier to do with offshore workers onsite, but to cut costs they must push as
much overseas as possible. Conversely, the more manpower based offshore, the
more project problems and delays. Barry-Wehmiller's Hergenroether says the
amount of workers you can reasonably send offshore depends on the type of
work being done. Industry- or company-specific system development requires
more developers onsite. Legacy maintenance or simple upgrades may not require
a soul.
"On some of our projects, up to 50 percent of
offshore workers are onshore; on others it's closer to 10 percent,"
Hergenroether says. In some cases—where specific skills are the reason
for offshoring—he may even bring in offshore talent over long term.
"But if you're going to do that, your cost savings diminish
dramatically," he says. In fact, there may be no savings at all.
Bottom line: Expect to spend an additional 2 percent to 3
percent on transition costs.
The Cost of Layoffs
Laying off American employees as a result of your
offshore contract poses other sometimes unanticipated costs. To begin with,
you have to pay many of those workers severance and retention bonuses.
"You need to keep employees there long enough to share their knowledge
with their Indian replacements," Zupnick explains. "People think if
they give generous retention bonuses it will destroy the business
proposition. They cut corners because they want quick payback. But then they
lose the people that can help with the transition and incur the even bigger
cost of not doing the transition right."
Layoffs can also cause major morale problems among
in-house "survivors," in some cases leading to disaffection and
work slowdowns. Companies with experience in offshoring factor productivity
dips and potential legal action from laid-off employees into the cost-benefit
analysis.
"You can never underestimate the effect these issues
will have on the success of [your offshore venture]," says Textron
Financial's Raspallo. CIOs must take time to communicate with their staffs,
being "brutally honest," he says. "If your intention is to lay
off some workers and move work offshore, let them know. If you want to move
legacy systems offshore and retrain staff for other systems, tell them that.
And constantly reinforce what the vision is."
Raspallo sets aside time for a monthly meeting with all
staff (offshore included) by video. "In the beginning, we spent the
whole time talking about the offshore proposition," he says. "If
you don't spend that time doing that, your staff is going to make up stories
about what's happening themselves."
Without this kind of effort, offshore endeavors are
doomed.
"Internal people will refuse to transition to the
offshore model because they have a certain comfort level, or they don't want
their buddy to lose his job," Renodis's Manivasager says. "There
has to be a mandate. Trying to build consensus can take a very, very long
time." Manivasager has seen some relationships take as long as three
years to get off the ground because the strategy was neither shared with nor
embraced by employees.
Bottom line: Expect to pay an extra 3 percent to 5
percent on layoffs and related costs.
The Cultural Cost
One of the biggest impediments to offshore savings is
productivity. "You simply cannot take a person sitting here in
America and replace them with one offshore worker," GE Real Estate's
Zupnick says. "Whether they're in India or Ireland or Israel."
One reason for that is the American workers' comfort level
with speaking up and offering suggestions. "A good American programmer
will push back and say, What you're asking for doesn't make sense, you
idiot," Zupnick says. "Indian programmers have been known to say,
This doesn't make sense, but this is the way the client wants it." Thus,
work takes more time and money to complete. And a project that's common sense
for a U.S. worker—like creating an automation system for consumer
credit cards—may be a foreign concept offshore. Additionally, offshore
vendors often lack developer experience (the average experience of offshore
developers is six years).
On average, IT organizations going offshore will
experience a 20 percent decline in application development efficiency during
the first two years of a contract as a result of such differences, Meta Group
Vice President of Service Management Strategies Dean Davison says. According
to Meta Group, lags in productivity can add as much as 20 percent in
additional costs to the offshore contract.
Another productivity killer is high turnover at offshore
vendors. Attrition rates climb as high as 35 percent in India, according to
the National Association of Software and Service Companies. "Unless you
can somehow address that in your contract, you're paying for someone to learn
your product and then they're gone," Zupnick says. Turnover can cost an
additional 1 percent to 2 percent.
Finally, communication issues can slow things to a halt.
"We had to do a lot more face-to-face interaction than originally
anticipated because [offshore workers] just didn't interpret things the same
way," says DHL's Kifer. "That resulted in a lot more travel there
or bringing them onshore to bridge that gap. We did that a lot more often
than the model would have prescribed." Language and other cultural
differences can cost an extra 2 percent to 5 percent, according to Meta
Group.
Bottom line: Expect to spend an extra 3 percent to 27
percent on productivity lags.
The Cost of Ramping Up
Well-defined and accepted internal software development
and maintenance processes are also key to making an offshore situation work.
"If you're an organization that develops and maintains by the seat of
your pants, or it's a case where Mary Jo and Fred have been here for 30 years
and they know how to do everything, you are in trouble," says
Raspallo, who currently sends 65,000 man-hours of work to India.
Raspallo spent five months and $80,000 in consulting fees
to get ISO certified in 1998, which puts his company at about Level 3 in
terms of his employees' "capability maturity" in developing
software. He also invested in an automated Web-based system to support the
new software development and labor management practices. Most of the Indian
offshore companies are ISO certified and at Capability Maturity Model (CMM)
Level 3 or 5. "If your own staff can't get used to working at that
level, you're going to have a major disconnect," Raspallo says.
If a company doesn't create solid in-house processes,
"the vendor will have to put more people onsite to compensate for your
inadequacies, and they'll spend all of your savings," says Meta Group's
Davison.
DHL America's IT department spent a full year to get to
CMM Level 2 in 2002. Kifer is aiming to be at Level 3 in the United States
this year, with the ultimate goal of achieving Level 3 across the entire
global IS team. "It's a big project, and it entails a significant level
of training and education," he says. "But if you're going to take
full advantage of offshore outsourcing, you have to raise your own maturity
level." Not everyone was gung ho about the new level of discipline
required, but Kifer lit a fire under them with annual bonuses tied to
certification.
The ability to write clear specifications is also
critical to achieving offshore savings.
"When you're doing this stuff internally, you tend
to be much more cavalier," says Hergenroether. "When you have to
package specs to go outside the company, that has to be done exceptionally
well." Creating a great spec package is costly and time-consuming. On a
1,000 man-hour project for example, Hergenroether's staff will spend 100
hours to create a spec package.
At the other end of the process is quality assurance (QA)
testing, an area which must become more robust in an offshore arrangement.
"We essentially picked up two shifts of people in India working while we
slept. The work we sent out at 4 p.m. came back to us at 10 a.m., and we
didn't have a QA funnel big enough to handle that," says Radio Shack CIO
Evelyn Follitt, who now hires more temporary QA staffers during development
time.
Bottom line: Expect to spend an extra 1 percent to 10
percent on improving software development processes.
The Cost of Managing an Offshore Contract
Managing the actual offshore relationship is also a major
additional cost. "There's a significant amount of work in invoicing, in
auditing, in ensuring cost centers are charged correctly, in making sure time
is properly recorded," explains DHL's Kifer. "We have as many as
100 projects a year, all with an offshore component, so you can imagine the
number of invoices and time sheets that have to be audited on any given
day."
At DHL, each project manager oversees the effort. He
audits the time sheets from the vendor and rolls the figure into an invoice,
which then has to be audited against the overall project, which is then
funneled to finance for payment. Kifer's staff has been a bit overwhelmed.
"We knew there would be invoicing and auditing," he says. "But
we didn't fully appreciate the due diligence and time it would require."
At GE Real Estate, managing the offshore vendor is such a
big task that Zupnick assigned someone to handle it on a half-time basis at a
$50,000 salary. The individual makes sure projects move forward, and develops
and analyzes vendor proposals against the RFPs when it comes time to bid out
new work.
"It's a critical job," Zupnick says.
"That's the price you have to pay to make this work."
Bottom line: Expect to pay an additional 6 percent to 10
percent on managing your offshore contract. 
Share your offshore outsourcing stories with Senior
Writer Stephanie Overby at soverby@cio.com.
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