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30 Chartpack

Rethinking the model for


offshoring services

BPO providers often rely on a limited number of geographic locations, exposing


themselves to unnecessary risk. They can mitigate these risks in the same way that
financial managers do—by diversifying their holdings.

Tor Mesøy, Barnik The outsourcing and offshoring industry is at a concentration may result in lower labor costs at the
Maitra, and turning point. What began as a small-scale sector outset, the overall risks are higher, according to
Matthias Daub dedicated to application development, accounting, our research. The same is true on a microlevel: our
and payroll has become, as of 2008, an $80 billion data show that when a delivery center in a large
global industry, addressing a range of business Indian city grows beyond 3,000 employees, costs
processes and technology services. As the IT ser- spiral and performance begins to deteriorate.
vices and BPO industry matures, however, chal-
lenges are emerging. Offshore service providers can mitigate these risks
in the way a financial manager would—by diversi-
Our research finds that more that 70 percent fying their holdings. While diversification has long
of offshore delivery centers, including both wholly been the rule for investment decisions, outsourc-
owned captive operations as well as vendors, ing providers were under little pressure to change
narrow their global operations to just three loca- their lowest-cost-country approach until recently,
tions, often situated in only two countries when rising volatility in many favored offshoring
(most frequently India, China or the Philippines). markets began to impair providers’ ability to
This reliance on a limited number of geographic predict costs and manage talent needs. As a result,
regions—historically driven by the availability of many are looking to address these vulnerabilities
highly skilled, low-cost labor in these areas—is while still reaping a cost advantage.
exposing providers to a variety of location-specific
risks. These include abrupt currency and wage Offshore delivery centers can accomplish this goal
fluctuations, intense competition for employees, by diversifying their operations in two ways: on
and regulatory limits. While a narrow geographic a macrolevel, by expanding their global footprints
31

to reduce overconcentration in any one region; and global companies a sharper edge in this period of
on a microlevel, by broadening the range and rapid change. The remainder of the article and
scale of activities conducted in any one center. The exhibits that follow illustrate the benefits inherent
result is a network approach to offshore delivery in moving to this new model.
management that features centralized global deliv-
ery hubs and decentralized local or specialized The benefits of a portfolio approach
MoBT 16 service spokes. This next-generation model not The underlying volatility of today’s markets makes
Offshore networks only improves overall global delivery but also planning more difficult, particularly in the cost-
Exhibit 1 of 5 brings greater predictability to cost management sensitive IT and BPO service industry model. With
Glance: One Paris-based company offshored
while fostering betterhigh–end IT services
coordination, work across
flexibility, several locations,
increasing seeking
pressure on margins,to service
minimize expo-
centers
sure to geographic, currency, and labor issues.
and responsiveness—characteristics that can give need to anticipate changes in costs—and avoid
Exhibit title: Why diversify

Exhibit 1
A location portfolio buffers the effects of structural volatility . . .
Why diversify
Potential IT services center locations, number of employees, and IT specialist annual wage1
One Paris-based company
offshored high-end IT services 100
France Romania
across several locations, Lille 300
$40,000 Iaşi
seeking to minimize exposure
Paris $25,000
to geographic, currency, and
labor issues.

1,300
India
Egypt
$20,000
300
Cairo Bangalore
$20,000

. . . which decreases overall risks while still enabling significant cost savings
Risk and wage development for IT services center, single location vs portfolio

Wage development1 Level of risk for portfolio2

Paris (home base) $45,000 Offshore location only in Bangalore 3.77

Offshore in Decreased talent risk –0.42


$20,000
Banglalore only

Portfolio Less currency volatility –0.36


$25,500

Improved business environment –0.23


–56%
Portfolio of offshore locations
–43% (Bangalore, Cairo, Iaşi, Lille) 2.76

–27%
1Based on weighted average wage, 2008.
2Uses weighted average risk values for portfolio, plus additional synergistic effects of currency volatility and talent risk.
32 McKinsey on Business Technology Number 16, Summer 2009

sharp movements in local market conditions (such that offer more stable economic profiles or whose
as higher wages, labor shortages, and inflation). market movements counteract those of the original
Such swings have been particularly marked in pre- location. Doing so allows companies to hedge their
ferred offshoring destinations such as India, exposure to risk and makes managing costs more
where the economics of doing business were signi- predictable. Such considerations form the basis
ficantly altered in the space of the 15 months of strong portfolio planning.
between January 2008 and March 2009. Over that
period, the rate of wage inflation fell by eight The following composite example illustrates how
percentage points (to 4 percent), the US dollar rose one company, based in Paris, used this strategy
32 percent against the rupee, and employee to its advantage (Exhibit 1). The company was
turnover declined by 15 percent. These double-digit looking to offshore 2,000 specialized, high-end IT
MoBT 16
swings would have wreaked havoc on any cost jobs and initially planned on sourcing the entire
Offshore networks
projections and have made planning quite tricky. project in India. It opted for an alternative scenario,
Exhibit 2 of 5
however, after running the numbers as part
Glance: Nontraditional offshoring locations offer trade-offs between cost and risk.
Delivery centers can ease the planning burden by of its due diligence. With a view to minimizing its
Exhibit title: Considering the options
adding other geographies to their portfolios—ones exposure to geographic, currency, and labor

Exhibit 2
Considering the Risk rating1 for business process offshoring (on a scale of 1 to 5, where 1 = “attractive” and 5 = “unattractive”)
options 4.5

Nontraditional offshoring Ukraine


locations offer trade- 4.0
offs between cost and risk. Russia
3.5
India
Southeast Asia2 Romania
3.0
Egypt Brazil
China
2.5 Poland
Czech Republic
2.0 Malaysia

1.5

1.0
US Midwest

0
5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000 45,000

Fully loaded cost per FTE,3 $ per year

1Composite assessment of investment risk, security environment, threat of disruptive events, regulatory risks, data security, quality of
infrastructure, and extent of government support.
2Southeast Asia represents average values for Indonesia, Philippines, Thailand, and Vietnam.
3FTE = full-time equivalent; fully loaded cost includes wages plus costs such as telecom, infrastructure, and overhead.
Rethinking the model for offshoring services 33

An enhanced North America China, India South America Southeast Asia


menu of location • T he
midwestern United States • Large,multiskilled talent pool • A rgentina and Brazil have • Philippinesfeatures strong
can provide high-quality different risk profile and English-speaking talent pool;
choices services, reflecting shared
• Highconcentration of research
infrastructure specialties; potential for voice services
universities
language and culture European languages • Malaysian government active in
• Potential for scale centers
• O ffers
access to large market, • Potential
for same-time-zone cultivating strong research base
• I T
services are special focus
proximity to customer base, support for local subsidiaries • V ietnam
and Indonesia
and presence in United States area for Chinese government
continue to be attractive low-
North Africa cost locations
Eastern Europe • Low-cost countries, such as
• S trong specialist and multi- Morocco and Egypt, feature
lingual talent base, excellent government support, improved
infrastructure technical skills
• Multitieredmarkets within close • O ffer
potential source for
proximity to one another, balancing other, more
offering high-, medium-, and saturated, scale locations
low-level skill sets

issues, the company tiered the work across several high-quality talent. Yet markets such as Egypt,
locations, placing roughly two-thirds of the South America, and Southeast Asia have been on
project in India and splitting the remaining third the map for some time as viable offshoring loca-
across three other regions. It kept 100 jobs in tions. For scale-oriented delivery services, their
Lille, France, and nearshored 300 more in low-cost comparable cost and risk structures make them
Romania, because of the proximity of these attractive alternatives to heavily penetrated coun-
locations to European markets. A further 300 were tries like India (Exhibit 2). By tapping into non-
placed in Egypt, where government programs traditional destinations, companies may succeed in
have substantially broadened the talent base. The achieving a comparative cost advantage versus
company then housed the remaining 1,300 roles the competition. Qualitative factors—such as time
in Bangalore. By diversifying in this way, the zone, the suitability of the local skill base, the
company significantly lowered its overall portfolio region’s proximity to key customers, and the exis-
risk while incurring only marginally higher costs tence of government initiatives—also play an
than it would have under the all-India approach. important role. Although Eastern European coun-
tries are more expensive, for example, they bring
A qualitative and quantitative advantage strong specialist talent, the requisite language
In popular offshoring locations, processing centers skills, and excellent infrastructures; these factors
are often pitted against one another in the war may often compensate for the higher cost.
for talent—a battle that often results in higher wage
and recruitment costs for delivery centers. A Diversifying on a microlevel
diversified location portfolio acts as a buffer against Government initiatives have enhanced the service
talent shortages while expanding access to a options available for companies looking to
broader range of business, technical, functional and choose an offshoring location (see sidebar, “An
domain skills, languages, and other competen- enhanced menu of location choices”). Some
cies. India, for instance, remains a top offshoring emerging markets, such as India and Malaysia,
destination because of its reputation for low-cost, are becoming attractive R&D locales as a result
34 McKinsey on Business Technology Number 16, Summer 2009

MoBT 16
Offshore networks
Exhibit 3 of 5
Glance: Companies that leverage the full breadth of the talent pool improve the performance of their offshoring centers.
Exhibit title: An integrated service model

Exhibit 3
An integrated Offshoring service centers, average cost, $ per FTE1 per hour
service model Data entry Transaction processing

Companies that leverage the Nonintegrated 7.96 9.19


full breadth of the talent
Integrated 6.24 8.09
pool improve the performance
of their offshoring centers.
–22% –12%
1 Full-time equivalent.

of a concentration of elite universities and public– there is a tipping point, after which disecono-
private research parks. These locations offer mies emerge based on the size of the available talent
specialized pockets of talent and subject matter pool and the need to fill more seats with increas-
expertise. Despite these opportunities, many com- ingly scarce and therefore more expensive talent.
panies tend to focus on “transaction only” centers—
those that cater to basic needs such as data entry, We found that when centers in Hyderabad and
simple payroll processing, and account documen- Bangalore grew to around 2,000 to 3,500 seats, for
tation. This narrow scope can cause a center’s instance, their cost performance began to dete-
overall performance to deteriorate over time, since riorate. To counter this, companies should assess
competitors often converge in similar markets their own performance profiles and scout new
and draw down the available talent pool. locations before their existing centers grow too
large. As Exhibit 4 shows, having multiple
As a result, it becomes important for companies to locations versus one or two megacenters not only
diversify on the microlevel as well. By expanding maintains the right cost–performance balance,
the range of work conducted in centers to include but also helps to foster network effects.
higher-level skills, such as market research and
analytics, delivery centers can limit their exposure A next-generation strategy for offshore
in any one competency and provide more attrac- operators
tive career choices—improving employee retention When a provider has only three outsourcing centers,
and lowering costs. Our data indicate that those it is easy to consider them as separate entities.
outsourcers and offshorers that leverage different Yet the use of multiple sourcing locations can create
types of talent within an integrated service model valuable network benefits in the form of improved
(often called a center of excellence) can achieve governance, process standardization, workflow
cost savings of 12 to 22 percent over those of their transitions, and contingency planning. When coor-
transaction–processing-focused peers (Exhibit 3). dinated well, the whole can be greater than the
sum of its parts.
The limits of scale
A center’s performance generally improves with One service provider, facing too narrow a concen-
scale, but there are limits. Our research into more tration of geographies, skill sets, and centers,
than 80 offshore service centers in India shows sought to create a next-generation global delivery
Rethinking the model for offshoring services 35

model (Exhibit 5). Before the change, it operated At the same time, the company decentralized
a cluster of centers in India and China. These its software-development labs, creating a network
free-standing units managed everything from HR of competence centers around the world, each
to service delivery at the center level. The result specializing in a specific product line or software
was unnecessary duplication of activity and poor capability. These centers integrated a mix of
coordination between locations. In addition, a high-level skills—including product R&D and
few centers were highly skilled in some applications, system programming, along with more basic
but because competing projects stretched exist- tasks—in order to boost productivity and volume.
ing resources and slowed development time, the
provider was unable to leverage and channel This new structure yielded several benefits. Con-
the right skills for the appropriate tasks. To address solidating core operating functions eased the
these issues, the provider moved to a global oversight burden, allowing management to focus
network approach with global operations hubs its attention on high-level issues, while enabling
delivering finance and accounting, HR, and individual centers to cooperate on day-to-day
MoBT 16 customer service in four locations in Asia, Eastern matters more directly. This new approach allowed
Offshore networks Europe, North America, and South America. These the company to standardize processes, estab-
Exhibit 4 of 5 facilities managed global back-office functions lish common frameworks, enforce best practices,
Glance: Companies must onsearch for new locations and set up new centers
a centralized basis, eliminating redundancy and proactively, before the
improve delivery performance
speed, of existing
and streamline process
centers deteriorates. improving knowledge sharing across the network. handovers for round-the-clock global coverage in
Exhibit title: The tipping point

Exhibit 4
The tipping point Comparative costs for offshoring service centers at scale

Companies must search for Cost,1 $ per work hour


new locations and set
120
up new centers proactively,
before the performance of
existing centers deteriorates. 100 Bangalore

80

60

Hyderabad
40

20

0
200 2,000 4,000

Center size, number of seats

1 Logarithmic scale.
36 McKinsey on Business Technology Number 16, Summer 2009

MoBT 16
Offshore networks
Exhibit 5 of 5
Glance: One provider sought to create a next-generation global delivery model by allocating work dynamically.
Exhibit title: International distribution

Exhibit 5
International International distribution of development and back-office work, disguised example of software and services company

distribution Operations hub for finance and accounting,


Internal marketplace distributes HR, and customer service/telesales
work among centers Development labs
One provider sought to
create a next-generation global Standardized governance and
processes allow for fast
delivery model by allocating
integration of new centers
work dynamically.

Germany Czech Republic


Canada
Bulgaria China
United States France
United States Japan
(West Coast) Israel
(Northeast)

India

Singapore

South America

the global operations hubs. Meanwhile, the decen- outsourcing sites concentrated in China, India, and
tralized spokes (the company’s network of the Philippines. But with the wider economy
specialized development labs) focused on develop- poised for what will likely be a sustained period of
ing specialist skills to enhance innovation underlying market volatility, financial and struc-
speed and superior project delivery for high-end tural risks are rising. As the industry matures, so
IT projects. These changes combined to lower too must its service model. To sustain future
costs and improve performance. growth, providers need to create a network of off-
shore centers to diversify their risk and provide
Global service delivery for business and tech- greater management flexibility.
nology services is gradually coming of age. The
operating model of service delivery centers
has traditionally benefited from low labor costs at

Tor Mesøy (Tor_Mesoy@McKinsey.com) is a principal in McKinsey’s Oslo office, Barnik Maitra (Barnik_Maitra@
McKinsey.com) is a consultant in the Delhi office, and Matthias Daub (Matthias_Daub@McKinsey.com) is a consultant in
the Frankfurt office. Copyright © 2009 McKinsey & Company. All rights reserved.