IT Offshore Outsourcing in China: Costs, Risks, and Strategic Benefits Minder Chen George Mason University MSN-5F4, 4400 University Dr. Fairfax, VA 22030, U.S.A. mchen@gmu.edu 1-703-993-1788

Why China? An IDC study found that China's offshore outsourcing revenue is $932.8 million US dollars in 2005, an increase of 55.6% from 2004. This is only about 2.3% of the worldwide IT outsourcing market. The compound annual growth rate (CAGR) is estimated about 41.2% (IDC 2006). 61% of the offshore outsourcing business in China comes from Japan while only 20.4% comes from Europe and United States. Embedded software is an important part of China's offshore outsourcing business. China has the opportunity to take a leadership position in open source software related outsourcing projects due to Chinese governments' incentives in deploying open source solutions (Li et al. 2004).

Outsourcing in China $932.8 million US dollars in 2005, an increase of 55.6% from 2004

Global Outsourcing Opportunity Rating Minevich, M. and Richter, F.-J., Global Outsourcing Report 2005, Going Global Ventures Inc., New York, March 2005.

Global Outsourcing Index (GOI) Cost: The cost factor, which includes compensation and wages, infrastructure cost, and tax and regulatory cost, makes up 30 percent of the GOI. Risk: Every country possesses its own strengths and weaknesses, risks and rewards. The Overall Risk Rating, which makes up 54 percent of the GOI, aggregates a variety of risks every potential outsourcer must take into account: Geopolitical risk (10% of GOI) Includes stability of government, corruption, geopolitics, security. Human capital risk (10%) Includes quality of educational system, labor pool, number of new IT graduates. IT competency risk (10%) Includes project management skills, high-end skills and competence (custom code writing, system writing, R&D, business process experience). Economic risk (6%) Includes currency volatility, GDP growth. Legal risk (6%) Includes overall legislation, tax, intellectual property. Cultural risk (6%) Includes language compatibility, cultural affinities, innovation, adaptability. IT infrastructure risk (6%) Includes IT expenditure, quality of key access infrastructure. Market Opportunity Rating: This number, which makes up 16 percent of the GOI, includes expert third-party analysis of each country, its global competitiveness and IT market share. The rating serves as a check on any imbalances elsewhere in the report.

http://www.cio.com/archive/071506/2006_global_outsourcing_guide.pdf

Why China? (Continue) Software industry in China may also develop a strong presence in enterprise resource planning (ERP) and supply chain management (SCM) software due to China's dominant role in the worldwide manufacturing outsourcing. The central and local governments have invested in infrastructures and have also provided tax incentives to encourage the development of software outsourcing industry. For instance, close to two billion dollars have been invested to build the Dalian software park, located at the northeast of China, which currently houses 500 software firms (DLSP 2006).

Outsourcing Delivery Modes In-house: The IT jobs are done by in-house staffs. This is not outsourcing, but it provides a baseline for comparison. Onsite: Consultants of the service providers are working on the client sites. The consultants are sent by offshore service providers via some kind of "guest worker program". Near-site: Offshore service providers have offices to house their own developers at the nearby locations of their clients to facilitate better interactions with their clients. Near-shore: The service providers are outside the client's country within 1~3 time zone and are at most 4~5 hours away by flying. Offshore: Typically offshore means the service providers who are cross an ocean and 6~12 time-zone away from their clients.

Gartner, 2002.

Total Net Benefits TNB = TNB: Total Net Benefits from a outsourcing project LCihbi: In-house Unit Labor Cost for an i type of developer before outsourcing MHinbi: Man-hour required for type i developer before outsourcing LCihi: Unit Labor Cost for type i in-house developer after outsourcing MHihi: Man-hour required for type i in-house developer after outsourcing LCosi: Labor Unit Cost for type i outsourced developer after outsourcing MHosi: Man-hour required for type i outsourced developer after outsourcing RMTCj: Risk Mitigation Costs or Transaction Costs for activity j with outsourcing SBk: Strategic Benefits k with outsourcing

Total Unit Cost (per hour per person)

Some India firms now have a floor rate of $30~40 dollars. Labor Costs The relative low hourly rates of software developers in countries such as India and China have allured many firms to consider offshore outsourcing. A $100 an hour programmer in the US may cost only $20 (corporate-to-corporate rate) in Bangalore, India or in Beijing, China (Overby 2003). Some India firms now have a floor rate of $30~40 dollars. Costs for developers of different skill sets

Strategic Benefits Top IT Talents: There were 400 foreign funded R&D centers in China in 2004, an increase from 150 in 2002. Time-to-Market: Follow the sun model (Carmel 1998). One of the service providers we studied is capable of staggering time zones between its developer centers to create an 18-hour work day for its clients. Access to Growing IT Market in China Category China (FY 2003-2004) India (FY 2003-2004) Software Output 27 billion USD 12.8 billion USD Software Exports 2.8 billion USD 9.2 billion USD Domestic Market 24.2 billion USD 3.6 billion USD Source: Chinese Ministry of Information Industry and NASSCOM

IT Services Market?? Source: http://www.cio.com/archive/091505/nypro_sidebar_one.html

Source: http://www.cio.com/archive/090103/money.html                                                                                                                                                                           Source: http://www.cio.com/archive/090103/money.html

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Source: Feeny, D. and Willcocks, L. (1998) Source: Feeny, D. and Willcocks, L. (1998). Core IS Capabilities For Exploiting Information Technology. Sloan Management Review, 39, 3, 9-21. http://www.cxoeurope.com/images/figs/zoom/top03e18f1.gif

Best Practices: Management Of Offshore Outsourcing Geopolitical concern Does vendor offer: Does contract address: Type of management needed Labor pool: Availability, suitability, language, visas, education Best-of-breed vs. general-contractor comparisons Force majeure (French for "greater force") conditions Constant surveillance and management Political stability and risk Security Impact of failure on other services; potential for multiple failures Monitoring Proximity to domestic operations; time zones Multiple onshore and offshore resources Flexibility to allocate onshore and offshore resources; impact on costs; pricing transparency Load balancing Cost-benefit factors, including local tax credits, employment incentives, employee-or contract-termination costs Customer evaluation of vendor's choice of location for offshore centers Identifying and managing the risk of force majeure; state and governmental intervention in contract rights and operations Government relations in host country; process improvement; global innovation DATA: Bierce & Kenerson PC

The Challenges to Offshore Outsourcing Salary inflation: One service provider in China is paying a senior software engineers a monthly salary ranging from 1.2K to 1.8K USD in Beijing and it is paying a monthly salary is from 0.6K to 1K USD at its new development center in Yunnan Province's capital Kunming. Hidden Cost (Transaction Costs) Risk: travel expenses telecommunication costs contract and project management costs transition costs for hardware and software redeployment employee attrition.

The Challenges to Offshore Outsourcing Intellect Property Risk: Set up business entities in foreign countries such as United States so that their clients' IPRs are protected by the US IPR laws. Service providers at the request of their clients can purchase comprehensive professional liability insurance, also known as Errors and Omissions (E&O) insurance, which may include Intellectual Property Liability Coverage (TechInsurance 2006). Service providers should implement extensive security procedures including physical and information security to ensure that the critical information and code of their clients are safe-guarded. Outsourcers can also parcel out their jobs into modules to multiple vendors to prevent any one of their service providers knowing too much about their "trade secret". However, this approach requires a very modularized architecture design.

The Challenges to Offshore Outsourcing Communication Risk Language skill and culture differences will also add to the communication risk. English language skill is considered to be a disadvantage for Chinese outsourcing firms working with English speaking clients. Outsourcing clients may need to spend more time and money in documenting their requirements and specifications in much detailed fashion to reduce the communication risks with their service providers. Some researchers are promoting the use agile methodologies a which encourages more frequent feedbacks between service providers and clients to facilitate better communications (Ambler 2005).

Challenges to Service Providers IP Protection Process Maturity Recruitment & Training Hidden Cost English Language Skills

Potential Research Model Outsourcing Labor Cost Saving Total Outsourcing Costs - + - Transaction Costs Realized Total Benefits + Risk mitigation costs + + + Perceived Benefits Perceived Risks

Future research Apply Supply Chain Model to Outsourcing Why are the differences between manufacturing, service, and IT outsourcing? Study human resource issues Recruiting, training, and retention. Impacts of government policies to outsourcing Competitive analysis between India and China Develop maturity models for both sourcing suppliers and clients and study their relationships to outsourcing success Virtual teams and collaboration technologies