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Uncovering the Soft Costs of Offshoring

Submitted by Biplab Saha on Mon, 08/01/2011 - 9:45am.

This article is of use to companies that plan to offshore work and also to offshore service providers (vendors) who can use the observations to improve their engagement with prospective clients.


Offshore outsourcing has transformed the way U.S. companies do business, and McKinsey predicts global offshore outsourcing spend to hit $110bn by 2010. The attraction to offshore outsourcing is primarily the cost savings that happen due to it. However, many companies fail to recognize that there are additional soft costs that need to be incurred over and above the direct contract cost of the offshore outsourcing engagement and these costs can undermine the success of the engagement, if not factored in at the start of the process.

These soft costs include time involved in vendor selection, process transition, training and monitoring operations in offshore locations, and in overcoming the challenges of working in a foreign country including communication challenges, low-skilled workforce, unfamiliar laws and regulations, and infrastructure constraints. These factors directly affect the outcome of the offshoring process, and along with the direct contract cost constitute what can be termed as TCO – Total Cost of Offshoring. Investment in these needs to be made upfront, even before the actual work gets underway.

This article analyzes the soft costs mentioned above and recommends that companies budget for these in advance to make their offshore outsourcing endeavor truly successful. It also tries to bring up some reasons for failure or mid-way abandonment of offshoring engagements and suggests ways to overcome them.

Cost of Vendor Evaluation & Selection
The first step in an offshoring endeavor is to determine which functions are best suited for offshoring. While some tasks can be performed efficiently even when done remotely, other tasks may necessarily need a face-to-face interaction. In their article “The Rise of Offshoring – It’s not wine for cloth anymore” Gene Grossman & Esteban Rossi-Hansberg of the Department Economics, Princeton University, share the paradigms set forth by various scholars to classify tasks on these lines. For example Edward Learner & Michael Storper distinguish between tasks that require codifiable information and those that require tacit information. The former can be done remotely because they can be expressed as a set of symbols, be they mathematical, linguistic or visual. The latter non-codifiable tasks require that both parties have a broad common background to “know” each other well enough; the doer needs to interact face-to-face with the receiver of the service to perform such tasks.

After determining whether the function in question is amenable to be offshored, the next step is to identify vendors that can match your needs by defining the relevant skills and experience needed for the function being offshored. After this a first cut analysis of the shortlisted vendors will need to be made. All these steps can cost anywhere from 0.2% to 2% of the Direct Contract Cost (DCC) because of the additional time incurred on the following activities:

  • Evaluation of the in-house functions to determine if they can be offshored
  • Documenting the specifications, skill-sets required and the scope of work in the RFP
  • Identifying potential vendors, sending out the RFP, and managing the responses
  • Bids evaluation and negotiation
  • Due diligence of the vendor capability
  • Travel expenses to the overseas location

The vendor evaluation and selection process may need an in-house resource working full time on this, in addition to other resources chipping in with time & domain expertise. Travel is recommended to get the actual feel of the vendor’s staff capabilities, rather than evaluating just the paper bids or basing it on your interactions with a limited set of people on the vendor side (usually the sales team and the operations head), and is an essential part of the due diligence process.

Cost of Transition & Training
The process of transition & training can take between 3 months to a year before work can be completely handed over to the offshore team. Typically this is the most expensive stage in the offshoring process and can cost an additional 2% to 3% of the DCC.

The costs here will typically be those incurred due to travel & temporary relocation of the vendor’s project team to the client’s office(s) in the home country, so that they can learn the intricacy of the functions from the in-house staff that has been doing them for years.
Also there will be a cost of reduced productivity of the in-house staff because of their time spent in training the vendor’s team. To offset the costs at this stage it can be negotiated that the cost of travel and relocation be borne completely by the vendor.

Cost due to lower productivity of the offshore workers
Once the project or function is completely offshored, you will realize that the offshore team lags behind due to a variety of reasons that range from work culture, lack of good understanding of the business of the company, bad ergonomics at the place of work, lesser work experience (staff of most offshore companies are typically graduates or post-graduates with 5-7 years experience as opposed to an average of 10-15 years in the US), long commute times to the place of work, underdeveloped civic amenities, unstable political environment, and many more. Therefore though you may paying say $10 per hour for an offshore worker as against say $40 per hour for an in-house employee, you can end up incurring twice the cost due to his reduced productivity. Hank Zupnik, CIO of GE Real Estate, who has overseen numerous projects outsourced offshore for over a decade, observes that because of these differences you cannot assume that one offshore worker can simply replace all the work done by one American worker.

Another reason for low productivity is the high turn over at offshore vendors. With attrition rate as high as 30% in some industries, companies spend time re-training everytime critical resources leave the vendor to join another offshoring outfit.
Thus it needs to be understood that lower productivity of offshore workers can offset the assumed savings by a factor of 3% to 10% of the Direct Contract Cost.

Cost of lay-offs & reduced output of in-house staff
Companies should also be ready to factor in productivity dips of the in-house staff after the offshoring transition has been completed. This is because of the low morale of the employees due to their colleagues suddenly losing their job, and extra workload on the existing in-house staff. The severance package of the laid-off employees also needs to be factored in the cost of the offshoring endeavor. Also some ex-employees may also initiate legal action against the company, thereby adding a legal expense to the cost of lay-offs.

Communicating with your current staff on the impact of outsourcing and planning ahead for redundancies that are necessitated after the outsourcing transition can avoid some of these costs.

Cost of managing the ongoing project
An offshore project needs to be managed differently than a in-house processes, and you may need to invest the time to develop a project plan; something that may not have been required all this while when it was an in-house processes. Once fully offshored, one of the key people you will interface with are the first level leaders of the team offshore; they may be called by various titles – team lead, tech lead or project manager. These people tend to be more technical or operational and less “project management” oriented – you cannot assume that they know “project management” the way you may envision it just because of their titles. Someone from your in-house staff, say the functional head or the department head will need to take on the additional responsibility of resource planning & allocation and management of the offshore team.

Over and above the direct project management cost, there’s a significant amount of time taken up in handling invoicing & auditing of the offshore work – e.g. ensuring that cost centers are charged correctly and manhours are appropriately recorded without inflating the hours. It is also observed that a 100% offshore model (all resources working from offshore) is very challenging for both the service provider and the client. Interactions and exchange opportunities are missing which often leads to functional, technical, and cultural misunderstandings. Frequent exchanges or a policy of maintaining 10-20% of the service providers team on your site is recommended.

Finally it will be realized that though vendors use certain standard baselines and assumptions when costing the project, there is a “scope creep” in most projects and the actual work varies from estimates initially provided to them. If the cost of the project is escalates due to this, the vendor will expect the client to bear the incremental cost.
Summarizing the above, the additional cost are those on account of (a) time invested in developing the project plan; (b) putting additional in-house manegerial resource to manage the offshore project; (c) accounting & auditing of the ongoing project; (d) having 10 – 20% vendor personnel onshore; (e) cost due to change (or addition) in scope of work during the project.

Cost due to upfront investment in infrastructure
Besides the manpower cost, there is a cost of infrastructure that may need to be installed or upgraded at both ends to facilitate seamless integration of the two work sites – the customers & the offshore vendor location. For example additional networking equipment may be needed to provide data connectivity between both sites. Or additional software tools or licenses may be needed the because, now there is an additional location (the vendor’s facility) and more often than not the same tools/licenses cannot be shared across two different locations. In some cases additional data communication costs may need to be incurred where companies have had to dedicate separate “communication pipes” in order to keep the offshore and local data bases synchronized. In addition, there is the cost of voice communication, video conferencing, e-mail and chat sessions. You need to measure the increase in communication cost to attribute the incremental additions to the total cost of offshoring (TCO).

While the vendor usually agrees to take care of the cost at their end, the company may need to absorb the cost of infrastructure at their end, unless the vendor agrees to invests in that too, and amortize its cost over the period of the contract.

Dean Davison; Top 10 Risks Of Offshore Outsourcing
Fleming Parker; Key Success Factors for Offshore Outsourcing to India;
Gene M. Grossman & Esteban Rossi-Hansberg (Dept of Economics, Princeton University);
The Rise Of Offshoring: It’s Not Wine For Cloth Anymore;
Dr. Joe Greco; The Hidden Costs in Offshore Outsourcing – a Case Study;
M.M.Sathyanarayan; How to Determine True Business Value of Offshore Outsourcing;

Stephanie Overby; The Hidden Costs of Offshore Outsourcing; Sep. 1, 2003 Issue of CIO Magazine

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