Rising Costs Threaten India's Hold on Offshore IT

Wednesday Feb 8th 2006 by Sharon Gaudin
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Escalating labor costs in India are forcing companies like SAP to look elsewhere for low-cost IT workers. How will this affect the offshoring giant and the U.S. businesses doing work there?

The increasing costs of offshoring IT work to India will have many U.S. companies checking out alternative low-cost, skilled labor sources like China and The Philippines -- as early as later this year, according to industry analysts.

Salary levels for IT workers in India have gone up 10 percent to 15 percent just over a year ago, say observers. Companies that have opened IT shops and offices in India already are feeling the pinch of the price increase, while companies that are offshoring their work through third-party service vendors in India will begin to feel the difference in their wallets by later this year.

The price differential between IT workers in the United States and their counterparts in India is five fold today, says Frances Karamouzis, a research director with Gartner, Inc., a major industry analyst firm based in Stamford, Conn. Within four or five years, she says that differential will have dropped to three fold, or maybe even as low as two fold.

And if the huge cost savings in IT labor is taken out of the equation, could India, now an offshoring powerhouse, lose its premier standing in the global software development market? And how will this affect U.S. businesses that are having IT work done there?

''India is still a very competitive price structure today,'' says Karamouzis. ''Are prices going to continue to go up and will that [labor cost] gap close? Absolutely. People are going to have to justify their use of India beyond the cost to make it a worthwhile endeavor... A lot of companies have looked at other countries but it's been more for an evaluation process. They're not confirming with their pocketbooks yet, but they will.''

SAP AG, a giant in the business software market, is one of the companies that will be looking for alternative sources of cheap and experienced programmers.

Just last week, Henning Kagermann, chief executive officer of SAP, which is based in Germany, reportedly told the German edition of the Financial Times that rising personnel costs in India are forcing him to start looking to other countries. ''India is slowly getting expensive,'' he is quoted as saying. ''We have decided to hire a certain number there, and then start looking at other locations.''

SAP spokespeople did not return several calls but reportedly have said they are likely to cast an eye to doing work in China and Eastern Europe. They might have less competition for skilled high-tech workers there. In India, on the other hand, the company has to compete with Microsoft Corp. and IBM, along with major India-based IT service companies, like Tata InfoTech, Infosys Technologies, Ltd. and Wipro Technologies.

Dell, the world's largest computer maker, is undeterred by the competition or the rising cost of doing business in India. The company announced last week that it is setting up its fourth call center, and executives are looking for land to build a manufacturing plant there, as well. Dell, which also has software developed in India, already employs 10,000 workers there.

''We still continue to see a very, very big uptake in India,'' says Karamouzis. ''The pipelines are very robust. We actually do polling every three or four months and ask people if they're going to increase their level of spending there. [They tell us] there are plans to increase it anywhere from 10 percent to 30 percent this year.''

India Remains Strong

There are several reasons why that kind of money is still flowing into India's IT sector.

One factor is that Indian IT service providers are sucking up the higher labor costs and not passing it along yet to their customers, says Karamouzis. ''It's a high-growth market and they're much more interested in revenue and market share so they are willing to forgo a small amount of profitability to grow their brands and their client base,'' she explains.

Brian Rogan, a senior vice president at Sierra Atlantic, an outsourcing company based in Fremont, Calif., says their rates for work done in India have remained flat over the last three years. ''There has been an increase in wages,'' he says. ''It's been for more highly skilled workers. We counter that by hiring new recruits out of university. One almost offsets the other. It's specifically aligned to our clients' needs, but it also does keep the salaries at a consistent rate.''

And Patni Computer Systems, Ltd., an IT services company based in Mumbai, India, also is trying to hold prices steady for its outsourcing customers, despite the rising labor costs. Tony Viola, director of business strategy for Patni, says a junior-level programmer with no specialty would have earned $12 to $15 an hour several years ago. Today, the same level of programmer would earn $15 to $18 an hour.

Viola, though, says the higher costs are offset by the increasingly mature skill base that India is able to offer.

''I would say that five or six years ago, you probably couldn't find that many skilled specialists in India,'' adds Viola. ''First of all, a lot of that work was still being done locally. The offshore model at that time was still unsophisticated... It's another thing to understand today how to Web enable [an application], how to connect it to middleware and how to make it work with legacy applications.''

Ashutosh Sheshabalaya, a former journalist and technology consultant who heads Allilon, an IT services firm in Europe, says the rising personnel costs in India are only to be expected.

''First, everyone went to India for cost. Then they went for value,'' says Sheshabalaya, who, in 2004, authored Rising Elephant a book about offshoring U.S. IT jobs. ''Now the shift is towards quality, to integrate into the frontiers of high quality, and you pay a price for this, especially given the sheer pervasiveness of India in the world IT scene.''

While prices may continue to rise in India, Sheshabalaya says he doesn't believe there will be a spike in cost. He bases part of that belief on the amount of inter-state competition in the country. He notes that as pay scales rise in hubs like Bangalore and Hyderabad, other regions have entered the IT services market, bringing more lower-wage jobs to the table. And he adds there simply is a great influx of new IT workers hitting the Indian market. In 2005, India had 250,000 engineering graduates, according to Sheshabalaya. Last year, 450,000 students enrolled in four-year engineering courses, so that means by 2009, there will be a near doubling of newly available engineers.

Read on to find out what the alternatives are for companies looking to offshore elsewhere.

Considering Alternatives

While India remains a source for increasingly skilled workers who earn a fraction of what their Western counterparts take home, many companies will see the rising wages there as good reason to look elsewhere for IT services.

Some analysts say wage increases will become more apparent in companies' wallets later this year, forcing them to consider alternatives for offshoring. Eugene Zakharov, director of professional services for Technology Business Research, Inc., a firm based in Hampton, N.H., says that shift already has started to happen.

''It's making many companies look at other locations,'' says Zakharov, who adds that companies may set up new deals or open new offices in other countries, but he doesn't see many companies pulling out of India in one fell swoop. ''India is not the only offshore possibility. There's The Philippines, and China is one of the more popular locations for offshore developing and engineering work.''

But other countries have their own hurdles for foreign companies to climb over.

A number of companies are checking out China, with its large labor pool and educated workers, as a growing source of offshored work. Peter Ryan, an outsourcing and offshoring analyst with Datamonitor, an analyst house based in London, says some IT executives are approaching China cautiously because of its lack of intellectual property rights, its problems with software piracy, and its smaller base of workers who speak English.

''Are they at a point where they need to be with their Western language skills?'' asks Ryan. ''I'm not sure they are. And China, to a very large degree, has not yet absorbed Western business practices like they have in India... It can be very trying to work with the government.''

But Ryan also is quick to add that China is still worth a good hard look.

''I'd say China's pros outweigh the cons,'' he says. ''The pros are a scalable labor force, a strong emphasis on engineering and information technology, and there's a desire there to develop outsourcing as a sector and work with Western companies.''

Ryan says companies also might consider doing work in South Africa, which has a 'high degree of commercial sophistication' and a strong understanding of Western business practices.

However a surprise player in the offshoring market just might be Egypt, according to Ryan. ''Keep your eye out for Egypt, which has come on strong in the last few years,'' he adds. ''I went down there and was thoroughly impressed with what I saw. They have 200,000 university graduates coming out every year and 80,000 have engineering or IT backgrounds.''

In terms of players in the offshoring market, though, India remains the big dog on the block.

''I mean, really, in terms of IT, what's happening is people will still look at India because of the resources on the ground -- the labor force, the ability to set up shop quickly and the real estate market, which is still fairly fluid,'' says Ryan. ''You're still taking on a huge cost savings there. It's compelling enough still for U.S. companies to look at India as a serious option. The U.S. dollar has dropped over the last few years and Indian wages have increased, but we're still looking at a pretty wide gap.''

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