“So really, when you get down to it, what is the actual cost of outsourcing?” The fact is that many buyers perform price calculations based on easy and quantifiable metrics that yield pretty graphs, but don’t give the total cost picture of what they’re getting into. And so they often receive nasty surprises six months into their outsourced project, when the numbers add up to more than they budgeted for.
If you’re a buyer who thinks your sourcing decisions should be based on the hourly wage rate, we’re here to tell you different. Labor arbitrage is an important component, but not the only component. Here are some of the main factors that contribute to the Total Cost of Outsourcing.
“Most clients truly underestimate the cost of governing their contract,” says Steven Hall, Partner and Managing Director of CIO Services at TPI. “They don’t realize how difficult and expensive it can be to manage that ongoing relationship – they think their procurement organization can handle it.” According to him, governance is typically 3-5% of the annual contract value (ACV). In terms of the potential savings from the project, managing your provider can eat up to 12% of the value, as Marty Pine, former VP of Strategic Sourcing at ACE Group told us last year.
Cost of the onsite team – Another cost of governing your provider that often goes unaccounted for is the onsite presence they require to liaise between your team and their offshore team. And here’s something many buyers don’t know: the vendor’s team onsite is paid the onsite rate, not the significantly lower offshore rate. In other words, the more presence you need onsite, the greater your costs will be. That’s a strong argument for Latin American outsourcing. “A typical farshore provider needs 25-30% of its people onsite in order to coordinate operations. But because of the time zone and proximity of the Nearshore, we can do with only about 8% of our team onsite, which significantly lowers costs.” says Leonardo Matiazzi, VP for International Business at Brazil-based Ci&T.
The outsourcing relationship
Long term benefits – Another hidden contributor to the TCO is the type of relationship you have with your vendor. The thing to remember is that a long term affiliation with continuous workflow is usually the cheapest option. Many buyers opt to issue an RFP and hold a bid for every outsourcing project, thinking that having vendors compete for each assignment results in lower costs. But if your pricing agreement is transaction-based or determined on a project by project basis, there is naturally a ramp-up at the beginning of each phase, and a ramp-down at the end, leading to a lot of time and resources wasted in adjusting service volumes. On the other hand if you have a long term relationship with your vendor, you can keep the same team working on different projects, one after the other, and channel demand and throughput better over time.
To a certain extent, we’re seeing this in the Nearshore. “Latin America has increasingly high contract renewal rates,” says Chris Nuttall, Managing Consultant at PA Consulting Group. “Vendors in the region get most of their organic growth from existing accounts, and not so much from new accounts.”
Changing service volumes – Nuttall also cautions buyers to be very careful in defining their service level to vendors. If you define a service level that is too high, the provider will build a solution around that, and over the long term it could be much more expensive than what you need. “The decision is between a fixed price model and a variable price model – it all depends on your volume certainty,” he says. “You pay higher premiums to the vendor for fixed price, but neither model is better. Buyers usually divide their contract or sourcing portfolio between the two, but often they’re not diversified well, and that bumps up their costs.” Changing the agreement later is also costly – vendors often make more money on modifications to the contract than they do on the original contract.
The importance of process – The productivity factor in the outsourcing operation is the one that almost every buyer misses. Never assume that sourcing productivity works on a 1:1 ratio. If it takes one person to perform a function in your company, that does not mean it will take one person to do it offshore. For everything except very complicated IT work, “it’s all about processes,” says Hall. “Until you have strong processes in place, you’re not going to achieve high levels of productivity.” Since it usually takes a while for the outsourcer to become well integrated into your organization, expect lower productivity for the first 12-18 months.
An important point to keep in mind is that when you outsource to the farshore, you need ‘heavier’ processes than for the nearshore, which means more documentation and quality specifications. “Usually the buyer and the provider each have their own team understanding these documents, so it greatly decreases productivity,” says Matiazzi. “In the nearshore, we need much less documentation. Things like communication guarantees are unnecessary – the buyer can just pick up the phone.”
Sourcing gurus often argue that culturally, workers from certain geographies are more or less productive than others, but that doesn’t hold true either. “Productivity is not about cultural aspects. There are very few cultural differences that we see, at least on the macro level,” says Hall. “The productivity in Argentina is just as high as in India.”
Turnover – It seems obvious, but the fact is many buyers just don’t account for attrition in their cost calculation, even though it can be a huge drain on resources. “In our estimates, which do not take into consideration the opportunity costs, each percentage point in turnover represents, on average, an increase of 0.24% in costs,” writes Matiazzi says in this Nearshore Americas blog post. “Usually this doesn’t show up in the nominal price, so it’s critical that buyers are aware of it.”
Nearshore versus farshore
We all know the arguments for time zone and proximity of the nearshore, but what you may not have considered is how important those factors are in complex IT and software development. Especially if you’re running an agile operation, quick back and forth communication is key. The waiting times inherent in Indian and Chinese locations have the potential to be very costly.
Geo-political risk is also a critical cost issue, as we’ve seen recently in North Africa with the implosion of the strong Egyptian sourcing market. Hall says TPI builds risk models for each geography, taking into account factors like fiscal policy, government involvement, education system, scalability, etc. He sees many clients today agreeing to higher unit rates for a less risky region. According to him Latin America currently has a higher risk profile than locations in India and China.
In spite of the recent wage inflation in India, not many regions can compete with it from a pure salary standpoint. “But the sophisticated buyers are now going beyond just costs, and are looking at service levels and added benefits,” says Nutall. “Those buyers are increasingly turning towards the Nearshore region.”