Friday, March 05, 2004

Outsourcing and labor costs

Outsourcing skilled work like software development has been in the news quite a bit lately. I've been surprised by how simplistic the thinking seems to be of some business managers when deciding whether to outsource. The argument seems to be, "The wages are less abroad, so we save money doing it." In a talk a few months ago, I heard a CEO from a major US company claim that, with Chinese wages at 25 cents an hour, you can't afford to not be in China.

But labor costs are not determined by wages alone. Labor costs are determined by two factors, wages and productivity. High productive but high cost workers can be competitive with less productive but cheaper workers. To analyze your labor costs, you need to consider productivity.

There are some reasons to believe that productivity for outsourced software development and other skilled labor will be much lower even with substantial training and education. Infrastructure in many countries is very poor, with bad roads and unreliable electricity and telecommunications. Communication challenges, cultural differences, and management difficulties across thousands of miles and several time zones can reduce output.

This isn't to say that outsourcing isn't justified in many cases. But the analysis isn't as simple as using the lowest paid workforce.

Update: The April 28, 2004 New York Times ran a front page article, "Companies Finding Some Computer Jobs Best Done in U.S." that supports my claims, quoting one executive as saying, "The cost savings in India were three to one, but the difference in productivity was six to one," and another predicting, "the hype cycle about Indian outsourcing runs its course, [and] projects will come back to the United States when people find that their productivity goals have not been met." "Geographic distance and the differences in business contexts" are the cause of this productivity drop. The article also cites distance from the customer and "the customer's needs" as a cause of lower productivity and performance.

Another executive points out that, "Whenever the pace of innovation is very rapid is when the work should be done closer to the client. What cannot be sent to India is the invention of new business processes and technologies. Innovative business processes result from an understanding of the business that happens when people get into a room and talk to each other. That is very difficult to outsource."

Update: One year later, CNet reports on a Gartner Research study:
80% of organizations that outsource their customer management operations purely to cut costs will fail to do so, while 60% of those who outsource parts of the customer-facing process will have to deal with customer defections and hidden costs that outweigh any potential savings offered by outsourcing.
And InfoWorld reports on a Deloitte & Touche research study:
70% of participants have had negative experiences with outsourcing, [25%] realized that they could handle certain functions better in-house, and yanked those back inside the corporate walls, [and] 44% did not see cost-savings from outsourcing. 73% are [now] working to reduce outsourcing vendor dependancy.
Update: Two years later, I came across this excellent lecture by Paul Strassmann, "Is Outsourcing Profitable?" (PDF). Paul's research shows that there is no correlation between outsourcing and profitability, outsourcing increases overhead costs, and outsourcing damages the knowledge assets (and therefore the long-term potential) of a firm.