Offshoring, especially for business process outsourcing (BPO), is about to hit a wall. After all, despite being a relatively new phenomenon made possible by advances in communications, it remains subject to one timeless principle of economics: supply and demand.
The HR pros call it attrition. On any particular project outsourced to a service provider in India, you can expect at least a 15% turnover rate for personnel assigned to the project within a year. For some projects, BPO chief among them, it is not unheard of for a whole staff to turn over by year's end, according to Paul Schmidt, a partner in the global services delivery practice at TPI, one of the larger sourcing advisory organizations.
With technology so closely tied to business strategy, to talk about BPO today is to understand the consequences of not being able to deliver expected services in a timely manner because of high turnover.
Schmidt puts it much better than I can: "There is a tremendous opportunity for value leakage," he says. In other words, if you don't pay enough attention upfront to the realities of attrition at your service provider, you will end up with higher costs, lower-quality deliverables, or, worse, a project that goes bust.
The high attrition rate, particularly in India, finds its roots in the phenomenal growth of outsourcing and offshoring. A recently completed TPI study, "India: An Attractive BPO Destination Marred by Alarming Attrition" by Dinesh Goel and Prabhash Thakur, pegs the growth of BPO attrition during the past three years at approximately 50% per year.
What's fueling this attrition is that despite all you may have heard about how many computer science majors graduate from Indian universities annually, there is a finite talent pool -- and those graduates know it.
The study reports that "the rate of attrition seems to be increasing," and it questions whether the offshore BPO industry can sustain growth and satisfy clients over the long term given this trend. The study cites inconsistent delivery of service levels, loss of client-specific knowledge and additional investment in retraining service provider staff as consequences of these high attrition rates.
Obviously, you can't just ignore the problem and assume that it's up to the service providers to fix it. There are steps you should take, as an offshoring client, to help mitigate the fallout of attrition.
Schmidt recommends a carrot-and-stick approach.
A company must insist on a service-level agreement that quantifies the level of attrition it is willing to tolerate. There must also be clauses within the SLA stating that when turnover reaches a certain threshold, it is the service provider's responsibility to retrain and re-educate workers.
On the carrot side, Schmidt says the client should provide ample training and career movement. It should also consider including engaging and challenging work in the mix. And allowing individuals to rotate through opportunities to work in the U.S. is certainly a big motivator for keeping them on a particular project -- not to mention reward and recognition programs with financial incentives.
That said, Schmidt doesn't see service provider fees going up long term, mainly because of the competitive climate that persists in India.
Soon enough, supply and demand will increase the cost of offshoring. Over time, this will level the playing field and will motivate companies to reconsider whether they should keep projects in-house or send them overseas.
1/23/2007
Outsourcing Product Engineering to Offshore Service Providers
By Steve Banker
ARC is in the process of doing a study on outsourcing of Product Engineering to Offshore Service Providers. In other words, the majority of engineers are based in low cost countries, and there are cost arbitrage advantages that can result from outsourcing of product engineering.
At this point we have had initial discussions with most of the significant suppliers who compete based on the Global Service Delivery model. Perhaps the two most interesting conversations involved Satyam Computer Services, who sent a large team into visit ARC last week, and Quality Engineering & Software Technologies (QuEST).
Satyam, with revenues of over a billion dollars, is a provider of diverse IT and Business Process Outsourcing services, including engineering services. In what they call "extended engineering services", they did over $80 million in business in the last calendar year. In contrast, QuEST is a much smaller company. They had 2006 revenues of about $40 million. They were also much more focused on product engineering services (about 90 percent of their revenues come from engineering services).
Satyam emphasized that they could be a strategic partner that they could speed the customer's time to market. While they are willing to do simpler and more mundane forms of product engineering, they make it clear that they are also capable of providing much more complex services.
In contrast, QuEST was more willing talk about their desire and ability to do non-core engineering. Further, they stress the cost arbitrage advantages of offshoring. Initially, they argue, "Our engineers may only be 60 percent as productive as yours, but in 6 to 12 months, perhaps our engineers will be 80 percent as productive as yours."
Satyam's folks absolutely disagreed with the idea that Indian engineers had to be less productive than their client's. They pointed to one client that measured both Satyam's engineers and their own engineers on productivity. Satyam's engineers, based on these metrics, were indistinguishable from the client's engineers. With time, the right management, processes, and metrics, parity can be achieved.
While I accept the idea that with time, trusted outsource partners will be used more strategically, and their value will go beyond simple labor arbitrage, most companies will begin their engineering outsourcing with less complex tasks, and the initial focus will be cost savings. Based on that premise, what are the economics?
Economics
The surface economics of outsourcing product engineering are very positive. While pay differs by industry and specialization, a fully loaded (salary and benefits) American mechanical engineer with 10 years of experience will cost a company about $10,000 per month. In comparison, offshore providers charge as little as $2,400 per month for relatively simple activities like converting Computer Aided Diagram (CAD) diagrams for use in technical publications to as much as $7,500 for complex Computer Aided Engineering (CAE) modeling and analysis, where engineers are in short supply. $3,000 is a good estimate for the average rate for a seasoned mechanical engineer.
However, in a new engagement with an offshore supplier, there would typically people sent to the company's site, particularly early in the engagement to scope the requirements. The higher the ratio of engineers on site with the customer (the customer pays for travel), or near site (supporting the customer from an office in their home region) as compared to offshore, the more it will cost. However, as a rough industry guide, Western companies should expect to pay a blended rate of about $25 per hour ($4,150) per month.
However, Indian engineers will not be as productive as American engineers. The offshore productivity ratio is the true key to the economics of offshoring Product Engineering Services. Let's assume that offshore suppliers are being overly optimistic on their employee's productivity, and that the true productivity range is from 25 percent to 70 percent. Let's further assume your blended fee for an Indian engineer is $25 per hour versus $60 for an American. If the offshore engineer is 25 productive as the American, the Western firm would have better off keeping all the work internal. They will find themselves 40 percent less cost effective than if they had done the work themselves. If the Indian engineers are 70 percent as productive as the US based engineers, the Western firm is a clear winner. They will find have spent 68 percent less on labor to accomplish a given amount of work. The break even productivity rate is 42 percent. That is the point at which there is no cost advantage, or disadvantage, from offshoring.
This analysis does not consider the extra costs of supervision and travel that would be incurred by a Western firm, which can be substantial.
Factors Affecting Productivity
It is clear that a primary consideration affecting the cost efficiency of an outsourced arrangement is the productivity of the engineers at the out-sourced firm. What are the factors that affect this?
First of all, good metrics are critical. But beyond that, the more seamlessly the two companies’ PLM systems are integrated, the easier it is for offshore engineers to be productive.
The offshore, nearshore, on site ratio also matters. Offshore engineers are the least expensive. On site engineers, foreign engineers from low cost countries that spend several months at a customer's development center working on a project, cost more. Near shore engineers, engineers in a development center in the same region, cost the most, and in fact will cost more than a Western companies own engineers. While some suppliers tout the advantages of 24 hour follow the sun development, these advantages can be more mythical than real, particularly with more complex engineering or projects that are difficult to scope. The vast difference in time zones between North America and India - 6:30 am in Boston is 5:00 pm in Bangalore, India - make having telephone conversations onerous. This makes ongoing supervision and control very difficult. Thus, the higher the ratio of offshore to onshore (or nearshore to offshore), the higher the productivity, but the higher the cost will be.
The ratio of on site, or near site, to offshore should differ depending upon the complexity of work undertaken and a particular supplier's business model. If CAD migration is done, or drawing conversions, all that may be needed is a relatively quick trip to the customer's site to understand the requirements and how they will be measured. With time, as the customer and the outsourcer get to know each other, not even that is required. Specs can just be faxed or emailed over. In contrast, higher value activity, like conceptual design, analysis, and design validation will usually require a higher onsite presence to guaranty productivity.
The tool, industry, and customer experience of the outsourcers' engineers also affects productivity. CAD/CAM/CAE tools are complex. It takes time to learn how to use them well. According to QuEST, many Indian students graduate with no experience having used any of these tools. To deal with this problem, QuEST works with six engineering schools. Experienced QuEST engineers teach courses on how to use CAD tools. The college students can take this course as a paid elective. Of their 900 engineers, about 200 have come out of these CADAM programs. This allows them to get people they know are dedicated to mechanical engineering, and it gives them better insight into which of the graduates have the right skills.
The folks at Satyam vehemently disagree with this premise. They believe that if you recruit more prestigious Indian schools, the typical graduate has better CAD skills than the typical American graduate. One Satyam manager used to work at GM and was responsible for hiring engineers. She argued it has been far easier to find Indians with tool skills than Americans.
From a productivity perspective, even after you have learned to use one tool well, for example Dassault Catia v5, if a customer needs the firm to use different tool, say UniGraphics' NX, the time required to come up to speed on the new tool is significant.
Industry experience affects productivity, including the productivity on a particular tool. If an engineer has aeronautic industry experience, they understand how an airplane is assembled, how they are stamped, and because of this knowledge, they can use the tool in a more productive fashion. Similarly, knowledge of a customer's processes and operations can make the offshore provider more efficient. Unlike in manufacturing, where Lean and Six Sigma are considered operational best practices, there is little agreement on what constitutes operational excellence in product development. The product development processes vary greatly company to company. To the extent that a Western company develops a long term relationship with an offshore company, and the offshore supplier dedicates staff to that customer, productivity can improve.
Satyam has a required course that new engineers assigned to important clients most pass through. The course trains the young engineer on their client's processes and works to pass on some industry domain expertise. Further, they attempt to train their engineers on the industry domain knowledge by actively rotating engineers onsite to see first hand the manufacturing processes.
Productivity can also be adversely affected by the different culture's communication styles. Indians can be very agreeable. In an effort to please they may tell you that work is complete, when it is not done yet. Having Indian managers, who are trained in "soft skills", to manage their own Indian engineers can be one way to avoid this problem.
Finally, it is clear that the cost of Indian engineers is rising and that retention of good engineers is an issue. However, at Satyam the attrition rate is in the single digits, lower than the double digit rates in the IT area. To the extent that Indian companies can keep their engineers engaged on interesting projects, they can help to retain their best engineers. For this reason, a certain amount of rotation of engineers into and out of key accounts may be necessary. Satyam also points out that while wages are rising, young engineers are available. At one of their client's, the average age of the internal engineering force is in the high 50s. In some multinational manufacturers, a whole generation of engineers is on the verge of retirement, and there do not appear to be enough young domestic engineers to fill the vacancies.
One thing is clear; it takes time for offshore engineers to become more productive. This is one reason that companies that are looking to offshore peak engineering demands, rather than engaging in a long term relationship, will never have the productivity and cost efficiencies from their engineering services vendors of companies that view these relationships more strategically. Companies will find it very difficult to engage with large firms, like Satyam, if they are not interested in longer term relationships. But even smaller firms, like QuEST, are unwilling to engage in short term tactical engagements.
ARC is in the process of doing a study on outsourcing of Product Engineering to Offshore Service Providers. In other words, the majority of engineers are based in low cost countries, and there are cost arbitrage advantages that can result from outsourcing of product engineering.
At this point we have had initial discussions with most of the significant suppliers who compete based on the Global Service Delivery model. Perhaps the two most interesting conversations involved Satyam Computer Services, who sent a large team into visit ARC last week, and Quality Engineering & Software Technologies (QuEST).
Satyam, with revenues of over a billion dollars, is a provider of diverse IT and Business Process Outsourcing services, including engineering services. In what they call "extended engineering services", they did over $80 million in business in the last calendar year. In contrast, QuEST is a much smaller company. They had 2006 revenues of about $40 million. They were also much more focused on product engineering services (about 90 percent of their revenues come from engineering services).
Satyam emphasized that they could be a strategic partner that they could speed the customer's time to market. While they are willing to do simpler and more mundane forms of product engineering, they make it clear that they are also capable of providing much more complex services.
In contrast, QuEST was more willing talk about their desire and ability to do non-core engineering. Further, they stress the cost arbitrage advantages of offshoring. Initially, they argue, "Our engineers may only be 60 percent as productive as yours, but in 6 to 12 months, perhaps our engineers will be 80 percent as productive as yours."
Satyam's folks absolutely disagreed with the idea that Indian engineers had to be less productive than their client's. They pointed to one client that measured both Satyam's engineers and their own engineers on productivity. Satyam's engineers, based on these metrics, were indistinguishable from the client's engineers. With time, the right management, processes, and metrics, parity can be achieved.
While I accept the idea that with time, trusted outsource partners will be used more strategically, and their value will go beyond simple labor arbitrage, most companies will begin their engineering outsourcing with less complex tasks, and the initial focus will be cost savings. Based on that premise, what are the economics?
Economics
The surface economics of outsourcing product engineering are very positive. While pay differs by industry and specialization, a fully loaded (salary and benefits) American mechanical engineer with 10 years of experience will cost a company about $10,000 per month. In comparison, offshore providers charge as little as $2,400 per month for relatively simple activities like converting Computer Aided Diagram (CAD) diagrams for use in technical publications to as much as $7,500 for complex Computer Aided Engineering (CAE) modeling and analysis, where engineers are in short supply. $3,000 is a good estimate for the average rate for a seasoned mechanical engineer.
However, in a new engagement with an offshore supplier, there would typically people sent to the company's site, particularly early in the engagement to scope the requirements. The higher the ratio of engineers on site with the customer (the customer pays for travel), or near site (supporting the customer from an office in their home region) as compared to offshore, the more it will cost. However, as a rough industry guide, Western companies should expect to pay a blended rate of about $25 per hour ($4,150) per month.
However, Indian engineers will not be as productive as American engineers. The offshore productivity ratio is the true key to the economics of offshoring Product Engineering Services. Let's assume that offshore suppliers are being overly optimistic on their employee's productivity, and that the true productivity range is from 25 percent to 70 percent. Let's further assume your blended fee for an Indian engineer is $25 per hour versus $60 for an American. If the offshore engineer is 25 productive as the American, the Western firm would have better off keeping all the work internal. They will find themselves 40 percent less cost effective than if they had done the work themselves. If the Indian engineers are 70 percent as productive as the US based engineers, the Western firm is a clear winner. They will find have spent 68 percent less on labor to accomplish a given amount of work. The break even productivity rate is 42 percent. That is the point at which there is no cost advantage, or disadvantage, from offshoring.
This analysis does not consider the extra costs of supervision and travel that would be incurred by a Western firm, which can be substantial.
Factors Affecting Productivity
It is clear that a primary consideration affecting the cost efficiency of an outsourced arrangement is the productivity of the engineers at the out-sourced firm. What are the factors that affect this?
First of all, good metrics are critical. But beyond that, the more seamlessly the two companies’ PLM systems are integrated, the easier it is for offshore engineers to be productive.
The offshore, nearshore, on site ratio also matters. Offshore engineers are the least expensive. On site engineers, foreign engineers from low cost countries that spend several months at a customer's development center working on a project, cost more. Near shore engineers, engineers in a development center in the same region, cost the most, and in fact will cost more than a Western companies own engineers. While some suppliers tout the advantages of 24 hour follow the sun development, these advantages can be more mythical than real, particularly with more complex engineering or projects that are difficult to scope. The vast difference in time zones between North America and India - 6:30 am in Boston is 5:00 pm in Bangalore, India - make having telephone conversations onerous. This makes ongoing supervision and control very difficult. Thus, the higher the ratio of offshore to onshore (or nearshore to offshore), the higher the productivity, but the higher the cost will be.
The ratio of on site, or near site, to offshore should differ depending upon the complexity of work undertaken and a particular supplier's business model. If CAD migration is done, or drawing conversions, all that may be needed is a relatively quick trip to the customer's site to understand the requirements and how they will be measured. With time, as the customer and the outsourcer get to know each other, not even that is required. Specs can just be faxed or emailed over. In contrast, higher value activity, like conceptual design, analysis, and design validation will usually require a higher onsite presence to guaranty productivity.
The tool, industry, and customer experience of the outsourcers' engineers also affects productivity. CAD/CAM/CAE tools are complex. It takes time to learn how to use them well. According to QuEST, many Indian students graduate with no experience having used any of these tools. To deal with this problem, QuEST works with six engineering schools. Experienced QuEST engineers teach courses on how to use CAD tools. The college students can take this course as a paid elective. Of their 900 engineers, about 200 have come out of these CADAM programs. This allows them to get people they know are dedicated to mechanical engineering, and it gives them better insight into which of the graduates have the right skills.
The folks at Satyam vehemently disagree with this premise. They believe that if you recruit more prestigious Indian schools, the typical graduate has better CAD skills than the typical American graduate. One Satyam manager used to work at GM and was responsible for hiring engineers. She argued it has been far easier to find Indians with tool skills than Americans.
From a productivity perspective, even after you have learned to use one tool well, for example Dassault Catia v5, if a customer needs the firm to use different tool, say UniGraphics' NX, the time required to come up to speed on the new tool is significant.
Industry experience affects productivity, including the productivity on a particular tool. If an engineer has aeronautic industry experience, they understand how an airplane is assembled, how they are stamped, and because of this knowledge, they can use the tool in a more productive fashion. Similarly, knowledge of a customer's processes and operations can make the offshore provider more efficient. Unlike in manufacturing, where Lean and Six Sigma are considered operational best practices, there is little agreement on what constitutes operational excellence in product development. The product development processes vary greatly company to company. To the extent that a Western company develops a long term relationship with an offshore company, and the offshore supplier dedicates staff to that customer, productivity can improve.
Satyam has a required course that new engineers assigned to important clients most pass through. The course trains the young engineer on their client's processes and works to pass on some industry domain expertise. Further, they attempt to train their engineers on the industry domain knowledge by actively rotating engineers onsite to see first hand the manufacturing processes.
Productivity can also be adversely affected by the different culture's communication styles. Indians can be very agreeable. In an effort to please they may tell you that work is complete, when it is not done yet. Having Indian managers, who are trained in "soft skills", to manage their own Indian engineers can be one way to avoid this problem.
Finally, it is clear that the cost of Indian engineers is rising and that retention of good engineers is an issue. However, at Satyam the attrition rate is in the single digits, lower than the double digit rates in the IT area. To the extent that Indian companies can keep their engineers engaged on interesting projects, they can help to retain their best engineers. For this reason, a certain amount of rotation of engineers into and out of key accounts may be necessary. Satyam also points out that while wages are rising, young engineers are available. At one of their client's, the average age of the internal engineering force is in the high 50s. In some multinational manufacturers, a whole generation of engineers is on the verge of retirement, and there do not appear to be enough young domestic engineers to fill the vacancies.
One thing is clear; it takes time for offshore engineers to become more productive. This is one reason that companies that are looking to offshore peak engineering demands, rather than engaging in a long term relationship, will never have the productivity and cost efficiencies from their engineering services vendors of companies that view these relationships more strategically. Companies will find it very difficult to engage with large firms, like Satyam, if they are not interested in longer term relationships. But even smaller firms, like QuEST, are unwilling to engage in short term tactical engagements.
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