In-Depth

The True Costs and Potential Risks of Outsourcing Software Development

Outsourcing has sparked serious and growing debate. We use a hypothetical software development project to explore the costs and risks for both onshore and offshore outsourcing.

• 10/02/2007

by Matt Lockhart

Few topics in IT have garnered as much attention, press coverage and debate as the trend toward outsourcing of software development initiatives to offshoring centers like India, China, and Russia. In fact, general business philosophies and attitudes towards the overseas outsourcing of heretofore American jobs and core competencies has sparked intense interest and heated debates at all levels of society. Like most epic IT debates, opinions are easy to come by and parties are hardening their views, yet hard “facts” are elusive.

Despite the fog that tends to hover over this debate, a few things are crystal clear. Every business executive wants to save money; all are under tremendous pressure to deliver cost savings and ROI, increase profitability and shareholder value, and achieve aggressive management objectives. While few top executives would deny the increasingly vital role that IT plays in their success, many tend to view IT resources as a commodity, and are understandably drawn by the hypnotic allure of offshore development rates. With hourly offshore rates at one-third to one-half of domestic outsourcing rates, offshoring looks highly attractive. Increasingly, however, companies are learning to look below the surface to understand the true cost and risk factors associated with offshore software development.

The Big Picture

For all but the smallest, lowest-impact projects, offshoring quickly becomes a major commitment of time and money. Any firm serious about partnering with an offshore software development firm must step back and analyze the situation in much the same way you would analyze the acquisition of an overseas company. In many respects, offshoring is much like acquiring an IT development firm that could become an integral part of your company for years to come (or a significant setback of cost and time), so much of the risk/reward analysis holds true. No company would consider acquiring a company in China, India, or Belarus without understanding the myriad complex business implications, nor should they for offshore software development.

To explore offshoring further, we will use a hypothetical software development project, assessing some of the potential high-level costs and risks as they relate to both onshore and offshore outsourcing. This does not represent the detailed analysis that most large companies should conduct.

Our hypothetical project—building a customer relationship management application using .NET—has a budget of between $500,000 and $550,000. Two man-hour estimates have been received: 5,000 hours (from a domestic vendor) and 6,650 hours (from an India-based vendor). We estimate the project duration at 6 months.

In this example, the client has several domestic outsourcing partners and is considering offshoring to a mid-tier vendor in Bangalore, India. The 33 percent difference between the two man-hour estimates is fairly typical, as offshore suppliers tend to devote additional resources to projects to compensate for some of the offshoring considerations we present in this article.

Hourly Rates: Your Starting Point

Since lowering labor costs is a familiar and popular offshore driver, consider the typical hourly development rates for both the offshore and the domestic vendors. Vendor rates vary somewhat, and are certainly influenced by city, country, level of expertise, and other variables. That said, $100/hour is fairly typical in the U.S. for the type of work our hypothetical project outlines; it is the rate we will use for our analysis. In Bangalore, $31/hour was a typical rate in 2006.

Domestic IT outsourcing rates have remained flat over the last three years, in large part due to basic economic factors of supply and demand. Rates in India, on the other hand, are rising about 20 percent per year (see Note 1) as a direct result of unbridled demand for cheap labor. For the sake of our analysis, we’ll assume the $31/hour rate from your Indian vendor rose 20 percent to $37/hour by the time the ink was dry on your offshore proposal. At those rates, your baseline costs for offshore vs. onshore development options are $247k and $500k respectively.

Relationship Management and Learning Curve Costs

For companies considering a significant offshore outsourcing engagement, one of the most misunderstood and unexpected cost elements is the investment required to start up, build, and manage the relationship. This “onboarding” phase includes the daunting task of bringing an entirely new team up the learning curve on many levels, including an understanding of your company, industry, value proposition, products, and services, competitors, processes, organizational structure, system environment, and more. This cost category also includes working through the many aspects of day-to-day coordination, procedural norms, communication expectations, process and project management standards, as well as management oversight of the project and the relationship. Offshoring necessitates involvement from a host of the client’s management team in areas such as HR, QA, testing, project management, and IT architecture, along with participation from several top executives. At their salary levels, these “hidden” costs of offshoring add up quickly.

For a typical offshore outsourcing engagement, these costs can account for 50 percent or more of the total budget, versus 5 to 10 percent for a typical domestic outsourcing relationship (see Note 2). In our example, we’ll use a 40 percent slice of the total budget (i.e., $247k for offshore) and 7.5 percent for the onshore supplier, raising the total project costs to $346k and $538k respectively.

Onsite Travel

Most clients expect monthly, onsite meetings with their vendor, typically with two or more representatives from the corporate office. While most of us would relish the opportunity to visit India, China, or Russia, the cost and business impact of monthly trips overseas can quickly dampen the allure. A trip to any of these locations will consume an entire business week, and the direct costs are high.

Assuming only three trips over the six-month life of our engagement (one preparatory, one mid-project, one project closure), with two individuals traveling per trip, the travel cost to India could exceed $36,000, while a similar domestic travel schedule only amounts to $9,000.

For our sample project, travel costs bring our estimated costs to $382k for offshore vs. $547k for onshore outsourcing.

The Engagement Manager

When evaluating the possibility of offshoring mid- to large-sized projects, especially those that involve significant business impact, an “engagement manager” is an essential requirement. This is usually a seasoned professional from the vendor’s organization with considerable IT and customer relations experience, who will travel to your headquarters and spend a month or two on site. Like a scout, their mission is to learn everything they can about your operations, build relationships with key stakeholders, and study your business and your systems. Upon returning home, the manager facilitates some of the communications and knowledge transfer.

Again, this role is often vital to success in offshoring, but it is invariably expensive. Based on a two-month stay, including airfare, food, lodging, and eight hours/day of billable labor, our engagement manager will conservatively cost about $57k. Our running totals are now $439k for the offshore solution, and $547k for your domestic outsourcing partner.

Capacity Maturity Model Process Impacts

All offshore suppliers utilize some form of process control methodology as a means to mitigate the cultural and communication challenges that are inherent in the offshore model. Indian firms, in particular, value the Capability Maturity Model (CMM) and expect requirements and other documentation in the CMM-specified format. To be sure, processes are necessary and CMM is a fine system in general, but if the client is accustomed to a different methodology, the delays, training, and frustration associated with accommodating a CMM-based supplier can be overwhelming. Simply changing a few headers on a report may require a lengthy impact analysis and set your project back a day or two.

Let’s be conservative and assume that rigor of the offshore CMM processes result in a 10 percent increase in total project hours, including the impact on both supplier and client. In our example, offshore costs increase by nearly $25,000 and our totals are now $464k for offshore vs. $547k for the domestic supplier.

IT Infrastructure Upgrades

Starting up a new, in-house IT development center for a company in the U.S. is going to cost money, and the same holds true for offshore suppliers. Reputable offshore suppliers all have considerable infrastructure in place, but your project will invariably require some unique software and hardware upgrades to simulate or be compatible with your environment. In a worst-case scenario, projects that run flawlessly in India are plagued by bugs in your domestic environment, and the supplier may never be able to resolve them.

On top of core infrastructure (such as servers, operating systems, databases, enterprise applications, and up-to-date licenses for each), other systems must be reviewed. Even basic communications and administrative tools such as phone systems, VPN, e-mail, IM, audio- and video-conferencing, and project management software increase costs and compound long-distance communications issues if not addressed, adding significant risk to the project.

While start-up IT costs could easily top $100k, we’ll assume a minimal expense of $30k in India, and $10k domestically, bringing our offshore and onshore cost totals to $494k and $557k respectively.

Communication, Miscommunication, and Cultural Barriers

Arguably the most controversial offshoring topic, this category includes the multitude of concerns and unknowns that first come to mind when most people think of offshoring: language barriers, cultural barriers, miscommunication impacts, time zones, and apprehension about work ethics, quality, and teamwork. Most U.S. companies take pride in their company culture, and most countries are similarly proud of their culture. The likelihood of the two meshing seamlessly is not high.

Time zones present one of the most problematic issues with offshoring. India is 11 or 12 hours ahead of most of the United States, so status calls or direct contact necessitates client teams jumping on a conference call at 6:00 a.m., or the supplier’s team working until 8:00 p.m. or later. Worse yet, urgent changes or issues can’t be resolved for at least 24 hours, and up to four days if they fall near a weekend.

Language and cultural differences can be equally troubling, causing frustration, miscommunication and delays in the best case, or leading to massive rework or outright project failure at the far extreme. Most offshore vendors work hard to overcome this notorious obstacle to success, but missteps are still commonplace and American slang and technical jargon are among the leading culprits.

To be fair, onshore development projects encounter miscommunication problems as well, but the scale and cost implications are an order of magnitude less.

We’ve included a 20 percent increase in total offshoring hours and a 5 percent onshore increase to account for development missteps, rework, and the need for more thorough communication and documentation. This brings our cost analysis to $544k for offshore and $582k for onshore development.

Thus far, we have evaluated the most common tangible cost factors. Our analysis shows that the offshoring alternative offers a savings of about 7 percent ($38,000) compared to our onshore vendor—a far cry from the 63 percent differential in raw hourly rates.

Macro-Level Risk Factors

Above and beyond the tangible costs presented thus far, there are myriad project and business risks that must be weighed when evaluating an offshore relationship. Much like our company acquisition analogy, there are many macro-level risks that simply cannot be ignored. Legal issues, political and regulatory concerns, intellectual property risks, and natural disasters are a few of the issues that must be addressed. Unfortunately, only you can assign a dollar value to these risks based on your specific situation. As you prepare your own outsourcing analysis, ask yourself these questions:

1. What is the potential impact (on your project and your business) of a material change in the political, regulatory or legal environment in your offshore vendor’s country?
2. How will legal disputes be handled should they arise between the parties?
3. How might changes in currency valuation impact your contract?
4. What is the impact on your project, your company and your job if your entire offshore team resigns after you’ve invested in training them?
5. Is your intellectual property adequately protected by foreign laws?
6. What is the impact if your intellectual property ends up with a competitor as a result of a job change by one of your offshore team members?
7. Is there a risk that your overseas resources could be impacted by a natural disaster? Utility system failure? A countrywide strike? Wholesale political upheaval?
8. On the home front, will this new relationship result in layoffs? Will your employees’ jobs change in some way? Will these changes cause employee distress or impact employee morale?
9. If you are considering a large-scale or long-term offshore engagement, could such a move impact public opinion? Could it affect the local, regional, or national economy?

The Bottom Line

In their quest to achieve corporate goals and trim costs, senior executives hear about cheap overseas labor, and zero in on the 63 percent differential between baseline offshore and onshore labor rates. This is understandable, but as we’ve shown, these rates don’t tell the whole story. There are hidden costs to consider, and these costs are not optional. What’s more, the macro-level risks are not to be taken lightly. While the likelihood of any one of them occurring may not be high, the potential damage to your company from every one of them is quite high.

Many CIOs enter into an offshoring relationship expecting huge savings, only to have their post-mortem analysis reveal results that are more like the break-even scenario we’ve outlined. Because the quality of your offshore code may be substandard, maintenance costs can become an ongoing and painful reminder of your offshoring endeavors.

There was a day when most IT organizations couldn’t imagine outsourcing their strategic IT initiatives. That day has long since passed, and virtually every large company today takes advantage of the benefits of outsourcing. In the early days, some of the issues mentioned in this article applied to onshore outsourcing as well, but to survive, vendors worked long and hard to overcome these challenges, and today the obstacles are minimal. In time, leading vendors in India, China and Russia will also adapt, grow and learn in order to lessen the impact of some of today’s offshoring drawbacks.

As the saying goes, there is a time and place for everything. We have outlined a fairly typical engagement scenario here, representing the tactical offshoring approach that is certainly the most common approach used by most firms. For companies willing to make a long-term investment in implementing a strategic offshore vision, some of the upfront issues and costs presented here can be amortized and then minimized, making it a more efficient and profitable relationship over time. Even then, many of the unknown macro-level risk factors do not dissipate over time, so the strategic implications of these important issues must be considered with care.

As with any highly strategic business decision, executives evaluating onshore vs. offshore IT outsourcing are obligated to undertake a thorough analysis of all of the true costs, tangible benefits, and business risks—all with an eye toward the long-term impact on employees, customers, partners, shareholders and the court of public opinion.

NOTES:

(1) Global Services Location Index, A.T. Kearney, 2006

(2) CIO Magazine, Stephanie Overby, February 1, 2007

Matt Lockhart is general manager, managed services for Magenic Technologies, a provider of technical consulting services. Magenic serves organizations in such areas as IT strategy, software development and support.