A Fine Balance* The Impact of Offshore IT Services on Canada s IT Landscape. Executive Summary. *connectedthinking

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1 A Fine Balance* The Impact of Offshore IT Services on Canada s IT Landscape Executive Summary *connectedthinking

2 These footprints in the sand were photographed in Rajasthan, India. Rajasthan, formed in 1948, in northwest India, borders Pakistan on the west and comprises 132,150 sq mi (342,269 sq km). Its capital is Jaipur. Rajasthan is divided into the hilly southeastern region and the dry northwestern Thar Desert, sparsely inhabited by pastoral nomads. The sand dunes, stretching into Pakistan s heartland, have been used frequently by trade caravans of silk and spice travelling from the Indian subcontinent to Persia. The camel fairs of Pushkar and Tilwara among others are still conducted through the Thar Desert. In 1974, the desert region was the site of the underground explosion of India s first nuclear device.

3 Executive Summary Despite being bombarded with opinion, rhetoric and news about the trend to outsource domestic IT services jobs offshore, Canadians face a frustrating lack of information about the impact this trend is having or will have on the country. To help understand this issue PricewaterhouseCoopers LLP (PwC), in cooperation with IT strategist and best selling author David Ticoll, undertook a research project called A Fine Balance: The Impact of Offshore IT Services on Canada s IT Landscape. The findings proved to be quite interesting. Service providers and Canadian buyers of IT services agreed unanimously that offshore outsourcing in Canada has lagged the U.S., but is about to dramatically take off. Though India is the leading centre for offshore outsourcing of knowledge work, many other countries are involved, including China, the Philippines, Russia, Spain, Ireland, Mexico, Argentina, and other emerging locations such as Eastern Europe and South Africa. A study for the Indian government projects the country s revenues from IT and IT-enabled services will jump from US$12 billion in 2003 to US$62 billion in 2009, translating into a manpower requirement of 1.5 million more jobs. Canada s reputation as a venue for nearshore IT outsourcing is somewhat exaggerated. Though the country may have some 150,000 call centre workers servicing U.S. firms, it s likely that the number of skilled IT workers engaged in outsourcing projects is well under 20,000, if not 15,000. It is possible that by taking appropriate, proactive action Canada could see an increase of 165,000 skilled IT jobs by The alternative is that we stand by and watch a potential 75,000 IT jobs migrate offshore or be retrenched back into the U.S. Canada must confidently step up and claim its share in the global marketplace for IT services. Offshore outsourcing of IT work is not just a passing fad. And not only IT jobs are moving offshore. Any knowledge-based function that does not require direct personal interaction is a candidate. Also, not only routine jobs are being relocated. Some of the world s leading companies like Apple, General Electric, IBM, Microsoft, and Morgan Stanley have set up shop in India, and now China, to conduct research, development, and product innovation. The fact is we are in the early days of a shift that will have profound implications for companies, their market offerings, competition, the careers of millions, and the competitiveness of nations.

4 Thomas Friedman, author of The Lexus and the Olive Tree, describes this change as nothing less than the third era of globalization. He suggests that the first era, driven by falling transportation costs, ran from the late 1800s to World War l. The second, from the 1980s to 2000, was predicated on the spread of personal computers and falling telecom costs, and is what we usually think of as our globalization. This era is over. We have now entered Globalization 3.0. A leading research firm, Meta Group believes that outsourcing within North America is growing at an average of 10-15% annually. In contrast, outsourcing to offshore venues is growing at a rate of more than 25%. Most of this rapid growth has been in the U.S. Canadian companies have outsourced IT services for decades, but they have tended to rely on local delivery. Meanwhile, in the U.S., offshore outsourcing has been rapidly increasing over the past 10 years. This difference, we believe, is about to disappear. With the higher awareness and the higher Canadian dollar, Canadian companies are waking up to the benefits of offshoring. And it s not just traditional global vendors companies with headquarters in India, Russia, and other offshore locations have also set up shop in Canada and are now marketing to Canadian companies. Why Go Offshore? Respondents estimated that cost benefits for shifting a major set of IT activities from the U.S. to India range between 50 and 70%. Service providers also said that U.S. customers can save 20-30% by moving certain IT activities to Canada. Low cost is a necessary condition, but it is not the only one. There is no point in buying a cheap service if it is of poor quality. Quality, therefore, is a critical driving factor for offshore outsourcing. Most of the large India-based firms have invested heavily in ensuring quality. Many have attained Capability Maturity Model (CMM) Level 5 the leading standard in software quality methodologies. They lead their North American competitors, as well as most of their customers, in meeting standards. According to our interviews with Canadian companies who have successfully used offshore sources, another factor weighs almost equally with cost savings and quality: ready access to pools of qualified resources. The Decision Process How do buyer organizations make the decision to invest in an outsourcing transaction? Our discussions with both buyers and

5 providers, as well as our review of published reports, paint the following picture: One or more triggering events give the buyer a reason to believe that offshore delivery may deliver a benefit. The potential benefit is weighed at a high level against a screen of feasibility, cost, and risk considerations. If the balance of prospective reward versus feasibility, cost, and risk is favourable, the buyer will invest further time and money to pursue the offshore option. A 2001 study of 50 IT outsourcing deals found that, while every company differs in how it sources its services, industry norms indicate that the average company will spend about 3% of the value of a traditional domestic outsourcing contract on choosing the right provider and creating and reaching the agreement. These numbers exclude the internal effort for change management, communication and the ongoing contract management costs. While no definitive research is available to show how this will differ on offshore deals, our experience leads us to believe that the transaction cost for an offshore contract can be significantly higher due to: Increased complexity on legal and tax implications Increased travel costs for site visits and contract start-up Network provisioning Security assurance Severance costs for employees made redundant in domestic outsourcing, the provider often assumes buyer staff as part of the deal; this is less likely when the provider is offshore Retention programs for key staff who may be threatened It is also important to ensure that anticipated cost savings from IT outsourcing are not eroded or eliminated by unintended, adverse tax consequences. We explored several potential tax implications from offshore outsourcing of IT services and found that, while migration of functions to lower cost locations such as India or the Philippines may well offer significant cost savings, these locations are also high tax regimes. When comparing potential sourcing locations, the business case should also include consideration of any investment tax programs available. While India may appear to be the logical choice to minimize costs, SR&ED incentives in Canada may reduce India s comparative advantage. When coupled with the advantages of proximity and ease of communication, the scales could easily be tipped in Canada s favour.

6 Risk Management Are the risks any different when offshore resources are engaged? According to IDC Canada, the top five risks buyers identified in offshore IT outsourcing are: Security Quality Service Knowledge transfer Risk that cost savings will not materialize Our research identified additional risks specific to the engagement of offshore resources. We recommend that buyers consider drilling down beyond general service and quality risks to consider: Proximity Currency Regulatory compliance Tax issues Political, employee, public relations and geopolitical risk Immigration and work visa issues Working with buyers around the world, PwC has gathered extensive insight into these and other risks which are unique to offshore sourcing. We have combined that global knowledge in a proprietary tool we call Offshore50 TM. This tool assists PwC advisors to perform a comprehensive risk assessment of a buyer s business case for offshoring IT or business processes. Leading Practices Have Great Importance Many lessons can be learned from those with experience managing an offshore IT services relationship. In the selection process, clients are increasingly weighing references and reputation as essential criteria over size of the resource pool. As companies gain more experience with offshore outsourcing, their awareness of proximity to resources goes up significantly. Both buyers and providers (onshore and offshore) stressed the importance of strong governance practices, with a focus on building the human side of a relationship.

7 Experienced buyers make site visits to their offshore providers in order to accomplish this, as well as to satisfy themselves of delivery capability. For many experienced buyers, structure was very important. Structure included: - Extra care in defining the project and deliverables and deconstructing them into buckets so they can be managed effectively - Reporting and project management tools, such as scorecards, project meetings and updates at the leadership level - Using the performance-based risk/reward provisions built into the service level agreements - Dispute resolution mechanisms It is common for buyers to leave the operational details of an offshore project to an onshore (often incumbent) provider. However, buyers realize that the final accountability for the success of any project, whether in-house, onshore outsourced, or offshore, rests with the buyers management. Why is this important? Recent studies indicate that in 2003 about one in five buyers still ended their contract prematurely. Offshore outsourcing is at this stage of its evolution still different enough from traditional onshore outsourcing to warrant special attention from buyer management, and corresponding participation from onshore or offshorebased providers. What Will the Impact be on Canada s IT Landscape? Experienced buyers tell us that the cost savings are real. Sure, companies may reduce costs and improve IT productivity and quality. But employees will lose jobs, and the entire job market for IT professionals may shrink. Wages will decline. Individual lives will be damaged. Many IT graduates already face unemployment. Some argue that this is but a phase in capitalism s cycle of creative destruction. A new generation will come along and create new industries. Be confident that we are on the eve of another wave of economic innovation. Skeptics respond that knowledge work is the end of the line. The next cycle may well be a decline in the standard of living for millions of North Americans a race to the bottom.

8 Sounds scary. Is protectionism the answer? We don t think so, for several reasons: It won t work. Many of today s corporations are global, and it is practically impossible to prevent them from seeking workers where they choose to. Barring domestic firms from offshoring would force them to compete on an uneven playing field. It s not the right thing to do. Workers and firms in emerging economies should also enjoy the fruits of innovation, growth, and globalization. The alternative is a threat to global peace and security. Offshoring does reduce the costs, and improve the quality, of products and services. This is beneficial to consumers and shareholders, and contributes to innovative development of the Canadian economy. The fact remains, though, that offshoring poses economic risks for many individual Canadians and, consequently, to the Canadian economy. It is entirely possible that 75,000 or more Canadian IT jobs will move offshore or be repatriated to the U.S. by 2010, along with an equal number of other knowledge-based functions. The Canadian way is to face up to the social and economic risks, take steps to mitigate them, and prepare to compete in the new environment. Specifically: Companies should make choices about outsourcing that will enable them to grow and compete. Companies and governments should work together to address the two key issues associated with outsourcing impact on laid-off employees, and competitiveness of the Canadian economy. Governments, business leaders, and the IT industry should focus on ensuring that Canada will compete and win in tomorrow s high-value IT services, research and development, and innovation. To differentiate Canada from low-cost centres in India, China, Russia and the Philippines, Canadian IT services companies must leverage industry knowledge, emerging technologies, and expertise in business processes.

9 Conclusion Buyers of offshore services need to balance the real benefits against the real and perceived risks. Buyers must look at their own unique situation and assess their readiness and willingness to go offshore, and then screen project characteristics for those most suited for offshore delivery. They should systematically assess and manage risks, particularly those unique to offshore. The worldwide shift to global sourcing of IT services is, at the same time, a great threat and an even greater opportunity for our domestic IT industry. We must define our role on the global stage by building up and marketing Canada s unique and sustainable advantage as a global supplier of IT innovation. Whether we choose to passionately pursue the opportunity, or suffer silently while departing jobs are left unfilled, we, as Canadians, are today in a fine balance. Contact PricewaterhouseCoopers LLP (PwC) works with clients around the world to understand, and manage costs and risks associated with IT. Coordinating and sharing its experiences around the world provides PwC with global perspective to aid in local assistance. Our work addresses IT planning, IT sourcing, IT project risk management, IT effectiveness and various other perspectives which matter in managing IT costs. For more information, please contact: Robert Scott Partner, IT Advisory Services PricewaterhouseCoopers robert.w.scott@ca.pwc.com

10 Notes

11 2004 PricewaterhouseCoopers LLP, Canada. PricewaterhouseCoopers refers to PricewaterhouseCoopers LLP, Canada, an Ontario limited liability partnership, or, as the context requires, the network of member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity. *connectedthinking is a trademark of PricewaterhouseCoopers LLP.

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