Offshore Outsourcing of IT and Business Process Services

Transcription

1 Offshore Outsourcing of IT and Business Process Services Hofland, Hilde Student ID#68537 Submitted to Aarhus School of Business Aarhus, Denmark September 2010 Supervisor: Philipp Schröder Abstract: As ICT has made trade in services easier, firms are locating services abroad in order to seek efficiency gains and attain competitive advantage. The thesis identifies trends in the development of IT services and business process services by looking at transaction cost economics and at how global value chain structures are governed and change. The trend seems to be a move towards standardisation of services making it easier for companies to outsource and offshore. Technology is improving rapidly in this sector, and companies need to actively follow the development in the market in order to take advantage of the benefits of offshore outsourcing.

2 Table of Contents PART I: INTRODUCTION Methodology and Delimitations Outline of the thesis... 5 PART II: TERMINOLOGY AND DEFINITIONS Vertical disintegration versus unbundling of corporate functions Outsourcing Offshoring Services Information Technology - and Business Process Services Method of delivery Intermediate summary PART III: THEORY Transaction cost theory TCE and Governance Structures Governance Structures Governance structure classifications Markets Modular value Chains Relational value chains Captive value chains Hierarchy Intermediate Summary PART IV: ANALYSIS The make or buy decision Frequency Asset specificity Uncertainty Legal issues Capabilities in the supply base India China Russia Latvia Romania Offshoring versus nearshoring Governance Structures PART V: CONCLUSION References:

3 PART I: INTRODUCTION The fragmentation of the production process is a major theme in international economics. Fragmentation of the production process has given rise to the restructuring of the firm to include locating activities outside the boundary of the firm and locating parts of the production process abroad. As such, production processes are becoming increasingly more geographically dispersed. Research on this area is however largely restricted to manufacturing and the underlying aspect of globalisation (Defever, 2006). Cross-border trade in services is however increasing rapidly much due to Information and Communication Technology (ICT) which has changed the way we trade in services. As ICT has made trade in services easier, firms are locating services abroad in order to seek efficiency gains and attain competitive advantage. Locating services abroad has been termed offshoring. A company may choose to offshore services that are kept in-house or outside the boundaries of the firm. The latter is termed outsourcing. Moreover, a company may choose to outsource and offshore a service which constitutes part of the production process of a final good or service, or outsource and offshore a business functions. The thesis aim to identify trends in the development IT services and Business Process services offshore outsourcing. Offshore outsourcing will be examined from a transaction cost economics (TCE) perspective. From this perspective, the choice of whether to locate services within or outside the boundaries of the firm will be made with the aim of minimizing transaction costs. As opposed to classical economics which view the marketplace as the most efficient means of exchange, TCE takes into account costs incurred when making a transaction. Taking transaction costs into account it may be cheaper to make than to buy. The make-or-buy decision can be viewed as a choice of mode of governance. That is, a buyerseller relationship may be mediated by an interfirm ( make ) or intrafirm ( buy ) contract. The first corresponds to using the hierarchy of the firm, whereas the latter corresponds to using the market. There exist a variety of hybrid governance structures within the span of hierarchy and market. The efficient governance of a contractual relation will vary with 3

4 the attributes of the transaction and move from simple market exchange to hierarchy as bilateral dependency builds up (Williamson, 2008). The thesis will thus go on to explain different modes of governance. IT- and Business Process services will be analysed in light of TCE. Possible governance structures will be proposed depending on determinants like complexity, ability to codify information and supplier skill base. There exists a number of IT and Business Process services which vary greatly with respect to complexity and codifiability. If a service is complex higher skilled workers will be required. Choosing the right service provider is thus vital to a company seeking to outsource and offshore. Countries differ greatly with respect to availability of high skilled labour and type of services offered. Transaction costs may however serve as an impediment to trade with some of these countries, making it cheaper to locate services at home or closer to home. From a European organisation s perspective locating service activities within the EU could for instance prove less costly then locating in Asia due to transaction costs. The topic will be discussed from European organisations perspective in order to capture the choice between nearshoring and offshoring. Hence, it will offer a comparative analysis between likely offshoring destinations within and outside the EU. Outside the EU, the main focus will be on Asian countries and India in particular. Nearshoring is likely to offer advantages regarding language, and geographical and cultural proximity. There also exist laws and regulation that might prevent European firms from offshoring to countries outside the EU Methodology and Delimitations The topic will be discussed and analysed based on applicable theory and desk research. As previously stated, during recent years ICT has changed the way we trade in services. This change complicates defining the term services precisely. Moreover, a lack of proper classifications as well as the nature of the way trade in services takes place makes it difficult to find adequate data capturing the extent of exports of intermediate services or business functions from affiliated and unaffiliated companies. 4

5 Nevertheless, the topic is widely discussed although debates on the topic largely concern the relocation of jobs and wages across national boundaries. This topic is often referred to as international sourcing relocation or delocalisation (in French) and has long been an issue in manufacturing. International sourcing implies some substitution of activities at home by production abroad, and the effect of exports of manufacturers from developing countries on jobs and wages in the home country is thus a hot political issue. Offshoring generally refer to low-cost nations, and most trade in services that involves developing countries takes place within IT- and business process outsourcing services (Matto & Wunch, 2004). Through offshoring of services, the fear of losing low-skilled jobs in manufacturing to developing countries has thus extended to include high-skilled service jobs (OECD a, 2007; Krugman, Cooper, and Srinivasan, 1995). As such labour movements are also a major theme within offshoring. These topics will however not be covered. At a national level the development of IT- and business process service outsourcing will have implications for how nations can anticipate future competitive factors in order to invest effectively in these areas and attract investment. Asian countries and India in particular has had major success in attracting offshoring investments from abroad. Transactions costs may however incur by locating outside the EU which could lead to trade diversion. A lack of adequate data does however make it difficult to give any empirical evidence of trade diversion, and will thus not be the main theme of the thesis Outline of the thesis The thesis is divided into five sections. The first part of the thesis consists of the introduction, methodology and limitations, and outline. The second part of the thesis will focus on the terminology; defining and exemplifying the concepts used. Firstly, the difference between vertical disintegration and corporate function unbundling will be explained. Vertical disintegration is well known from manufacturing and enabled through fragmentation and slicing up of the value chain. Vertical disintegration is increasingly witnessed in services as well, but in addition, corporate functions are outsourced. 5

6 Next, outsourcing and offshoring will be defined. Outsourcing is the make-or-buy decision, and will be defined as a choice of mode. Offshoring is the decision on where to locate. As illustrated in the below table (table 1) offshore outsourcing fit into the bottom right corner (marked grey), where companies choose to buy abroad. It is worth noting that outsourcing implies more than just a pure vendor relationship, and that there exist a variety of hybrid modes of governance structure within the span of make and buy. Home Location Abroad Mode Make Domestic in-house sourcing Offshore in-house sourcing Buy Outsourced to domestic suppliers Outsourced to foreign suppliers Table 1 Subsequently services will be defined. Due to the intangible nature of services, they are difficult to record and to define precisely. Moreover, ICT has led to increased trade in services and also changed the way we trade in services which further complicates defining and classifying the term properly. IT services and Business Processes is also hard to define due to the same reasons. In addition, these types of services span from simple call centres to more advanced finance and accounting services. The types of services will be categorised and exemplified as in the table below (table 2), where business process services are divided into three subcategories: 1. Information Technology Services Table 2 2. Business Process Services - Customer Interaction Services - Back-office operations - Other Professional Services 6

7 Part three of the thesis introduces the theory that will form the basis for the analysis. The concept of transaction cost economics and governance structures. Transaction costs will be divided into three main categories: The frequency of the transaction The uncertainty of the transaction The asset specificity of the transaction In addition, mode of governance will be explained taking into account the following determinants: complexity of transactions ability to codify transactions capabilities in the supply-base Part four of the thesis will analyse the IT-and Business Process services in light of the before mentioned theories. Different countries within and outside the EU will be presented in order to give an overview of the services offered, and in order to capture the possible advantages of nearshoring. Subsequently, the last part of the thesis will conclude. PART II: TERMINOLOGY AND DEFINITIONS 2.1. Vertical disintegration versus unbundling of corporate functions Outsourcing and Offshoring of Information Technology Services and Business Processes are not new phenomenon but similar to what has been witnessed before in manufacturing when sourcing intermediate goods from abroad. Fragmentation or slicing up of the value chain lets firms produce a good in a number of stages in a number of locations, adding a bit of value at each stage. Intermediate products might be produced in disperse locations, and assembled from subcomponents from yet other countries which can greatly increase the volume of international trade (Krugman et al., 1995). This is referred to as vertical disintegration. 7

8 The difference between vertical disintegration and unbundling of corporate functions is depicted in the table below (table 3). The two differs with respect to type of delivery as well as supplier upgrading opportunities and possible market consequences. Vertical Disintegration Description Suppliers provide inputs which is part of a final good or service Supplier s upgrading Moving up the value opportunity chain. The supplier end up competing in the same industry as the client firm Consequences Bilateral monopoly is a possibility with suppliers engaging in hold-up and buyers exercising monopsonistic power Table 3 Source; Sako 2006, pp 507 Unbundling of corporate functions Suppliers provide a services in corporate functions such as HR, IT etc. Deepen functional expertise, the supplier operates in a different market than the client firm Client firms are in a weak position with no monopsonistic power visà-vis suppliers Vertical disintegration thus refers to the slicing up the value chain to find niches for labour intensive production when producing goods that traditionally has been viewed as skill-, capital, or technology- intensive goods. Labour intensive parts of the production process can then be located in low-wage countries. A high-technology product like a notebook computer is assembled from intermediate products of which some are high-tech and some are low-tech. The high-tech parts are produced in America and Japan, while the plastic that surrounds it and the wiring that connects the high-tech parts are produced in low-wage countries. As such, the notebook computer assembly is a Newly Industrialised Countries (NIE s) industry (Krugman et.al., 1995). As services are becoming more easily tradable, fragmentation not only enables firms to outsource or offshore intermediate goods but also intermediate services. A company may for instance outsource application development as an IT service to a company in a low-cost 8

9 nation. The development of the application will then be a service performed as part of the final good produced. The way services have changed however also enables companies to outsource part or all of a business process as a service. This is termed corporate function unbundling. Sako (2006) views this as a novel way of restructuring corporations in which the make-or-buy decision no longer only concerns intermediate products but also business processes which reside in corporate-function unbundling. Corporate function unbundling provides a different base for the supplier to enhance value-adding activities from vertical disintegration (Sako, 2006) Outsourcing The choice of deciding what activities to buy and what to keep inside or internal to the firm s ownership structure is amongst others analysed in the literature on internalisation of which early analysis include Dunning (1977) (Markusen, 2005). Outsourcing can be viewed as the opposite of internalisation. Outsourcing is more precisely defined as the acquisition of an input or service from an unaffiliated company. This is according to Helpman (2006) the standard terminology used in industrial organisation. Buying services from a provider is not necessarily outsourcing. Outsourcing entails more than just purchasing a service from an outside supplier, which is just a pure vendor relationship. Outsourcing involves a considerable degree of two way information exchange, coordination and trust. Moreover, it implies that the supplier undertakes relationship-specific investments so that it becomes able to produce a good or service that fit the firm s particular needs (Erber, Sayer-Ahmed, 2005; Grossman and Helpman, 2002). Bhagwati, Pangariya, and Srinivasan (2004) make a noteworthy narrow definition of outsourcing as the offshore trade in arm s length services, excluding purchasing and FDI. That is, they take outsourcing to mean sourcing from not only outside the firm but also outside the borders of the home country. Moreover, they exclude trade in goods from the definition. 9

10 Bhagwati et.al derive their definition from the World Trade Organisation s (WTO) General Agreement on Trade in Services (GATS) which categorises trade in services into four different modes. Mode 1 involves the arm s length trade in services where supplier and buyer remain in their respective locations. Mode 2 involves moving the service recipient to the location of the provider. Mode 3 involves the service provider establishing a commercial presence in another country, requiring an element of foreign direct investment (FDI). The direct investment involved is however assumed to be miniscule. Mode 4 involves the service seller moving to the location of the service buyer. Hence, Bhagwati et. al (2004) does not distinguish between the sourcing decision and the decision of whether to locate at home or abroad. Markusen (2005) however warns against this narrow definition and emphasises the importance of keeping the outsourcing and offshoring terms apart, as the first is a mode choice and the second a location decision Offshoring In addition to the choice of internalising or outsourcing an organisation s activities, the choice can be made of whether to locate at home or abroad. Offshoring refers to the shifting of tasks to a location outside the home country borders. Moreover, it implies that the offshored tasks previously carried out at home will now be imported back into the country from the offshore location (OECD b, 2007). Hence, the offshore location will function as an export platform. How and where a firm choose to locate their activities globally can be an ownership specific advantage, and increase a firm s globally competitive position. A firm may widen or deepen their global value chain across or within nations taking advantage of countries comparative advantages. Offshore can refer to any destination outside the home country but is generally understood in the business jargon to mean low-cost nations. Thus, a software division in the US would typically not be termed an offshore destination. Low-cost nations would include emerging/transition and developing nations (Carmel & Tjia, 2005). 10

11 The term offshore has spawned a list of related terms. The opposite of offshoring is onshore services, which refers to the services provided by foreign firms onsite. Thus the term onshore is equivalent to Mode 4 trade in services of the GATS. Nearshoring refers to sourcing of services from a location close to the home country (Carmel & Tjia, 2005). The type of good or service sourced may determine the type of governance structure, and put requirements on the buyer-supplier relationship such as frequent face-to-face meeting that might favour the nearshoring option. Legal issues, and cultural proximity amongst others might also make nearshoring favourable. There are three different paths towards offshoring. A firm may simultaneously make the decision to outsource and offshore their activities, they may shift outsourcing activities from a local to a foreign supplier, or they may decide to offshore their activities to an overseas subsidiary. It is also possible for a firm to switch source from an internal subsidiary to an outside supplier (Sako, 2006). The latter is essentially a choice of mode of governance structure. Home Abroad Make Domestic in-house sourcing Offshore in-house sourcing Buy Outsourced to domestic suppliers Outsourced to foreign suppliers Table 4 The red arrows in the above table illustrate moving either in-house, outsourced activities from at home to abroad Services Here, a service will be defined as an intangible good. An economy may be divided into the goods-producing and service-producing sector where services traditionally has been defined as intangible, non-storable and non-transportable (Rugman, 1987). For a customer, the value of a service is not in receiving a tangible object but in the function performed by the seller. 11

12 Hence, the service is co-produced with the customer. This requirement has in the past made it difficult to transport services cross-borders. Information and Communication Technology (ICT) has however changed this and made geographical distance less of a barrier to the simultaneous production and consumption of services (Sako, 2006). Call centres are examples of this. ICT also enables standardisation and storage of services as for instance with medical diagnosis (Sako, 2006). Hence, services acts more like products and are more easily tradable now than they used to be. Consequently, the traditional distinction between services and goods are no longer viable. Moreover a firm is likely to have a combination between products and service activities that make it hard to differentiate between the two. Sako (2006) calls this the productising of services and serviceising of products. Products are becoming more like services in that software firms for instance are turning to services when their core product markets become saturated, and may offer maintenance, customisation and upgrading services. Hence, offering complementary services to the products sold is a way to seek growth (Sako, 2006). The productising of services on the other hand enables a larger degree of standardisation and the role of human skills is minimised. As the traditional distinction between goods and services are becoming blurred, Blinder (2006) suggests it more useful to separate services into personal and impersonal ones. Personal services are those that cannot be delivered electronically, or those who are notably inferior when delivered in that manner. Personal services require face-to-face contact such as going to the hairdresser or a check up at the doctor. Impersonal services do not require faceto-face contact in the same way, and it does not matter where the person performing the service is located (Blinder, 2006). Impersonal services have more in common with manufactured goods than with personal services. According to Blinder (2006) however, the dividing line between personal and impersonal services is not static and personal services might become impersonal as information technology improves. Automation through the use of information technology reduces the need for human intervention. Once a service is standardised and automated, it becomes easier to operate at a distance and services may be offshored (Sako, 2006). Hence, as the dividing line between personal and impersonal services changes, more services might be subject to offshoring. 12

13 Due to the changing nature of services traded today it is not easy linking them to any existing services sector statistical classifications (Mattoo & Wunch, 2004). Moreover, difficulties in defining services makes it hard to quantify the amount of services that cross the border, the very nature of services trade further complicate the situation. There are no tangible products crossing the border Information Technology - and Business Process Services Information Technology (IT) and Business Process Services can be defined as services provided by businesses for businesses, including computer services, professional services, R&D and other services provided by labour placement agencies and call centres (Sako, 2006). Tjia and Carmel (2005) categorise Information Technology and Business Process services by using the terms IT-services and IT-enabled services (ITES). By this definition IT services include any type of software-related activity, whereas ITES typically include call centres, medical transcription, architectural drafting, through to financial securities research. The below table is a non-exclusive listing of information technology and business processes services (Mattoo and Wunsch, 2004). 13

14 1. INFORMATION TECHNOLOGY SERVICES Software development and implementation services, data processing and database services, IT support services, application development and maintenance, business intelligence and data warehousing, content management, e-procurement and B2B marketplaces, enterprise security, package implementation, system integration, SCM, enterprise application integration, total infrastructure outsourcing, Web services (internet content preparation, etc.), Web-hosting and application service providers (ASPs) 2. BUSINESS PROCESS SERVICES Sales support, membership management, claims, reservations for CUSTOMER airlines and hotels, subscription renewal, customer services INTERACTION helpline, handling credit and billing problems, etc. telemarketing SERVICES and marketing research services. Data entry and handling, data processing and database services, medical transcription, payment services, financial processing (financial information and data processing and handling), human BACK-OFFICE resource processing services, payroll services, warehousing, OPERATIONS logistics, inventory, supply chain services, ticketing, insurance claims adjudication, mortgage processing. Human resource services (hiring, benefit planning and payroll, OTHER etc.), finance and accounting services (including auditing, PROFESSIONAL AND bookkeeping, taxation services, etc.), marketing services, product BUSINESS SERVICES design and development. Table 5 Source: Mattoo and Wunsch (2004). p. 4. Gartner defines Business Process Outsourcing (BPO) as the delegation of an IT-enabled business process to a third party that owns, administers and manages the process according to a defined set of metrics. That is, BPO is typically corporate function unbundling. Moreover, Gartner differentiate between Business Processes that are tailored to specific industries, and those that can be leveraged across specific industries (Singh et al., 2009). Examples are listed in the below table: 14

15 Horizontal offerings: Benefits administration Accounts payable Indirect procurement Contact centre operations More-holistic horizontal offerings, including HR-related functions Table 6. Source: Singh et al. (2009) Vertical-specific offerings: Revenue cycle management for the healthcare industry Mortgage origination for the banking industry Policy administration for insurance companies This is a useful distinction and shows how business process services may be customised not only to a specific firm but to industries as a whole. Service suppliers may specialise in providing services that fit for instance insurance companies or may provide more generic services. What Gartner defines as horizontal offerings fit more than one industry, but might also be customised to a particular company or standardised to fit more than one company Method of delivery IT- and business process services can be traded using various methods of delivery, location of delivery and methods of purchasing (Caminos et al., 2008). Depending on the type of service, and depending on among others the degree of automation and standardisation, IT- and business process services supplier-vendor relationship take different forms. Cloud computing is a delivery method for Information Technology Services in which internet is used as the platform for service delivery (Singh et al., 2009). Cloud computing came about as companies like Amazon, Google and Salesforce.com appeared in the consumer market and then spread into business organisations. This development is termed consumerization. By concentrating on rationalising and increasing standardisation of service offerings, service suppliers are able to deliver with greater predictability and cost savings (Caminos et al., 2008). Cloud computing is a suited delivery method for such standardised service offerings, 15

16 and may be used for services like or application services. Application Service Providers may thus use the internet to provide their services. Cloud computing is on the rise as an IT service delivery method and is equivalent to using the arms length market as opposed to hierarchy at the other end of the spectrum. Another method of delivery which is on the rise is 24/7 availability of IT support. A company may for instance set up several help desks in remote locations in order to limit the number of contacts hitting one help desk. By setting up global delivery networks based on the same homogenous processes and methodologies, the end user will experience the same service regardless of location. By taking advantage of different time zones, a company may ensure 24/7 seamless IT support. 24/7 seamless IT support would be the ultimate aim for providers, however still a work in progress for many (van der Heiden, 2009). Business processes may, in the same way as IT services, take different forms and may be delivered to the buyer using different delivery methods depending on the type of service provided. Gartner has defined the following four major categories of service delivery for business processes (Caminos et al., 2008): Discrete-process BPO Comprehensive BPO Multi-domain BPO Business Process Utility (BPU) The bulk of the BPO market falls into the first of the categories and constitute outsourcing of single sub processes such as benefits administration and accounts payable. This is what Mattoo & Wunch (2004) defines as back-office operations. This differs from Mattoo & Wunch s (2004) other professional and business services category which equals Gartner s Comprehensive BPO. Comprehensive BPO are characterised by support for multiple business processes within on area or business function, such as payroll, benefits administration etc. Multi-domain BPO support several functions across multiple process domains such as pieces of HR, F&A, procurement and customer service. These types of contracts are not common (Caminos et al., 2008). 16

17 Similar to how standard IT services are moving to the cloud, automated and standardised business processes may move towards utility like offerings. This is termed business process utility (BPU) and forms the last of the four delivery methods defined by Gartner. The term utility is used as a metaphor to illustrate how standardised business processes may be provided much in the same way as utilities like power and electricity. The business process service recipient will pay for the functionality but not own, build or develop the service provided itself (Young et al., 2010). This provides the user of BPU with flexibility, reduce cost, and speed to access among others. Thus, for some services Companies may gain from taking advantage of standardised offerings that are prebuilt and not prebuilt specifically to fit their particular organisation. BPU will be offered as a standardised process as a one-to-many technology platform (Caminos et al., 2008) Intermediate summary It is possible to make the distinction between vertical disintegration and corporate function unbundling. The first is known from manufacturing and enables outsourcing of intermediate goods or services, whereas the latter lets Companies outsource part of a business function like human resource functions (HR). IT- services may constitute part of a final good or service whereas corporate function unbundling enables outsourcing of Business Process services. Vertical disintegration and corporate function unbundling also differs in that suppliers of an intermediate service or good may end up competing in the same market as the client firm, as opposed to business function service suppliers. Suppliers of a business process compete in a different market then the client firm. A Company face the decision to either make-or-buy. As a simplification, outsourcing can be said to equal the latter. However, outsourcing is more than just a pure vendor relationship and involves relationship-specific investments that fit a Company s specific needs. IT services and Business Processes services differ with respect to the amount of customisation. Standardising and automation has been termed the productising of services (Sako, 2006), and impersonal services (Blinder, 2006). As information technology improves services may increasingly be automated and standardised. Services that are highly standardised and automated are moving to the cloud and utility-like offerings. The cloud type of service delivery method is closer to purely utilising the arm s length market, then outsourcing. Service providers of BPU, 17

18 providing services from a one-to-many technology platform also lack extensive relationshipspecific investments. Companies seeking to outsource also face the location decision. If a Company choose to outsource abroad, this is termed offshoring. Nearshoring refers to sourcing of services from a location close to the home country. Highly automated and standardised IT and Business Process services may be offered over the internet. As stated above, outsourcing entails a larger degree of bilateral dependency between buyer and supplier than just a simple vendor relationship. Hence, as these types of services fit in the buy part of the spectrum, it is not considered outsourcing by the definition in this thesis. Home Location Abroad Mode Make Domestic in-house sourcing Offshore in-house sourcing Buy Outsourced to domestic suppliers Outsourced to foreign suppliers (GATS mode 1) Table 7 Countries may specialise in different types of services. The choice of where to locate depends among others on the type of service outsourced, who can provide the service, and the cost associated with the transaction. Next, the theory forming the background of the analysis will be presented. PART III: THEORY Transaction cost economics explains the rationale of the so called make-or-buy decision. That is, the choice of either keeping the activity in-house or letting someone else produce the good or service outside the boundaries of the firm. The choice to buy would in this respect correspond to outsourcing. As stated above, outsourcing entails more than merely a vendor relationship. Depending on the type of transaction taking place, the buyer-supplier 18

19 relationship can take several forms within the range of either make or buy. TCE is operationalised by naming the key attributes to which transactions differ (Williamson, 2008). Drawing on the literature on TCE, production networks, and technological capability and firm-level learning Gereffi, Humphrey and Sturgeon (2005) similarly identifies three key variables describing governance structures. These three variables include the complexity of transactions, the ability to codify transactions, and the capabilities in the supply-base. TCE and governance structures will be explained and defined in the following section Transaction cost theory Classical economics based on the theory of efficient markets imply that it should always be cheaper to buy on the market rather than internalise. Classical economics does however not explain how large vertically integrated companies producing nearly everything in-house can be successful. The theory of transaction costs explains this by taking into consideration costs incurred when going out to the marketplace. These costs may be thought of externalities or transaction costs. Examples of transaction costs may include identifying suppliers, negotiation and contracting costs as well as follow-up of suppliers to make sure they deliver at the correct quality at the correct time (Rugman, 1987). These costs may be avoided by keeping activities within the firm, and hence explain how vertically integrated firms may be successful. According to transaction cost theory a firm should keep activities internal to the firm unless: Production cost savings > Sum of all Transaction Costs Transaction cost theory identifies three main factors which impact on whether a company should make or buy (Rugman 1987). These are; The frequency of the transaction The uncertainty of the transaction The asset specificity of the transaction Frequency of the transaction refers to whether a product is acquired frequently or not. If a product is acquired infrequently it is common to use the market. This is due to factors such as 19

20 setup costs and scale economics. As the cost of producing a good tends to fall as a firm produces at a higher scale of production, it might be too costly to internalise intermediate goods acquired infrequently. As Multinational Enterprises (MNE s) can draw advantage of scale benefits, these are this more likely to produce in-house than the average small firm. If economies of scale exist and there is sufficient demand, specialised service firms will develop. If services required are fairly standardised it could thus be attractive for companies to contract out as it is likely that specialised service firm will be able to deliver at lower cost. There is however difficulty in adapting to changes in customer tastes and the risk that a company offering the service might fail to adjust over time (Rugman, 1987). The uncertainty of the transaction relates to enforcement costs associated with the transaction (Rungman, 1987). This would include for instance policing the supplier to make sure that he delivers on time. Transactions may be subject to both market and technology uncertainty. Market uncertainty develops due to factors like bounded rationality, and self-interest seeking. Bounded rationality is the notion that rationality of individuals is limited to the information they have. Self-interest seeking behaviour is also described as opportunism, moral hazard and agency. This behaviour might lead to market participants taking advantage of measurement difficulties and underperform and/or overprice. The greater the uncertainty the greater the need will be for policing. Asset specificity refers to whether or not an investment is specific to a certain transaction. Standardised products are unspecific and make inter-firm relationships less complex. Moreover it lessens the risk of opportunism. On the other hand, customised products are specific to an investment and raise the risk of opportunism. The fact that a product is customised give rise to bilateral dependency in that the parties have incentives to promote continuity in order to safeguard specific investments (Williamson, 2008). Outsourcing will then be more costly as safeguards need to be put in place. Even without opportunism, transaction costs increase with increased need for coordination. Coordination problems are also reduced and the ease of description makes contract simple to write. Standard products can be made by a variety of suppliers and bought by a variety of customers, thus problems arising from asset specificity are low (Gereffi et.al., 2005) In conclusion, transactions which are frequent, uncertain or asset specific is more likely to be produced in-house. 20

21 TCE explains the exchange in the market place. With vertical disintegration and corporate function unbundling, TCE can be used in describing each make-or-buy decision within a firm. A firm have the choice between managing transactions through an interfirm or intrafirm contract. The latter alternative would correspond to the make decision, producing inhouse, while interfirm contract would correspond to using the market. There are however several ways to govern a buyer-supplier relationship through contracts. Between the limits of the using the arm s length market and being a fully vertically integrated firm a variety of hybrid collaborative structures exists (Carmel & Tjia, 2005; Gereffi et.al.2005). TCE and governance structures may be joined by identifying the transaction as the basic unit of analysis, and identifying governance structures as a way of managing these transactions. The objective of both TCE and choice of governance structure would be to minimize transaction costs (Williamson, 2008). Next, the relationship between TCE and governance structures will be explained in further detail TCE and Governance Structures From a TCE perspective, governance seeks to minimize on transaction costs by introducing order in the buyer-supplier relation where potential conflict threatens to upset opportunities to realise mutual gain (Williamson, 1999). Governance theory tries to look ahead to recognize hazards that may upset the supplier vendor relationship, and mitigate in order to realise this mutual gain. The characteristics of transactions differ from case to case. Governance structures also differ in the strength and weaknesses and need to be aligned with the type of transaction in order to reach the best solution for both parts. Standard goods and services may for instance be procured using the market, whereas more complex transactions require hybrid governance structures (Williamson, 1999). A transaction s characteristic will thus lead to different types of governance. Williamson (2008) focus on asset specificity and uncertainty as being the two main factors in TCE that leads to the need for more complex contractual relations then either make or buy. As stated above, asset specificity gives rise to bilateral dependency. Bilateral dependency would however not be a problem were it not for disturbance. Uncertainty is the source of disturbance to which adaptation is required. As bilateral dependency builds up, the most efficient way of 21

22 governing the contractual relation would move from simple market exchange to hybrid governance structures. The transaction may also be taken out of the market. By vertically integrating, a company will accrue bureaucratic costs by organising the transaction internally. Hence, from a TCE perspective internalising would be a company s least favoured solution (Williamson, 2008). Market Hybrids If everything else fail; Hierarchy Asset specificity may change over time during the contractual relationship. During the contract period, a bilateral dependency might build up. Hence, the buyer-vendor relationship is not static. Whereas standard products can easily be redeployed elsewhere, customised products cannot be put to alternative use without a loss of productive value, hence continuity preserving governance is important (Williamson, 2008). As previously stated Gereffi et al. (2005) draw on literature on TCE, production networks, and technological capability and firm-level learning to identify three key variables describing governance structures. These three variables include the complexity of transactions, the ability to codify transactions, and the capabilities in the supply-base. Gereffi et al. (2005) subsequently identifies five types of possible governance structures; Market Modular Relational Captive Hierarchy Literature on technological capability and firm-level learning states that regardless of frequency and scale economics, it might be too difficult, time consuming and effectively impossible for some firms to internalise production processes. The concept of core competencies moreover argue that firms that do not vertically integrate or incoherently diversify their activities, but focus on their core activities, will perform better (Prahalad & Hamel, 1990: Gereffi et al, 2005). Network theorists argue that factors such as trust, reputation, repeat transactions and mutual dependence help manage risks associated with asset specificity, and opportunistic behaviour. Hence, Gereffi et al. (2005) argues that more complex inter-firm relationships are made possible than what is put forward in TCE. Next, the governance structure classifications suggested by Gerreffi et al. (2005) and the rationale behind the classification will explained. 22

23 3.3. Governance Structures The theories regarding asset specificity, and the different motives for constructing complex inter-firm relationships generate three possible modes of industrial organisation; market, network and hierarchy. Gereffi et.al. (2005) draw on these theories and identify three key variables that help to explain how global value chains are governed and change. These three variables include the complexity of transactions, the ability to codify transactions, and the capabilities in the supply-base. Complexity refers to the information and knowledge transfer required to sustain a particular transaction with respect to product and process specifications in particular. Codifiability refers to whether or not this knowledge and information can be easily codified, and thus transferred efficiently between the parties and without transactionspecific investment. Capabilities refers to the skill of actual and potential suppliers in relation to the transaction specific requirements. By giving each variable a value of either high or low they identify eight types of global value chain governance structures. Only five options are however found to exist as the combination of low complexity and low ability is unlikely to occur, and the combination low, high, low would lead to exclusion from the value chain and hence not form a type of governance as such. Thus, five options remain running from low to high levels of coordination and power asymmetry. These options are; market, modular, relational, captive and hierarchy. The determinants identified by Gereffi et.al. (2005) also emphasise mundane transaction costs. That is, costs involved in coordinating activities along the value chain. Mundane transaction costs increase as the need for coordination increase e.g. with acquisition of nonstandard products, integral product architectures, and time sensitive output (Gereffi: Baldwin and Clark, 2000). 23

24 Lead firms may increase complexity by putting new demands on the value chain, by for instance increasing product differentiation. They may also decrease complexity by for instance using technical standards. Standards codify information and may simplify complex transactions. Standards thus go a long way in explaining the governance of value chains. Standards make network structures more fluid and flexible as suppliers and customers are more easily linked and de-linked. Certifications in relation to quality, labour and the environment may also provide similar functions. Both private and public organisation can define standards and in some cases also certify that products comply with them (Gereffi et al. 2005). The three determinants can be used to show how power operates in global value chains. Hierarchy and captive structures suggests a high degree of coordination needed and buyers will be the dominant firm. In relational global value chains the power balance between supplier and buyer is more symmetrical given that both contribute with key competencies. In a modular and market types of governance structure both suppliers and buyers may easily link or de-link and work with multiple partners. Hence, power asymmetry is low. Governance type Complexity of transactions Ability to codify transactions Capabilities in the supplybase Market Low High High Modular High High High Relational High Low High Captive High High Low Hierarchy High Low Low Table 8 Source: Gereffi et al., 2005 Degree of explicit coordination and power asymmetry Low High 24

25 3.4. Governance structure classifications The different types of governance structures as presented by Gereffi et al (2005) are neither static nor associated with a specific industry. The type of structure depends on how interactions between members of the value chain are managed, and how technologies are applied to design, production and the governance of the value chain itself. The model explains the way the value chain governance is likely to change. If a buyer seeks to obtain more complex inputs, the governance structure will depend on whether or not the existing supplier is able to meet the new requirements. Increased complexity might be spurred by new technologies that again might make it more difficult to codify the transaction. It is likely to take some time before new technologies are standardised, hence there exist a tension between innovation and codification. The Modular form of governance structure appears to play a more central role in the global economy as technologies, standards and capabilities in the supply base increase (Gereffi et.al., 2005). Starting off with a Relational type of governance a shift to Modular is expected to happen as standards improve. Standards thus make for more flexible value chains and offers decreases in cost and risk. Standards might change when new technology is introduced, but also if there is a drive to bundle value chain activities in new ways. Hence, it might be difficult to know the standard. Also there might be competing standards making investment difficult and risky (Gereffi, et.al., 2005). The following section explains the different governance structures as outlined in the above table number eight Markets When inputs are clearly defined (codifiability is high) and can be produced by the seller with little input from the buyer, they can be acquired on the arm s length market. Asset specificity is low, hence little coordination is needed. The seller sets specifications and prices. It is easy for both parties to the transaction to switch partners and the cost is low for doing so. 25

26 Modular value Chains Modular value chains can arise when codifiability is high but extend to complex products. Modularity refers to the way different parts are tied together. High modularity signifies loosely coupled, relatively independent building blocks. This enables dis-aggregation and standardisation. As such, modularity help simplify the buyer-seller relationship in the face of complex transactions as seller may supply standardised packages and modules that internalise hard to codify (tacit) information. This reduces asset specificity and hence the buyer s need for direct monitoring and control. As opposed to simple market exchange the seller alone does not set the price in a modular value chain type of governance. Although complexity is higher, the possibility to codify knowledge means that many of the benefits such as speed, flexibility, and access to low-cost inputs are the same as acquiring input on the market. Due to codifiability, complex information can be exchanged between buyer and supplier with little explicit coordination. The cost of switching to new partners remains low Relational value chains Relational value chains may occur when codifiability is low, transactions are complex and supplier capabilities are high. The main drive for lead firms to outsource activities in spite of low codifiability and complexity is the need for complementary resources. The supplier-buyer relationship is characterised by mutual dependency and requires monitoring which is often managed through reputation, spatial proximity, family or ethnic ties and the likes, or through mechanism that impose costs. Frequent face-to-face interaction is often required and the high levels of coordination make the cost of switching to a new partner high Captive value chains Captive inter-firm linkages occur when codifiability and complexity is high but supplier capabilities are low. Outsourcing is frequently confined to a narrow set of tasks and requires a great deal of intervention from the lead firm. As such lead firms try to lock-in suppliers and 26

27 make exit an unattractive option for the supplier to exclude other firms from reaping the benefits of their efforts. The buyer-supplier relationship is thus characterised by high power asymmetry, the buyer being the dominant firm Hierarchy High complexity coupled with low codifiability and lack of highly competent suppliers will make in-house production the best option. The choice of keeping activities within the hierarchy of the firm may be driven by the need to exchange tacit knowledge between value chain activities, as well as the need to manage complex webs of inputs and outputs, i.e. the different activities may be more integral than modular. There might also exist the need to control resources, in particular intellectual property Intermediate Summary TCE lists three main characteristics to the transaction that impacts on the choice of whether to make or buy. The three main characteristics are: The frequency of the transaction The uncertainty of the transaction The asset specificity of the transaction Transactions which are frequent, uncertain or asset specific is likely to be kept within the hierarchy of the firm, as opposed to being bought on the market. Hierarchy and market can be viewed as contractual relationships or governance structures. Different types of governance structures may be put in place in order to manage a transaction. Gereffi et al. (2005) identify five types of governance structures. These are market, modular, relational, captive and hierarchy. These governance structures are dependent on the three key factors specific to the transaction: Complexity Codifiability Capabilities 27

28 The theory put forward by Gereffi et al. (2005) draw on TCE to identify these key variables determining how global value chains are governed and change. Complexity and difficulties in codifying information and knowledge will add to the cost of the transaction, and falls under the categories asset specificity and uncertainty of the transaction. Standard services are for instance usually easy to codify. Uncertainty of the transaction may increase if the service supplied is complex. Frequency Uncertainty o Complexity Asset specificity o Codifiability Capabilities in the supply base is a new determinant and says something about the location decision for a firm that seeks to outsource. A supplier needs to have the skills needed to be able to deliver what is required. However, taking into account the cost of the transaction, the location decision will be made with the aim of minimizing the cost. The way that a buyer-supplier relationship is governed is a result of the attributes of the transaction and these may change over time. A service may for instance become increasingly more customised over the course of the transaction period. Williamson (2008) states that as asset specificity increase, bilateral dependency builds up. Gereffi et al. (2005) illustrates this in their overview of governance structures (table 8 above) by introducing the notion of coordination needed and power asymmetry which increases when going from market to hierarchy. According to TCE, hierarchy is a Company s least favoured form of governance. Thus, standardisation will for instance be in a Company s best interest. A supplier on the other hand, might push for more customisation. If customisation is high, switching cost is high. A supplier specialising in offering standard solutions will push for Companies to choose their standard. The following section will apply the above theories to IT services and Business Process services and aim to identify trends in outsourcing and offshoring of these services. 28

29 PART IV: ANALYSIS A Company may choose to outsource part of an intermediate good or service, or outsource part of a business function. The make-or-buy decision may be applied to both types of transactions. According to the theory outlined in the previous section, a Company seeking to outsource should take into account the attributes of the transaction and evaluate to what degree a transaction is frequent, uncertain, or asset specific. Complexity and ability to codify a transaction falls in under these categories. Another issue is where a Company choose to locate, and this will depend on the supplier skill base. Countries differ widely in which type of IT- and business processes services they are able to offer. A Company may choose to offshore their activities, but this may incur extra transaction costs due to risk and challenges associated with choosing a specific supplier or location. These costs may in some instances be reduced by locating closer to home, i.e. nearshoring. From a European Company s perspective, locating services within the EU could for instance prove less costly than locating in Asia. The key factors influencing the transaction costs listed above may be managed through different types of governance structures as previously outlined. This section will look at the transaction costs associated with specific IT- and business process services. It will look at the attributes of the transaction of IT and business process services and discuss to what extent they are frequent, uncertain, and asset specific. Ability to codify the transaction and complexity will be discussed along with asset specificity and uncertainty respectively. Transaction costs associated with going abroad will be listed. Legal issues will be discussed in a separate section as this is considered a major part of the costs of offshoring and also illustrates the pros and cons of nearshoring versus offshoring. Countries vary with respect to the services they offer, this will be illustrated by comparing selected countries. The topic will be discussed from the perspective of a company operating in Europe in order to capture the benefits of nearshoring. Nearshoring options for European companies can be found in Eastern Europe in particular. Offshoring alternatives include countries worldwide. The countries chosen for the purpose of this analysis is the Big Three nations: India, China and Russia as offshore destinations. These countries are due to the 29

30 volume of software offshoring going these nations. Moreover, they are among the main traders in services world-wide. The big three also have a fairly large pool of high skilled labour. As nearshoring alternative, Latvia and Romania has been chosen. From the perspective of a multinational that operates in Europe, these countries offer cultural and linguistic similarities, greater ease of ensuring compliance with European regulations, e.g. pertaining to privacy as well as high levels of technical ability. Lastly, the type of governance structures will be discussed The make or buy decision There exists a number of IT and business process services which might be delivered to customers in a variety of different ways. Depending on the method of delivery and type of service, the attributes to the transaction change with respect to the key factors determining whether to make or buy. The key factors will be discussed in the following order: Frequency Asset specificity (including ability to codify) Uncertainty (including complexity of the transaction) Frequency Frequency of the transaction refers to whether a product is acquired frequently or not. If a product is acquired infrequently it is common to use the market. This is due to factors such as setup costs and scale economics. Specialised service firms will develop if demand is high enough and economies of scale exist. Within the IT and business process services there are a number of specialised firms that are able to deliver at low cost. Highly standardised and automated services may be offered over the internet, and for some companies it might be more efficient to buy prebuilt solution over the internet than internalising. By procuring prebuilt processes and services over the internet, a company avoids the setup cost of producing in-house. The service might be used so infrequently that it would be too costly to setup production in-house. 30

31 Many services are however used frequently, and could as such be kept in-house. Business processes in particular are functions within the company that may be used on a day-to-day basis. Notwithstanding, business processes are often outsourced. As an example, human resource services are often outsourced in spite of being frequently used. One reason for this could be that human resource services are fairly standardised, and hence taking into account the other factors determining whether to make or buy, transactions costs would be low. One could also argue that the relative frequency is low for one particular firm. That is, as human resource services often are standardised across companies and industries, economies of scale exist for service providers. Hence, frequency of the transaction would be higher for the service provider of human resource services than for one particular company. Customer interaction services (ref. table# 5) are also frequently outsourced despite of high frequency of the transactions. Customer interaction services like customer services helpline may be standardised or customised. The same logic applies as for human resource services. By standardising customer services help lines, economies of scale will exist for service providers which may offer the same support to several companies across industries. Hence, transaction costs will be lowered. Call centres may be used where the requirement for company specific knowledge is low. If company specific knowledge is required this type of customer services helpline may be kept internal to the firm. It is also possible to outsource part of the service while keeping part in-house. Services needing a high degree of company specific knowledge would be kept in-house. Consequently, frequency of the transaction at first does not seem to fit the IT- and business process services sector as many of the business processes are regularly outsourced in face of being used frequently. However, taking into account asset specificity, specialised service providers are able to offer standardised solutions across companies and industries. The frequency of the transaction is comparatively higher for the service provider. As a result, companies may choose to produce in-house or take advantage of the lower costs obtained by specialised service suppliers through economies of scale. 31

32 Asset specificity As information technology improves, services may become increasingly more automated. This is also described in the previous sections as the move from personal to impersonal services. Automated services may also be standardised, and services which are both standard and automated are moving to the cloud or utility based service offerings. Cloud computing is internet based service offerings. Utility is standardised business process services offered from a one-to-many technology platform. Business process utility may be viewed as the next-generation of BPO. Traditional forms of business process outsourcing like payroll outsourcing is according to Gartner reaching the Plateau of Productivity. These types of business process services may mature to the point of becoming utility like services. High degrees of process standardisation and automation are believed to be the path for traditional business process outsourcing services. According to Singh et al. (2009) the following is factors to look for determining if a business process is becoming utility like: Transactional pricing, on a pay-as-you-go basis (as opposed to the multiyear, contractual lock-in of traditional BPO) Utilisation of the Internet as the connectivity medium for service delivery ( cloud sourcing ) Use of a one-to-many platforms (not customised, one-to-one applications platforms) The cloud sourcing and utility type of delivery method is close to a pure vendor relationship and requires little policing, the transaction avoids the problems with asset specificity and if required infrequently it will be easy for companies to buy. Hence, cloud and utility like offerings fall into the buy category and comprise the far end of the make-or-buy spectrum as such. Whereas utility like service offerings may easily be procured in the market, there exist an array of IT services and business process services which complexity must not be underestimated. Service offerings and methods of delivery is continuously evolving, and services may for instance be bundled, or customised in varying degrees according to business 32

33 needs. Seamless 24/7 IT support is an example of a delivery method that may offer standard services. The type of IT support offered should be easily codified in order to setup a global delivery network where the end user should receive exactly the same support no matter where in the world the service is supplied from. The type of support could however also be made more complex. Discrete process BPO or back-office operations may also be standardised in varying degrees. A company may choose to outsource to a supplier specialising in the industry particular to that company, or it may choose to outsource to a supplier which offer services that can be leveraged across industries. An insurance company looking to outsource it policy administration for instance could outsource this to a supplier to the insurance industry. Asset specificity would thus increase. Comprehensive BPO is support for multiple business processes within an area or business function. A company might for instance outsource multiple processes within their human resource management. This could for instance include, hiring, benefit planning and payroll. These might also be company specific to varying degrees. Multi-domain BPO offering support in more than one business function, for instance human resource management as well as finance and accounting. These processes could also be offered with varying degrees of standardisation depending on business needs. Some businesses may seek prebuilt solutions that enable them to switch suppliers easily, and increase flexibility, whereas other companies may need service that is customised. In conclusion, IT and business process services vary with respect to the asset specificity. The trend is however to move towards utility like services as the type of service offering matures. Services that are easily codified are more easily standardised, for seamless 24/7 IT-support it is important that it is possible to codify the information in order for the end user to receive the same support regardless of where the service provider is located. 33

34 Uncertainty The uncertainty of the transaction relates to enforcement costs associated with the transaction. For the IT and business process services sector the uncertainty is closely related to the speed of changes in technology. As technology improves services are more easily traded and may even be offered over the internet. Moreover, as improvements in technology increase automation and standardization, asset specificity decreases. The two factors are thus closely linked. Technology improvements seem to decrease the uncertainty of the transaction in that the problem with asset specificity is lowered. However, many of the IT- and business process services offered need to be customized to a higher degree. Policy administration for insurance companies could be outsourced to a service provider specializing in providing services for that particular industry. As the attributes of the transaction becomes more asset specific, mutual dependency between the buyer and supplier builds up. Mutual dependency would not be a concern were it not for uncertainty and factors such as opportunism, bounded rationality and technological uncertainties. If a company is locked in to a service supplier, the company is dependent on the service supplier delivering the services required even if the requirements may change over time due to technological improvements. Hence, both IT and business process service providers and customers need to predict to a certain degree the direction of the market. In addition to uncertainties with respect to transactions in the home market, there exist a number of extra costs associated with going abroad. Carmel & Tjia (2005) lists transaction costs associated with offshoring IT and IT enabled services. The list may not be exhaustive but gives a good overview of possible extra costs that may accrue when offshoring. The list comprise of the following items: Search and Contract Restructuring Infrastructure: technology and connectivity Knowledge transfer Efficiency Travel 34

35 Overhead allocation Governance Mitigating risks These extra costs associated with locating abroad as opposed to outsourcing domestically are listed under the section uncertainty. This is because it lists costs that are incurred due to offshoring, without considering frequency or asset specificity of the transaction. Knowledge transfer may constitute a major hidden cost by going abroad, and could also have been mentioned in relation to asset specificity and in particular ability to codify transactions. Ability to codify the transaction would ease knowledge transfer. Nevertheless costs associated with knowledge transfer include among others difficulties regarding cultural differences, translation, and transition to the work which adds to uncertainty and complexity of the transaction. The first item on the list, search and contract includes provider selection, research, consulting fees, legal, contracting and travel. Legal issues will be discussed in detail in the next section as it constitutes a major part of the choice of whether or not to outsource IT- and business process services. Moreover, legal issues are country specific. Restructuring is connected to costs associated with lay-offs when moving part of production abroad. These costs include severance pay and retention pay (paying essential employees to stay). Costs related to restructuring are more common in the US than in Europe. In Europe offshoring frequently starts out small, and layoffs are thus not that common. Infrastructure relates to for instance procuring technology, which typically constitute a small and predictable cost. Connectivity costs are also improving. International call rates are for instance falling rapidly. Efficiency is the cost that it takes for the offshore unit to produce at the same level of productivity as the onshore unit. That is, if a unit is transferred from onshore to offshore, it might take time for the new unit to go up the learning curve. Efficiency may be difficult to measure, and the cost will depend on the type of service offshored. Travel costs may also be extensive depending on the amount of follow-up needed, and of course will be less if the work is done nearshore. Overhead allocation, governance and mitigating risks comprise the last three items on the list. The economic benefits from offshoring may be turned from positive to 35

36 negative due to overhead costs. Governance and risk mitigation are costs incurred when following up the supplier and investing in resources in case of failure (Carmel & Tjia, 2005). Type of Service Frequent Asset specific Uncertainty Make or Buy HR services Yes Could be Could be fairly Make/Buy standardised complex Policy administration for Yes Industry Higher degree of Make/Buy insurance companies specific uncertainty Business process utility Yes No No Buy (BPU) Cloud computing Yes No No Buy Customer service support Yes Could be customised Not a complex transaction Buy Table #9 The above table summarise some of the examples given and illustrate how the decision to make or buy can be evaluated with regards to the TCE key determinants. Services that is more difficult to define as either make-or-buy could be managed through a hybrid governance structure. This will be discussed later on. Uncertainty and the complexity of the transaction will however increase when offshoring and a company are likely to incur extra costs by doing so. The next section will go into detail on legal issues that can make an impact when offshoring. Legal issues are discussed in a separate section as it may constitute a major part of offshoring costs, moreover they are country specific Legal issues By offshoring IT and business process services, companies may gain economic benefits from lower wages as well as gain access to high skilled labour. There are also substantial global benefits to be gained from cross border trade in services. Replacement of jobs from developed to developing nations might however lead to protectionist measures being put in 36

37 place. In fact, offshoring is subject to a number of legal issues, notably Intellectual Property (IP) protection, labour and employment rights, export control restrictions, privacy and data transfer restrictions, government approval of offshoring, taxes, and currency conversion exposure. Full commitment on market access and national treatment on the cross-border trade of services under the GATS would prevent this. Such a full commitment does however seem implausible due to the way GATS negotiations are carried out today. Firstly, the GATS only apply to the sectors a WTO Member chooses to list. A Member is thus free to restrict trade in services not listed. Even if one wanted to liberalise trade in all sectors, such a positive listing poses a problem. As previously discussed, no classifications may capture the changing nature of services and increasing amount of services being traded due to changes in technology, and business practice and skills (Mattoo & Wunch, 2004).. Secondly, WTO Members negotiate access in services trading partner by trading partner. Negotiating requires high costs in terms of negotiating resources. This might cause inefficiency. Moreover due to uneven bargaining power the results might not be equitable (Mattoo & Wunch, 2004). The European Union (EU) has put in place the Acquired Rights Directive to protect worker s rights. Through this Directive worker s rights are protected in case of the transfer of a business or a portion of business to a new employer. This Directive may in some cases apply to outsourcing and offshoring of jobs. The transfer of employees must in this case comply with various principles and regulations, such as safeguarding that employees are subject to the same terms and conditions that they had prior to the transfer (Eisner, 2005). Other countries also impose strict labour regulations. In India layoffs and closure might need government approval. This might for instance be the case if a company employs more than 100 people. If approval is denied, a firm might be forced to implement voluntary retirement schemes and pay the employees to resign (Eisner, 2005). Within the area of privacy regulation the EU has been a leader in enactment and enforcement. All firms that collect or process data from outside or within the EU are likely to be subject to the European Union Data Privacy Directive (95/46/EU). The EU privacy law regulates the 37

38 collection and processing of employee data, customer data, patient data, and other personal information. This will thus affect many of the services that are subject to offshoring. Human resource, financial and IT functions that involve personal data will for instance be subject to the regulations (Eisner, 2005). If you want to transfer personal data from the EU to other countries outside the Union, this is also regulated by the privacy regulations. This holds true even if you are transferring data within the same company. The Directive requires that data covered by the regulation can only be exported to countries with adequate protection. Only a few countries have been found to comply with this requirement. Major offshoring locations such as India, China, and Russia have not been deemed to have adequate protection. If a firm wants to transfer data regulated by the Directive to these locations, it has to use one of the approved methods for transfer. This is not an easy task (Eisner, 2005). If a firm within the EU wants to transfer personal data to for instance India, approval could be sought from the home country s data privacy authorities. This could be time-consuming, and new approvals would be required in case of change to the transfer deal. Alternatively, each customer could give approval for the transfer of his or her personal data. Another option, and probably the easiest one, would be to use the EU s approved data transfer contract clauses. The clauses make sure that the transfer of the regulated data are subject to a set of contract provisions consistent with the data EU privacy laws, and allows for enforcement by the EU authorities and the people that the data describe, referred to in the EU privacy law as data subjects. For transfer of personal data to the US, it is possible to use the US Safe Harbour scheme. A US company can self certify that they comply with these arrangements to the US Department of Justice. If they do, firms from the EU are allowed the transfer of personal data. Other countries that do not comply with the EU privacy law regulations are considering passing similar laws. India is considering entering into an arrangement with the EU that would make it easier for transfer of data (Eisner, 2005). For developing countries the choice of whether or not to enact laws in compliance with the EU is a difficult one. If they choose not to pass such laws they will be more or less shut off from providing services involving transfer of personal data. If they do pass the required laws, it might increase the cost of doing business (Mattoo & Wunch, 2004). 38

39 Offshoring is a hot political topic both in the US and Europe, and in these areas measures have been proposed to limit and regulate offshoring. Organisations looking at offshoring need to keep a close watch on these developments (Eisner, 2005) Capabilities in the supply base Capabilities refer to the skill of actual and potential suppliers in relation to the transaction specific requirements (Gereffi et al., 2005). Countries may have an advantage compared to other countries in producing a particular good or service. Advantages may be natural, such as oil deposits or they may be manmade, such as the concentration of computer companies around Silicon Valley (Blinder, 2006). Advantages that are derived from human effort may change over time. For instance in textile manufacturing the United Kingdom used to have a comparative advantage until the advantage shifted to New England, and jobs were moved from the United Kingdom over to the United States. Today textile-manufacturing jobs are mostly carried out in China. Within the IT and business process services the comparative advantages can be said to be manmade and derived from human effort. The three software stars of the 1990s: India, Israel and Ireland, focused heavily on the software sectors during the 1990s technology boom and was largely successful. As within the textile manufacturing example above, the advantage has changed over time. Both Israel and Ireland have been hurt by the global competition from firms in countries like China and India which offer lower wages (Carmel & Tjia, 2005). Whereas India started out with software exports as Israel and Ireland, India was successful in expanding into similar markets like software R&D. The shift from exporting IT- services and later expanding into similar knowledge-based industries like IT enabled services or the business process services sector has been witnessed in other countries as well. The shift in production from one location to another has been explained by Vernon (1966) through the international product cycle. The model has three stages. First, a new product is developed in an industrial nation. Second, the production starts to move abroad to low-wage nations. Third, the product is standardised and can be mass produced with low-skilled labour. 39

40 In consumer electronics, production moved first to Japan and then shifted to newly industrialised countries (NICs), often referred to as the Asian tiger economies (South Korea, Taiwan, Singapore and Hong Kong) with lower wages, and then to other Asian countries (China, Thailand, and Malaysia) with even lower wages (Carmel & Tjia, 2005). International economists refer to this pattern as the Flying Geese Formation, as the lead nation is followed by a second and third tier of countries. The Flying Geese Formation is appearing in the software industry as well where the US is the lead nation followed by India, Israel, and Ireland. The second tier of exporters is China and Vietnam (Carmel & Tjia, 2005). The below table illustrates how the shift in production from one location to another in the software industry; The 3-tier taxonomy of the world s roughly 100 software exporting nations Tier 1 Mature software exporting nations Mostly industrialized nations such as: USA, Canada, UK, Germany, France, Belgium, The Netherlands, Sweden, Finland, Japan, and Switzerland Entrants from the 1990s: Ireland, Israel, and India. Entrants from the 2000s: China and Russia Tier 2 Tier 3 Emerging software exporting nations Infant stage software exporting nations Brazil, Costa Rica, Mexico, The Philippines, Malaysia, Sri Lanka, South Korea, Pakistan, Ukraine, many other Eastern European countries, and several more elsewhere Cuba, El Salvador, Jordan, Egypt, Bangladesh, Indonesia, Vietnam, and others Noncompeting Non-competing About 100 of the mostly, small, least-developed countries of the world, including most African, and many Middle-Eastern nations. These nations have few to no software exporting firms Table #10 Source: Carmel & Tjia,

41 In contradiction to this, economist Jagdish Bhagwati (2005) argues that industries are becoming more footloose and no longer follow a specific pattern. With the rise of globalisation, comparative advantages are no longer thick, or shielded by big buffers. Bhagwati uses the term kaleidoscopic comparative advantage as a metaphor for the way comparative advantages fluctuate from one country to the next. Thus, he does not view the changes as predictable patterns but volatile changes as if a kaleidoscope had been turned. Comparative advantages may thus manifest itself in one nation or region for a specific period of time, disappear and reappear at a later date. There is no easy match between the statistical data available on trade in services and the services being traded (Mattoo &Wunch, 2004). Hence, it is difficult to find data confirming the flying geese concept or the change towards a kaleidoscopic comparative advantage. The below table (table 10) depicts the growth rate in business services for selected countries from The table has figures for India and China as the Tier 1 countries, and Eastern European countries (Tier-2) which show relatively high growth rates. By the IMF Balance of Payments Statistics Business Services takes into account Total Services minus Transportation, Travel and Government Services. In other words, Business Services consist of: Communication, Construction, Insurance, Financial, Computer & Info, Other business, Personal, cultural and recreational services as well as Royalties and License fees. Average Growth rate of exports of business services for selected countries, ( ) Table #11 Source: IMF Balance of Payments Statistics 41

42 The below table (table 11) summarizes international trade in services for 16 of the main trading economies in services which together accounted for more than 76% of world trade in services in 2008 (Bielecki & Gori, 2010). Among the service categories for which total world figures are available (transports, travel and other services), other services had the biggest share (51%) in 2008, followed by transportation (25%) and travel (24%). Trade in services for main trading countries (in billion Euros) Share of world (%) Rank Exports Imports Net Exports Imports Net EU ,3 419,5 87,8 529,5 443,3 86,2 26, USA 365,3 273,8 91,6 370,9 275,5 95, ,3 2 2 Japan 94,2 109,7-15,5 101,1 115,3-14,1 5,7 5,8 3 3 China 89,2 94,9-5, ,1-8 5,2 5,6 4 4 India 63,5 51, ,8 10,2 3,2 3,5 5 5 South Korea 46,2 60,6-14,4 51, ,4 3 3,1 7 6 Canada 47,6 60,4-12,9 45,2 59,7-14,5 3 2,8 6 7 Russia 28,8 43,1-14,3 34,9 51, ,3 8 8 Switzerland 48 23,2 24,8 53,1 24,8 28,3 2 2,1 9 9 Australia 29,5 29,1 0,4 30,8 32,9-2,1 1,7 1, Norway 29,6 29 0,6 31,2 30,4 0,8 1,6 1, Thailand 22,2 28-5,9 22,9 31,6-8,7 1,4 1, Brazil 17,5 27,1-9,6 20,7 32,1-11,3 1,3 1, Turkey 21,1 10,9 10,1 23,8 11,9 11,9 0, Israel 15,4 12,8 2,6 16,4 13,5 2,8 0,8 0, Mexico 12,8 17,6-4,7 12,6 17,2-4,6 0,9 0, Table #12 Source: IMF, Eurostat 42

43 The Big Three service sector exporters are highlighted in the above table (table 11) with red borders. India is the largest net exporter of the three countries. Israel can be found on the list at number 16 in 2007, and 15 in the Both Ireland and Israel has fallen behind India, and did not expand into similar or more advanced markets. In this, Bhagwati may be correct in that industries manifest itself in one nation or region for a specific period of time, disappear and may reappear at a later date. The following section gives a country outline of the following nations; India, China, Russia, Latvia and Romania. As before mentioned, the first three countries are chosen as they are large in volume of software offshoring in particular. The countries are also among the Tier 1 countries in software exports, and within the world s eight major trading nations. India in particular is also moving into business process service offerings (table 9, 10 and 11). What is more, the countries are large in the traditional sense and have a fairly large high skilled pool of labour. Latvia and Romania belong to the Tier-2 category of main software exporters. The countries are interesting nearshoring alternatives for European companies seeking to offshore India India has had major success in the IT services sector. In particular, India has had major success in software development and has been the leading country in terms of exporting software development. India and Ireland led global exports in 2006 (Bielecki & Gori, 2010). Two-fifth of the Fortune 500 companies outsources software requirements to India. In 2002, India s IT industry grew 29% which, faster growth for this industry than in any other country (Mattoo & Wunch, 2004). India had great success in creating synergies between similar knowledge-based sectors which has enabled them to move into the software R&D sector and more recently IT enabled services (ITES) i.e. the business process services sector (Carmel & Tjia, 2005). In 2003 the growth of the IT industry slowed to 22%, whereas business processes grew 65%. The ITES market grew from near zero in 1998 to 2.4 billion USD by 2003 and is forecasted to grow eight-fold within 5 years. The services offered include payroll and customer care functions to headquarters (Carmel&Tjia, 2005; Mattoo & Wunch, 2004). 43

44 Carmel and Tjia (2005) list three main factors that have led to India s success in software: Vast human capital Successfully creating large, dynamic, multinational firms Successfully creating synergies between similar knowledge based sectors The latter is evident through the successful move from software development, to R&D and business process services. India has created large profitable multinational firms; by 2004 there were three Indian IT firms with more than 20,000 employees and two more above 10,000 employees. IT service providers headquartered in India include major companies like TCS, Wipro, Infosys and HCL, these have also significant BPO assets (Singh et al., 2009). This illustrates the second success factor. With regards to the vast human capital, India can offer high skilled labour. Many of these are English speaking. India has a network of quality universities which accept a number of students yearly. As an example the Elite Indian Institute of Technology accepts 3500 of 178,000 applicants a year (Carmel&Tjia,2005). Although the scale of human capital is enormous considering the huge size of the country and number of inhabitants, Bhagwati (2005) cautions that India does not have an endless supply of skilled workers. Only 6% of those in the age appropriate group make it to college. Two-thirds of these graduate, and a fraction of these can read English. Even fewer can speak the English language adequately. Hence, even for back-office work the number of people available is only a small fraction of what is often presented to be the case (Bhagwati, 2005). Moreover, companies seeking to offshore to India should be aware of increase in wages, China and Vietnam are said to be lower than Indian wages for comparable work (Mattoo & Wunch, 2004). 44

45 China According to Bhagwati (2005) the main difference between India and China has been the political rule. India is democratic whereas China has been ruled by the Communist Party which has not been compatible with the PC. Authoritarian regimes are often fearful of IT (Bhagwati, 2005). Consequently, China did not have the major success breaking into IT the way it has previously done in manufacturing. As recently as 1999 China was not on anyone s mind when it came exports of IT services. As of today however, Chinese software industry benefit from Government support. The country has followed the Indian model by providing IT services to foreign firms. Moreover, China continues to attract FDI due to global firms seeking market access and access to high skilled labour. Thousands of Chinese return from studies abroad, bringing with them know-how. This is termed brain circulation. As a result, in just 5 years, China has emerged to become a global player within the IT services sector. In China, more than any other nation today, structural changes happen quickly (Carmel&Tjia, 2005) In addition to the political rule, China differs from India in two main respects when it comes to the type of services offered; Indian does little work for domestic customer as opposed to China (see net exports table #11) Chinese industry is more linked to computer hardware and manufacturing industries Moreover, as the human capital in both countries is vast, the language skills in India are better. The language skills in China are however also improving. Moreover, China has relatively low wages compared to India for the same type of work performed China s main strength is as stated above mainly embedded in software at the interface between hardware and software, e.g. telecommunications equipment, data communications and wireless.. Huawei is perhaps the most interesting Chinese player in this segment, and a major competitor to Cisco. Growth does however take place in all major software segments; in services, product R&D, embedded software, and also in business process services. Most 45

46 large technology firms from the US, Japan, Europe and India have software centres in China. Whereas the US and Europe are the main investors and clients in India, Japan is a major investor in China (Carmek & Tjia, 2005) Russia Russia is the smallest of the Big Three nations. Russia had major potential in the IT sector after the break-up of the Soviet Union. The country has thus not been as successful as the Indian or Chinese in adapting the educational system to the IT sector. Although the workforce is highly educated within science, mathematics, and engineering, little of this has been absorbed by the IT industry (Carmel & Tjia, 2005). Nonetheless, the Russian software export industry has been growing steadily. As in China most work within the IT sector is for domestic customers. Russia has not focused on foreign customers seeking to offshore, as the domestic customers have been more profitable. There exist further limits to the growth of the industry in that Russian firms are relatively small as opposed to the Indian companies. Few Russian firms employ more than 200 people. Among other reasons, this is due to lack of capital, taxation, and wanting to stay off the radar screen of organised crime. Moreover, there is a Russian cultural inclination towards working in intimate family-like organisations. Hence, software firms often work in forms of alliances in order to be able to accept work without growing their workforce (Carmel & Tjia, 2005) Latvia Latvia serves as a nearshore destination for Eruopean companies. Around 50 Latvian IT companies are actively engaged in offshoring DATI being the largest offshore provider and one of the biggest software houses in Easter Europe. The success in Latvia is much due to work done for German organisations. Through contacts with Latvian emigrants working in Germany, the first software orders came from German customers. Clients included: Siemens, Nixdorf and the German State insurance office, which used Software AG products. Latvia served as one of the Silicon Valley clusters within the former Soviet Union, but with the fall of the Soviet Union, nearly all state scientific institutes were disposed of and the big industrial 46

47 enterprises fell to pieces. Work for Germany did however keep the industry going, and the focus today remains on German customers Romania Romania is the largest exporter of software in the former Soviet bloc besides Russia. Romania provide software services for the domestic market as well as software services for export. The main factors driving the Romanian success is; Low wages Language Within the transition economies of Eastern Europe, Romania has capitalised on its low wages, comparable to Indian wages. As Romania is a Latin language, English and especially French are spoken more widely than in other Eastern European nations. Language has also enabled firms in the IT sector to move into the business process services market. Business process services offered include call-centres for French firms and domestic e-publishing (Carmel & Tjia, 2005). The major impediments to industry growth has been the infrastructure, lack of capital (little venture capital), and continuing brain drain of the best graduates of its technical and engineering schools. With EU membership the fear is that one of Romania s main competitive advantages, namely the low wages, will be erased. More recently however, the threat of skilled labour shortages as mentioned by Bhagwati (2005) has given rise to offshoring to Eastern European countries. 47

48 Offshoring versus nearshoring Uncertainty and complexity of the transaction will vary with respect to where a company choose to offshore. Countries differ in respect to the services they offer. Proximity to the customer remains an important aspect and makes it easier for a company to identify market opportunities, identify more carefully tailor services to clients needs, and clearly understand cultural, administrative and regulatory issues. From the perspective of a European company Central and Eastern European countries make up attractive nearshoring destinations. These countries offer proximity with regards to language, culture and physical distance. In addition, the EU has put in place regulations which increase complexity and uncertainty of the offshore transactions versus nearshoring. The European Data Privacy Directive (95/46/EU) in particular makes it difficult to offshore services related to human resource, financial and IT functions that involve personal data to countries which do not meet the EU requirements. Neither India, China nor Russia meet these requirements. Putting in place approved methods for transfer of personal data will increase the complexity of the transaction. Consequently it will be more costly and time consuming to locate these services within the big three countries. The below table (table 13) summarizes some of the main pros and cons related to the countries that have been presented. IT and ITES refers to whether the country export IT services or IT enabled services (business process services). The list is not exhaustive but is meant as an illustration of the types of factors which may increase the cost of doing business in that particular country. In addition to the factors mentioned with regards to culture, language and regulatory issues geographical proximity is a major advantage for European firms as travel expenses related to outsourcing and managing the buyer- supplier relationship is often underestimated. In face of the advantages of nearshoring, India can be said to be a more mature offshoring destination in terms of IT- and business process services. India has the high skilled labour required, and are present in both the IT - and business process services sector. Wages are however increasing, and the access to high skilled English speaking labour is not endless. China experience growth in both the IT and business processes services sector and have the advantage of low wages which might offset the advantages of nearshoring alternatives. 48

49 India China PROs - IT - ITES - High-skilled labour force - Language (high skilled labour force) -IT -ITES growing -Wages CONs - Cultural differences - Language (could be a problem) - Do not comply with EU privacy law regulation - Enough skilled labour? - Wages increasing - Cultural differences - Language - Do not comply with EU privacy law regulation Russia - IT - Cultural differences - Language - Do not comply with EU privacy law regulation - Small firms - Focused on domestic market Latvia - IT - Former silicon valley of Soviet Union - Nearshoring destination for Germany - Comply with EU privacy law regulation - Low wages Romania - IT - Wages might rise with EU membership - ITES - Comply with EU privacy law regulation - Language Table# 13 49

50 4.3. Governance Structures Different types of governance structures may be put in place to manage transaction costs. The need for governance develops where uncertainty and asset specificity is high. Gereffi et al. (2005) defines three key factors determining the type of governance that is suited to manage the transaction. Based on the above discussion the following section will explain how IT and business process services may be governed and change. This will be illustrated by using the same examples as in table 9 explaining the make-or-buy decision. Type of Service Complexity Codifiability Capabilities Governance type HR services Low High High High High High Market* Modular** Policy High Low High Relational administration for insurance companies Business process Low High High Market utility (BPU) Cloud computing Low High High Market Customer service support Low High High Market Table #14 *Nearshore **Offshore Human resource services like hiring, benefit planning and payroll are fairly standardised and easy to codify. In the words of Gereffi et al. (2005) modularity is high, which signify loosely coupled relatively independent building blocks. Complexity of the transaction is also low. A 50

51 human resource service provider may easily offer the same type of service to more than one company. These type of service providers exist nearshore and offshore and the capability in the supply base is thus high. This combination leads to market exchange which signifies little input from the buyer, low need for coordination, and low switching costs. It is however important to be aware of national differences in regulations regarding human resource management. If outsourcing domestically, the service provider will be familiar with the local regulations. Complexity of the transaction will increase if a company choose to nearshore. If a company choose to offshore their human resource services outside the EU, legal requirements will make this difficult. The European Data Privacy Directive (95/46/EU) in particular makes it difficult to offshore services related to human resource that involve personal data to countries which do not meet the EU requirements. With the added legal requirements, the cost of offshoring increase and the need for coordination in order to manage the transaction increases. This is illustrated in table 14 by going from market to modular type of governance structure when choosing to offshore. The added need for coordination and the need to adapt to new regulations add to the cost of offshoring and nearshoring might prove a less costly alternative. Policy administration for insurance companies is high in complexity and difficult to codify. Capabilities in the supply base exist. Costly operations and high maintenance costs related to insurance companies policy administration, including call centres, correspondence, billing and claims handling makes this a good candidate for business process outsourcing. The interest in BPO for insurance companies rose in 2008 but declined in 2009 due to the economic conditions which have driven insurers to be more risk-averse. In 2009 the insurance companies shifted the focus towards improving operational processes and put BPO on hold. Insurance companies in general are fearful of loss of control, the impact BPO will have on customer service, and costs associated with shifting from an old to a new platform offered by the BPO provider. Considering tougher economic conditions in for instance the UK, insurance companies may seek outsourcing in face of these fears (Singh et al., 2009). The combination of complexity and low standardisation leads to relation type of governance structure. As previously stated, the main drive for lead firms to outsource activities in spite of low codifiability and complexity is the need for complementary resources. For insurers this is the need for a system that is more standardised, easy to operate and maintain. The supplier- 51

52 buyer relationship in a relational type of governance structure is characterised by mutual dependency and requires monitoring. Frequent face-to-face interaction is often required and the high levels of coordination make the cost of switching to a new partner high. With a relational type of governance system proximity in terms of culture, language and geography could be an advantage. In that frequent face-to-face interactions may be required, travel costs may be substantial if the service is offshored to far away countries. In addition, as with human resource services, the European Data Privacy Directive is likely to cause problems for offshoring to India, China, Russia or the likes. The last group of examples, namely business process utility, cloud computing and customer services support can be procured using the arm s length market. Customer support services may be outsourced to most countries described in the previous section. The only factor that might prove a barrier is language. This could thus be a problem both in India, China and Russia according to table 13. The different types of governance structures outlined by Gereffi et al. (2005) are not static. The model explains how the value chain governance is likely to change. A buyer could seek more complex inputs which would lead to a closer knit buyer-supplier relationship. If a buyer seeks more complex input, this is also dependent on whether or not the existing supplier can match the new requirements. A company may also seek more standardised solutions. This will lead to a move towards a looser coupled supplier-buyer relationship. Insurance companies policy administration is a good example of an industry in need of more standardised solutions. If policy administration became more standardised, more companies could seek to outsource and the standardisation could lead to a move from relational to modular type of governance. The further you move towards standardisation in the IT and business process services sector, the less important the need for coordination along the value chain. The closer you move towards internalising, the greater the need for coordination. As need for coordination increase nearshoring seemingly becomes more important. Another factor that favours nearshoring is national and EU regulations. Language barriers are also greater outside the EU, and may be a problem even for tasks that are easy to outsource, such as call centres. 52

53 PART V: CONCLUSION ICT has changed the way we trade in services and the IT and business process service sector is in continuous development. IT and business process services may be traded using various methods of delivery and purchasing and location of delivery. New methods of delivery and purchasing seem to emerge at a rapid pace. Examples include cloud computing which developed through consumerization, and business process utility. New ways of taking advantage of outsourcing is also emerging, such as seamless 24/7 IT-support and increased outsourcing of business functions. In addition to new ways of delivering and purchasing these services, companies seeking to outsource are faced with a number of alternatives when it comes to location. An increasing number of countries engage in trade in services, and the growth in the IT and business process services sector is on the rise in many emerging economies. Companies need to be aware of this development and actively seek information on the different options available in order to be able to achieve lower cost, flexibility, and efficiency gains enabled through outsourcing. The choice to outsource and/or offshore can be viewed as two separate but interlinked decisions. The choice to outsource is the make-or-buy or mode choice. Offshoring is a location decision. This is illustrated in the below table: Home Location Abroad Mode Make Domestic in-house sourcing Offshore in-house sourcing Buy Outsourced to domestic suppliers Outsourced to foreign suppliers 53

54 The move towards the cloud and utility like IT and business process services signifies a move towards standard solutions which are easily linked and de-linked. The move towards standards is spurred by technological development. Prebuilt solutions enable flexibility for the customer and lowers costs. Move towards standard solutions are also witnessed in human resource management and more complex transactions like policy administration for insurance companies. Part of the IT and business processes sector are witnessing more complex transactions in terms of method of purchasing. As technology is improving, and options to outsource increases, a company is able to outsource increasingly more of their IT services and business functions. The sector might see an increase in multi-sourcing; a company sourcing different parts of their business functions and services from different suppliers and locations. Customer service support may be sourced from globally different locations enabling a seamless 24/7 support by taking advantage of differences in time zones. As automation and standardisation increase, the buyer-vendor relationship changes. Highly automated and standardised services that are easily traded may be procured using the market, requiring little interaction between the service provider and customer. Increased standardisation has in fact led to for instance internet based services. The change in governance structures is likely to go from more to less coordination requirements as mutual dependencies decrease. This may for instance lead to a move from relational to modular type of governance structure as is likely to happen with for instance policy administration in the insurance industry. Modular governance structures might also move to the market as standards improve. The move towards more loosely coupled buyer-supplier relationships implies less cost of coordination, and higher flexibility. Supplier switching costs will decrease. The different types of governance structures are illustrated in the table below. 54

55 Type of Service Complexity Codifiability Capabilities Governance type HR services Low High High High High High Market* Modular** Policy High Low High Relational administration for insurance companies Business process Low High High Market utility (BPU) Cloud computing Low High High Market Customer service support Low High High Market It is beneficial to locate transactions requiring a great deal of coordination and follow-up of the supplier closer to home. Travel may for instance be required, which make geographical proximity an advantage with regards to travel costs and the time it takes to travel. Moreover, if complexity is high and codifiability low, proximity in terms of language and culture may be advantageous. Companies may choose to outsource domestically the processes they feel a need to follow-up more closely. As technology changes, standards improve and complexity decrease, a company may choose to nearshore and subsequently offshore. Hence, a move towards standardisation will make it easier for companies to offshore outsourced IT and business process services. As the IT and business services sector matures more countries are moving into trade in these types of services. There has been a change in the type of services offered by countries from starting out by exporting software, moving into R&D software, and subsequently IT enabled services, i.e. business process services. 55

56 From a European company s perspective offshore destinations may offer a high skilled labour force and low wages. India, which has been the premium destination for foreigners wanting to offshore, is now facing competition as wages increase. Moreover, economists warn that India s supply of high skilled labour is not endless. China on the other hand, can compete with lower wages for providing the same type of services. Moreover, China is experiencing growth in both IT services and IT enabled services and might become an increasingly more attractive offshore destination. In spite of being attractive offshoring destination, countries outside EU may face problems when it comes to laws and regulations. This is especially true when it comes to the EU privacy law regulations which are an impediment to offshoring services which include personal data. Many of the business functions that are becoming more standardised and easily outsourced may not be offshored outside the EU without incurring substantial set-up costs. Hence, for services that incorporate personal data, nearshoring destinations may prove to be a better alternative in terms of costs. There are countries within the EU that offer these types of services to competitive prices, Romania being one of them. For services requiring a high degree of customer interaction, like customer services support, language may serve as a barrier to trade. In conclusion, the trend in IT and business process services seem to be a move towards standardisation and internationalisation. Technology is improving rapidly and new delivery methods and ways of purchasing are continually appearing. More and more countries are moving from IT services into similar knowledge based service offerings including business process offerings. Companies need to actively follow the development in the market in order to take advantage of the benefits of offshore outsourcing of these services. 56

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