6 am pacific

Thanks for all your comments on last week’s post on Local Hiring. Here’s the outline of the key issues we want to tackle in another chapter of the book called The Quest for Higher Bill Rates.

The need for higher bill rates, or rather services/solutions that will yield higher bill rates, is a consequence of two things.

One, with commoditization of major services like Offshore outsourcing, Application Maintenance, Customer service call centers and others (the list gets longer all the time), there is downward pressure on rates. Customers understand the service well and feel that they can manage the vendor to reduce risk. Deal consultants like TPI drive the commoditization even further.

Secondly, with strong growth comes competition for talent. Which leads to wage increases well above the rate increases that can be reasonably expected from clients.

Put together, the pressure on margins is tremendous. It helps that vendor switching costs are high, which mitigates the downward pressure somewhat with existing clients. But the need to do something to protect margins is going to become crucial in the future.

Increasing bill rates can be achieved in two ways. One, by differentiating core services to be able to command a premium over competition. Some services like large scale Offshore Outsourcing deals come with a fair amount of risk. Clients are often willing to pay a premium to a vendor who has a great track record and a solution that meets their needs. Within limits this can work well.

But what really pays dividends is investing in new services. New services are less competitive and the ability to make really high margins is great. For example, in the early days of ERP related services, we weren’t doing end-to-end implementations at Infosys, but revenue growth was strong and the margins were terrific. Why? because there weren’t too many service providers who could do offshore ERP work. The only alternative for clients was to have one of the Big 5 consultants do it for them at exorbitant rates, which left a lot of headroom for offshore service providers.

New services have always made good money. Until of course commoditization sets in. The trick therefore is to be a service innovator. Start early and stay ahead of competition. As the market expands, the early pain pays off in the form of high margin, high growth revenues.

But we are now at a stage in the industry where service innovation by itself is not good enough. The addressable space in new services that are being launched now is much smaller than the markets already being addressed. The impact that the new services can make on the company’s margin is therefore smaller. We may still not be there yet, but within five years, services that are new today will also have seen commoditization and there won’t be enough potential in introducing new services at that time.

This is not to say that the potential for innovation will go away. Quite the contrary. The action will shift from services to solutions – bundled services and IP that tackle a specific business problem. The IP included could be a platform that accompanies the service, or just a deep understanding of the business problem and the experience of having solved similar ones many times before.

By its very nature, each solution will have a smaller addressable space, but in aggregate could offer great potential. Pricing could be traditional time based pricing or it could be by transaction. The key thing is that competition will low and so there will be more freedom in pricing. The client is likely to look at the cost of the solution vis a vis the value it brings to his business.

This is a very profound change for the Indian offshore industry. Their approach to business thus far has been ‘build it and they will come’ – which works fine for services. But for solutions, you have to be out there, in the flow of what’s happening in your clients’ businesses. Identify pain points that can be solved by the combination of technology and services. And then invest the time and money to build a solution. You go from being an expert in delivering a service to becoming an expert on a business problem or process.

It also means that services companies will have to make many ‘bets’. Solutions require investment. How do you decide where to put your money? Or how much. Because of this difficult transition, I think that services companies will largely acquire technology or IP for their first solutions, instead of building it themselves.

How else will this transition from services to solutions affect companies?

I thought I knew the answer to this one. Turns out, the correct answer is “it depends”.

The GoI puts out a number which is called “Miscellaneous- of which Software Services” or Software Services in short. This data is available on the RBI website. The number for 2008-09 is $46.3 B (yes, the RBI does give data in both Rs. and USD).

This number comes from the Balance of Payments report. Software Services is actually not clubbed with Exports. It is part of Invisibles, along with Travel, Financial Services etc. – services that can be sold to parties outside the country but are never “shipped”.

This Software Services number includes both IT Services and BPO (and all other variants of XXS and XXO) but includes only revenue from billing done by Indian companies or Indian subsidiaries to their foreign clients or foreign parent companies. The problem with this number is that for an Indian company like Mindtree with no subsidiaries it will be pretty close to actual revenue, but for a company like Cognizant it will be what the Indian sub bills the parent for services provided. In all likelihood this number will be cost plus something like 15%, which is well below the typical mark up on offshore services of more than 100%. Additionally, for Cognizant the entire onsite revenue will be excluded.

I actually didn’t really check if Mindtree has foreign subs or not, but if it did then the RBI number would exclude the subsidiaries’ revenues, including only the Indian parents billing on the subs.

So, as you can see, the $46.3 B number is well under what you would consider the true revenue of the Offshore industry, which includes onsite operations related to the offshore business.

NASSCOM tries to correct for this revenue by including the revenue of foreign subs, but I don’t believe it does anything about the Cognizant situation where a foreign company has a sub in India. In truth, that is a slippery slope and it shouldn’t even attempt it. To figure out the onsite revenue associated purely with the offshore business is impossible to orchestrate over all companies. Imagine trying to do that at Accenture or Keane.

Also, included in the RBI number as also in the NASSCOM number are exports from Captives where onsite operations may not even be meaningful.

Anyway, that answers the question that used to puzzle me for the longest time – why are all the charts for software exports and not the Industry revenue? Sometimes you measure what’s measurable and leave the rest as an exercise for the reader.

By the way, I had been tearing my hair out trying to get the net Exports data for the IT-BPO industry. Finally found it when I came upon the RBI database dbie.rbi.org.in/ which is quite comprehensive and easy to use, though difficult to find. I sent some feedback. They fixed the data and sent me an email in one day! On the other hand, I sent an email to NASSCOM’s research department. No reply after a week. Go figure.

For some parts of the book that I feel the need to reach out to my blog readers. Your feedback will make a better product.

One of the chapters in the book is on Local Hiring – why Indian services companies haven’t hired in greater numbers and why it might become more important to do so in the future.

The percentage of employees in Indian IT Services companies who are Indian (born and brought up in India) is definitely over 95%. If you leave out the employees acquired through acquisitions, local hires (Americans in the US, Germans in Germany) are a rounding off error. Why is this so low?

Over 95% of the revenues of Indian services companies comes from outside India. 20 to 30% of billable employees are onsite. Shouldn’t you expect a higher proportion of employees to be hired locally? After all, IT Services is a high-touch business. If you are onsite, you are constantly working with client personnel. Cultural proximity, common backgrounds, networks from college and prior jobs must be of great value. Yet, local hiring is still very slim.

There are some good reasons why this might be so.

One, Offshore services is a very unstructured business. Every project is different – client needs, business processes, size of project – can all differ greatly from one project to another. The use of templates is limited to a few project processes only. Most of the project requires “new work” every time which in turn requires a fair bit of collaboration among the project team members – both offshore and onsite. This need for intense collaboration makes it much easier if the onsite team members are actually offshore team members who have moved onsite temporarily.

Then there are cost reasons as well. Not so much compensation which for most companies is within range of what it would cost them to hire locally. But there are other reasons why the costs are higher to hire locally. Like the fact that a local employee would likely need travel and living since the project can’t always be in the metro area in which she lives. Also, for local hires, bench costs are at onsite wages.

Outside of Delivery – in Sales and Consulting – the cost reasons above don’t apply. At one time, there was a salary difference. But now, Enterprise IT Sales and Consulting are both in decline and Indian Services companies have upped compensation substantially. So that isn’t a reason either.

But even here, I feel that companies feel torn between the need to hire folks who could be more effective in forming relationships with clients and the need for them to work effectively with offshore teams. Anyone who has worked in the industry knows that a salesperson’s effectiveness can often depend upon how good his access is to expertise and resources in the company.

The only place where there really are no barriers to hire are in senior positions in Sales and Consulting. Where you get the value of their experience in a certain industry and their networks but on the ground the proposals and staffing of projects is handled by other people. But here too there is a mismatch in expectations.

While Indian companies haven’t shown much urgency in hiring locally, it’s not as if potential employees are trying to break down the door either. Perceptions in the marketplace about Indian services companies are that you are generally “thrown into the pool to sink or swim” with very little support. Also, that policies aren’t as employee friendly as their current employers. You don’t have a life any more and work takes up every waking hour. Although, I think this is the nature of the offshore business, and if they are still working regular hours, it will change soon.

Going forward, local hiring will become more important. Winning business is now less about technical expertise, which is assumed. It is about domain expertise – do you understand my business process well enough? It is going to be pretty tough to build domain expertise organically – through the work the company does for clients. Hiring industry expertise into the company either from industry or from other consulting companies will become necessary to compete.

Also, there is the issue of optics. Can you do X billion dollars of business in a country, with tens of thousands of employees in the country and hire just a handful from the local market? The law may allow it, but you have to do much more in the court of public opinion.

Take Toyota for example. When they started putting up manufacturing plants in the US in the 80s, it was probably much easier to just expand in Japan. But they knew that if they were going to be a significant player in the huge US market, they had to do some local manufacturing. Today, Toyota has manufacturing facilities in many states in the US. When they ran into trouble earlier this year because of their quality problems, their American employees and politicians from the states that have the factories, supported them.

In a few years US or Europe based competitors who are rapidly adopting the offshore model will have a truly global workforce with a (largely) India delivery model. If nothing changes, Indian companies will be almost entirely Indian. The lack of diversity will lead to a lack of diversity of thinking. And exposed to political games.