The Offshoring Siren
February 1st, 2007
aka
The CEO’s guide to increasing the stock price by 11%
Here is an attempt to quantify the cost savings that are potentially possible in an information technology offshoring scenario. I also try to quantify the impact such a cost-reduction can have on the firm profitability and consequently the share price of the company undertaking the offshoring initiative.
Let us say company revenues are 100 and profits are 10. IT spending varies depending on the industry in which the company operates, but the benchmark is around 6%. This number is based on 2006 IT industry benchmarks available from Forrester.
Conventional wisdom says you don’t outsource everything – you keep the core, and outsource non-differentiating functions. Going by that logic, in IT too you want to keep those functions which help you differentiate your company from your competitors and want to outsource only the commoditized functions.
In recent years, pundits have started categorizing IT functions into two – the first variety, which helps your company to grow while the second variety helps to keep the lights on. Forrester calls these as “Innovation Capacity IT” and “Business as usual IT” respectively.
The ball park number for spending on these categories is usually pegged at 20/80. Using the numbers from Forrester, growth IT garners 24% of IT budgets, while the rest of it (76%) is for routine IT. Let us say, you don’t want to touch the growth IT but want to squeeze some efficiencies from the second bucket – if it is not making you differentiated, you might as well, do it for as little as possible.
This is where the offshoring sweet spot comes into play. The typical IT(1) budget looks something like 38% in wages, 18% hardware, 18% software, 14% consulting services, 13% in networking gear. So, the bulk of the costs are in wages.
If you are able to engage an offshore services firm that uses talent from low-cost countries, you will be able to save on the wage bill. Let us say this cuts wage bills by 50%. Also, you don’t have to pay for the purchase and upkeep of hardware used by your vendor’s employees. Say this reduces your hardware bill by 25%. The coordination/communication costs will go up and the consulting costs come down. Say, these balance out each other. The other costs more or less remain the same.
Essentially, it comes down to these three numbers – the wage bill savings (+), hardware savings (+), coordination/communication overheads(-). You can plug in the numbers that you think are pertinent to your case and see how the picture looks like for you.
Now let’s us do some math - based on these assumptions, your BAU IT spend which was previously 4.6 now becomes 3.5. So, your profits now become 11.1 and you have boosted your bottom line by 1.1%.
Assuming a P/E (2) of 17.8 (which is the current multiple of the S&P 500), this means your share price increases by 11% (all else being equal). Now, you must admit that something that can increase your share price by 11% is very powerful.
Of course, a few things to be noted here:
You do not overnight achieve these savings, but its more likely to happen gradually over a period of time (say 3 years). Also, you have to do it right – simply contracting an offshore vendor does not guarantee that you realize these benefits. It is an art (and one that is not easily mastered) that requires your navigate quite a few hurdles and calls for expertise that may not currently exist in your company. There are a lot of unsuccessful offshoring relationships indeed!
We have just looked at the IT spend. Other non-differentiated functions could be offshored as well – SG & A costs are another 6%, customer service functions – the so called BPO, KPO etc and you start to get a sense of how seductive this is.
This is not an article that extols the virtues of offshoring (3) and advocates that you pick up the phone to speak to an offshoring vendor right away or get on the plane to Bangalore, but just an effort to understand and explain why there is a clamor to offshore, why the offshore industry continues to grow at such a rapid clip.
(Thanks to my colleague Sowmya Ram for the illustration accompanying this article.)
1.You may not agree with these numbers. Fair enough – I grant as much. These vary from context to context. But here we are trying to present you the general gist.
2.Actually, it does not matter, what the P/E is, a 1.1% increase in profitability boosts your stock by 11%. Market Price per share = EPS * (P/E)
3. The other potential advantages of access to skilled resources, flexibility in staffing, quality benefits are not discussed here.
Entry Filed under: Offshore IT Services
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