IGG-10222003-01 J. Feiman Article 22 October 2003 CIO Update: Understand the Economics of AD and Outsourcing As enterprises look for cost-effective ways to globally staff their application development (AD) projects, it is important that CIOs and business unit leaders understand the factors that critically affect the AD outsourcing decision. As enterprises look for cost-effective ways to globally staff their application development (AD) projects, it is important that CIOs and business unit leaders understand the factors that critically affect the AD outsourcing decision. Development Expenses: Big Part of an Application s TCO Demand for AD outsourcing is strong. But perceptions about potential cost savings don t always match reality. For example: Capital costs represent only a small percentage of a developed application s total cost of ownership (TCO). Therefore, as a decision-making criterion, capital costs should not be weighted as strongly as development expenses, which are 50 percent to 60 percent of an application s TCO. Not all work in the five-phase AD cycle can go to an offshore outsourcer at significantly lower rates. Only the construction phase can typically be handled primarily through off-site work; all other phases tend to require significant on-site presence. Communications and Skills Effectiveness Two factors can seriously affect the value delivered from AD outsourcing: communication and skills effectiveness. A low level of communication, low programming and project management skills, or both will increase staff requirements or AD cycle time. More people could be needed to complete the project in the allotted time or, if project staffing is not increased, the project may take longer to develop. Communication and skills effectiveness provide many U.S. external service providers (ESPs) with an advantage that offsets the significant labor savings that enterprises can obtain from using offshore ESPs. U.S. ESPs also tend to have an advantage when the AD project requires a high percentage of on-site work. However, when more project work can be shifted off-site, the advantage swings back toward offshore ESPs in countries such as India and Russia, where labor costs are significantly lower than those in the United States. To assess the benefits of offshore outsourcing realistically, Gartner Entire contents 2003 Gartner, Inc. All rights reserved. Reproduction of this publication in any form without prior written permission is forbidden. The information contained herein has been obtained from sources believed to be reliable. Gartner disclaims all warranties as to the accuracy, completeness or adequacy of such information. Gartner shall have no liability for errors, omissions or inadequacies in the information contained herein or for interpretations thereof. The reader assumes sole responsibility for the selection of these materials to achieve its intended results. The opinions expressed herein are subject to change without notice.
enterprises must evaluate communication and effectiveness, and how they affect project duration and staffing requirements. As enterprises establish strategic relationships with outsourced consultants and system integrators, they must determine which roles are appropriate for ESPs, and which skills and roles best come from internal resources. Technical skills, such as coding and construction, tend to be easily outsourced. In-house resources are often the best sources for skills related to in-depth knowledge of the business and the problem being solved. The Importance of Communication Tactical Guideline: When determining whether offshore outsourcing offers advantages over on-site AD, enterprises should account for communication, which is highest when AD takes place on-site and much lower when AD is outsourced abroad. A serious problem negatively affecting AD offshore outsourcing is the communication difficulty that can arise due to language barriers, communication infrastructure and cultural differences. Low levels of communication cause misunderstandings, which in turn create delays as the problems caused by the miscommunication are resolved. A low level of communication can increase staff requirements or AD cycle time. More people could be needed to complete the project in the allotted time, or the project might may take longer to complete. Effective communication depends on language skills, communication infrastructure and cultural similarity. The Gartner model considers these three factors in terms of their impact on project effort (see Figure 1). U.S. in-house development, outsourcing to a U.S. ESP and outsourcing to an India and other countries were scored. Communication is highest in the United States when AD takes place on-site. It is slightly lower when AD is outsourced to a U.S. ESP, and drops further when AD is outsourced to ESPs in other countries. Figure 1 The Communication Factor in AD
Communication* (Example) 1.00 0.80 1.00 1.00 1. 00 1.00 0.90 0.80 0.79 0.73 0.71 0.73 0.60 0.49 0.53 0.51 0.40 0.36 0.20 0.00 U.S. Enterprise U.S. ESP Ireland India Russia China La tin America On-Site Off-Site * A lower score indicates additional effort is required to develop a unit of a project due to lower communications. The ideal is 1.0. Source: Gartner ESP external service provider Action Item: To realistically assess savings gained from offshore outsourcing, account for the communication factor caused by language barriers, communication infrastructure issues and the cultural differences with the ESP. Poor communication increases staff requirements and project duration, resulting in higher costs and lower savings. Skills Effectiveness Tactical Guideline: When determining whether offshore outsourcing offers advantages over on-site AD, enterprises should account for skills effectiveness, which is usually highest when an ESP does AD and lower when an enterprise does AD. Another serious problem negatively affecting AD offshore outsourcing is the effectiveness of an ESP s programming and project management skills. As was the case with communication, low skill levels can increase staff requirements or AD cycle time. Programming skills and project management skills determine effectiveness (see Figure 2). Those two factors the total weight of which is 100 percent were scored for U.S. in-house development, outsourcing to a U.S. ESP and outsourcing to an India and other countries. Figure 2 The Effectiveness Factor in Offshore Outsourcing Decisions
Skills Effectiveness* 1.00 1. 00 0.90 (Example) 0.80 0.70 0.76 0.74 0.60 0.40 0.20 0.31 0. 45 0.00 U.S. Enterprise U.S. ESP Ireland India Russia China La tin America * A lower score indicates additional eff ort is required to develop a unit of a project due to lower eff ectiveness. The ideal is 1.0. Source: Gartner ESP external service provider Effectiveness is highest (and equals to 1.00) when AD is outsourced to a U.S. ESP (in large part because U.S. ESPs tend to have top developers and strong management skills). Effectiveness is much lower when an average AD organization in a Type B or Type C enterprise in the United States does the AD work. Action Item: Consider the effectiveness of the service provider s programming and project management skills. Lower levels of skills effectiveness increase staff requirements and project duration. Choosing an Appropriate Outsourcing Type Strategic Planning Assumption: Through 2007, more than 85 percent of enterprises will lack the resources and capabilities needed to complete their own AD projects, and will delegate development of their global applications to ESPs (0.7 probability). Gartner has compared three outsourcing models skills, software and services (see Figure 3). Figure 3 Three Types of Outsourcing
Skills Software Services Outsou rcing Programming licensed software Selling service Business-oriented Technically oriented Eclectic Large professional pool Selling directly to enterprises Limited pro fessional po ol Sellingtovendors (OEM) Mixed pool Selling to individuals or enterprises Source: Gartner OEM original equipment manufacturer The most well-known representative of the skills model is that of offshore ESPs in India taking over foreign business-oriented projects (such as year 2000 remediation) and fulfilling them using a large resource of well-trained domestic professionals. The final product a finished application is directly sold to an enterprise. A good example of the software model can be found in Israel, where many vendors develop software systems (mostly operating systems, development tools and application servers) that require highly skilled technical professionals. Due to the country s size, the professional pool is limited as are vendors budgets, and marketing and support capabilities. The final product often is sold or licensed to a vendor (usually in the United States) that has the resources to market it. The service model s best-known implementation is a call center outsourced to another country, such as Ireland or the Philippines. The skill set depends on the complexity of the service (for example, ranging from a simple call center to a more complex brokerage service). Action Item: Determine the outsourcing type, sourcing country and ESP that will best augment the skills needed to develop applications, create out-of-the-box software systems or IT-enable services. The Best Skills to Outsource Tactical Guideline: Enterprises should outsource technical skills and develop business skills inhouse. Through 2007, most enterprises will lack the technical skills and qualified resources needed to support e-business AD initiatives. Consequently, many enterprises will have to establish strategic relationships with outsourced consultants and system integrators to deliver competitive solutions on time. Enterprises need to determine which roles are appropriate for ESPs, and which skills and roles are best obtained from internal resources (see Figure 4). For example, e-business analysts, who must have in-depth knowledge of the problem, are best provided through in-house resources. Alternatively, more technical skills, such as coding and construction, are more easily outsourced. Figure 4
Skills to Retain and Skills to Consider Outsourcing Keep In-House Don t Even Think of Outsourcing Business Analyst Business Knowledge HTML Author Graphic Artist QA Tester Web Site Designer Business Te ch nology Architect Webmaster Component Developer DBA System Administrator Ou tso urce Completely Technical Knowledge Ou tso urce b y Augmentation Sour ce: Gartner DBA HTML QA database administrator Hype rte xt Mar ku p Lang ua ge quality assurance Action Item: When staffing an e-business AD project, carefully determine what skills and roles should come from internal resources. Be prepared to outsource significant elements of the project to meet aggressive, competitive timelines. Leaders in the Offshore Outsourcing Market Strategic Planning Assumption: By 2004, the U.S. demand for offshore resources will grow from $7 billion to $12.5 billion, expanding at a compound annual growth rate of 35 percent (0.6 probability). India is the dominant offshore player in IT outsourcing, with: A multibillion-dollar export industry More than 900 software export firms Approximately 415,000 IT professionals About 70,000 new IT professionals entering the workforce each year Beyond legacy maintenance and staff augmentation, Indian vendors are becoming key providers of architecture services, e-business development and application integration projects. More recently,
they have successfully competed against leading IT service providers for business. Of the 58 Capability Maturity Model Level 5-certified companies in the world, 32 are Indian. China is poised as the next frontier for offshore markets. Although it has the capabilities to become one of the three top offshore countries, Gartner predicts that China will not effectively address its challenges until sometime between 2007 and 2010. Although the lack of government sponsorship and information make gauging the size of the Russian offshore software and services industry difficult, Gartner estimates it ranges from $100 million to $200 million. The market is enjoying considerable growth rates (40 percent to 60 percent per year), although that growth comes from a small base. The Russian software export industry already boasts more than 100 firms and around 8,000 experienced IT professionals. Many of those firms are small, employing fewer than 50 people. The cost of programmers is also low (from $300 to $1,500 per month, depending on experience), with the average experienced developer making approximately $7,500 per year. Success for Russian offshore providers will not happen overnight. However, by the end of 2007, Gartner expects that a credible and trusted business environment will begin to develop for Russian offshore providers particularly with enterprises in Western Europe and the United States. How Location, Communication and Skills Can Help U.S. ESPs Compete Tactical Guideline: Despite offshore ESPs sevenfold salary advantage, U.S. ESPs can still compete for many AD projects. An Indian ESP could offer high savings. However, in some circumstances, a U.S. ESP could achieve the same savings. For example, a U.S. enterprise located in a region with high living costs and salaries (such as New York, Los Angeles, San Francisco and Washington, D.C.) could outsource to U.S. ESPs located in areas with low living costs and salaries (such as Indiana, Arkansas, the Dakotas or Nebraska). When on-site and off-site billing rates increase, the savings offered by a U.S. ESP s savings decrease (as does its capability to compete with Indian ESPs). However, even if the cost-of-labor ratio is 1.2 for the ESP s on-site work (that is, the rate it charges is 1.2 times the client s in-house labor cost) and if this ratio is 1.1 for its off-site work the savings offered by a U.S. ESP may still be in double digits (see Figure 5), due to the better communication and increased skills effectiveness offered by the ESP. Figure 5 Cost Savings as a Function of On-Site vs. Off-Site Labor Cost
Savings (%) 40 30 20 Sample Scenarios Client based in U.S., co nstructio n off-s ite time fixed at 7 0% 37 37 30 19 15 15 10 0 ESP locat ion 0.75 /0.1 4 (India) 0. 9/0.75 1.0/0.9 1.1/1.0 1.2/1.0 1.3/ 1.0 1.2/1.1 Sample onsite/ off site cost-of-la bor ratios (vs. U.S. client's interna l labor cos t) Source: Gartner ESP external service provider Figure 5 uses a cost model that considers such cost-of-labor ratios as well as the skills effectiveness and communication factors discussed previously to calculate potential savings that a U.S. enterprise could achieve by using ESPs in several different sample scenarios. The first scenario shown represents a U.S. enterprise s the use of an Indian ESP whose billing rates represent cost-of-labor ratios of 0.75 for on-site work and 0.14 for off-site work. Also depicted are several scenarios representing the use of U.S. ESPs offering various combinations of on-site and off-site cost-of-labor ratios, representing differences in the locations (and resulting labor costs) of the client and ESP sites. In all cases, the portion of the project work conducted off-site is assumed to be 70 percent. How Increased Off-Site Work Can Strengthen an Offshore ESP s Position Tactical Guideline: The more an offshore ESP can conduct AD phases offshore, the better its chances become to win the bid. When the amount of off-site time on an AD project grows, an offshore ESP gains an advantage because of the low salaries it pays its developers in its country. When off-site time shrinks, a U.S. ESP gains an advantage through its higher levels of communication and effectiveness, which can outweigh the higher billing rates it charges. Although U.S. ESPs don t compete well with foreign ESPs on billing rates, they compete well in communication and effectiveness. However, once foreign ESPs become so effective that they can conduct more than 60 percent of the construction work off-site, U.S. ESPs will find it nearly impossible to compete with foreign ESPs (see Figure 6). Figure 6 Cost Savings as a Function of On-Site Work
Savings (%) (Example) 50 40 30 20 10 45 43 40 37 35 32 29 27 24 21 18 0 100 90 80 70 60 50 40 30 20 10 0 Off-Site Construction Tim e (%) Savings India (on-site/of f-site cost-of-labor ratios: 0.75/0.14) Saving s U.S. (on-site/o ff-si te cost-o f-la bor rati os: 1.1 /1.0 ) Source: Gartner Using the same assumptions about communications and skills effectiveness as those used in Figure 5, Figure 6 also presents sample scenarios of the cost savings U.S. enterprise might achieve using U.S. vs. Indian ESPs. However, unlike Figure 5, which used various cost-of-labor ratios for a single percentage of off-site construction time, the scenarios shown in Figure 6 assume one set of onsite/off-site labor cost ratios each for the U.S. and Indian ESP, and compare the savings achieved for various the percentages of off-site (vs. on-site) construction work (ranging from 100 percent to zero percent). Recommendations Recognize that maximizing off-site work yields the highest profit, but also that certain AD skills and phases should not be outsourced. Don t base offshore outsourcing decisions solely on salary differences. To assess benefits of offshore outsourcing realistically, evaluate communication and effectiveness, and how they affect project duration and staffing requirements. Do not rush into offshore outsourcing; also consider U.S. outsourcing options. Written by Edward Younker, Research Products Analytical source: Joseph Feiman, Gartner Research
This article is an excerpt of a chapter from a new report, Winning Asset Management Strategies. The report is an offering of the Gartner Executive Report Series, a new business venture of Gartner Press that provides buyers with comprehensive guides to today s hottest IT topics. For information about buying the report or others in the Executive Report Series, go to www.gartner.com/executivereports. For related Inside Gartner articles, see: CIO Update: Understand the Factors That Drive AD Outsourcing, (IGG-10152003-01) Management Update: IT Asset Management Is Mandatory, Not Optional, (IGG-08202003-01) Management Update: Asset Managers Should Assess How Their IT Spending Stacks Up, (IGG-08132003-01) CIO Update: To Control TCO, It Must Be Measured and Managed, (IGG-04162003-02) Management Update: Five Sure Ways to Reduce IT Asset Costs, (IGG-03262003-04)