Understanding Concentration Risk in Offshore Operations

Offshoring analyses routinely incorporate comprehensive risk evaluations of economic, political and other well-known risks, but often fail to consider how these intensify as offshore operations scale. This probability of magnifying other risks as operations become geographically clustered is called “Concentration Risk.”  The remainder of this post illustrates the concept of Concentration Risk by applying a simplified offshoring risk management architecture to the operations of a hypothetical U.S. company as it evolves through an offshoring lifecycle.

A Simplified Risk Architecture

For brevity, the simplified offshoring risk management system manages only economic and political risk.  Borrowing from the Operational Risk calculations in the Basel II Capital Framework, it multiplies the probability and magnitude of risk events to arrive at an expected value (cost) for a risk, and sums across all risks to get a risk cost for the organization.  It defines the probability of economic risk to be the probability of a significant change in relative purchasing power between currencies in countries in which it earns revenue (U.S.) and the countries in which it pays operating costs (U.S. and India) during a one year period.  The magnitude of economic risk is the difference in the cost of operations in the countries for the length of time required to make an alternative location operational.  The expected value of political risk is the probability that company operations will be disrupted by political forces or events multiplied by the likely cost of any interruption (magnitude).  Disruptive political events can, but need not, occur in the home or offshore countries, and include the actions of governments, political institutions, and minority groups.  (Note that companies with sophisticated risk management strategies would evaluate many more risks, incorporate expected risk costs into projected returns on investment as part of the business case for potential investments, and, when appropriate, substitute the cost of insurance for the expected value of a risk.  In addition, companies can operationally and contractually shift risk to offshore vendors by retaining them instead of deploying captive centers.)

Company Risk Profile

With this simplified offshoring risk management system in mind, consider the hypothetical U.S.-based company, Domestic-Technology, Inc. (“DomTech”), a technology services provider that, in 2005, operated only in the U.S. with 10,000 associates and revenues of $2.5B.  At that time, its offshore risk was zero using the simplified system.  By operating entirely within the U.S., there was no difference in purchasing power between the countries in which it earned and in which it spent, so the expected value was zero.  Additionally, because political transitions in the U.S. have generally been peaceful and orderly, and there are, and have been, strong independent executive, legislative and judicial branches of government, the probability of a political event that would disrupt operations, and its magnitude, was negligible.  The sum of the economic and political risk factors was therefore zero in our simplified system.

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Small Offshore Operation

When, in 2006, DomTech created a software application development unit with 500 associates in Mumbai, India, it increased its economic and political risk profile slightly.  The relative purchasing power of the dollar drifted lower from 2000 to 2006 when compared to the rupee, but movements generally became significant only gradually, so there was a low probability of a significant shift within one year.  The magnitude of economic risk was also low because the difference in cost between U.S. and India for such a small number of associates for one year relative to a 10,000 person company is low.  Multiplying the low economic risk probability by the low economic risk magnitude resulted in a low economic risk.  Political risk was similarly low, largely because of the small magnitude that resulted from the small number of associates in the unit.  The probability of a political risk event is relatively high in Mumbai because of its historical tension with its neighbors (i.e. Pakistan and China), its corruption (ranked 95th out of 182 nations in the 2011 Transparency International Corruption Perception Index), and its history of terrorism (2003 Mumbai Bombs, 2006 Mumbai Attacks, 2008 Mumbai Attacks ).  In spite of the propensity of political risk events, they have generally not resulted in lost work at offshoring facilities, so the probability of political events in India that would disrupt operations was medium.  However, given the small portion of DomTech’s operations subject to these risks, the magnitude of an event is low.  Therefore, the overall expected cost on DomTech of any set of political events is low-medium.   Adding the low economic risk to the low-medium political risk results in a low-medium level of risk in the simplified offshoring risk management system.  Consequently, the creation of a 500 person captive unit in Mumbai increases DomTech’s risk level from zero to low-medium in our simplified offshoring risk management system.  In addition, because the work was primarily focused on application development, which is generally not critical to the daily operations of a business (as compared to production support), the risk to the enterprise is relatively low.

Concentrated Offshore Operation

Subsequently, the hypothetical DomTech expanded its Indian operations by offshoring additional IT units and parts of its accounting, sales support, and legal functions.  By early 2009 offshore growth had resulted in a campus of 2,500 associates in a single suburban Mumbai location.  Consequently, DomTech’s overall operational risk profile increased significantly because approximately the same probabilities of risk events had to be multiplied by much larger potential interruption costs (magnitudes).  As in 2006, there was a low probability of a significant shift between dollar and rupee purchasing power within one year.  However, the magnitude of economic risk had become much higher because the difference in cost between U.S. and India in 2009 applied to 25% of DomTech’s operations where it had previously applied to 5% (500 people).  The low economic risk probability multiplied by the high economic risk magnitude resulted in a medium economic risk.  Similarly, the probability of political risk, as it had previously been, was medium.  However, in 2009 the magnitude of a potential impact on DomTech by any set of political events was high.  Consequently, the expansion increased political risk from low to medium-high.  The medium economic risk added to the medium-high political risk resulted in a medium-high level of risk in the simplified offshoring risk management system.  Consequently, the increase from a 500 to a 2,500 person captive unit in Mumbai increased DomTech’s risk level from low to medium-high in our simplified offshoring risk management system.  In addition, after the Indian expansion, a number of the Indian operations were critical to everyday production, which contrasts sharply with the initial application development unit that was not crucial to everyday DomTech production.

Mitigating Concentration Risk

The concentration of facilities and associates in a country that does not serve as a significant market for a company increases a company’s risk profile.  However, deliberate identification, assessment, and mitigation of the risks can take many forms and does not require the sacrifice of offshoring benefits.  The key to concentration risk reduction is diversification.  Techniques to manage diversification include permutations of offshoring to multiple sites and countries, a mix of captive and vendor centers, and strong multi-shore management and business continuity planning.  In a subsequent post I will highlight some of these techniques.  (A previous post, Beyond India – Optimizing the Locations of Offshore Operations, highlights the Hub and Spoke model, which can help manage concentration risk.)

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