Myth #2: Increased wages in India translate directly to increased costs for U.S. buyers of IT services

A common critique of offshore outsourcing is that wage inflation in India is quickly shrinking the value of labor arbitrage.   However, this analysis is based on three myths:

This post exposes the flaws in Myth #2 and explains how outsourcing professionals can leverage the truth to improve decision making and negotiations.  We explained Myth #1 here, and will explore Myth #3 in a future post.

Myth #2: Increased wages in India translate directly to increased costs for U.S. buyers of IT services

Reading the dramatic headlines about wage increases in India can lead U.S. management to assume that their Indian IT labor costs will increase by the same percentage. However, increased raises in India do not necessarily translate directly to increased costs for U.S. buyers, whether they are procuring India-based services on an outsourced basis or from a “captive” or in-house center.

Reality: Effective management of team pyramids can mitigate increases in individual wages

Savvy global managers who understand the Indian IT environment can “manage the pyramid” of their India-based teams to keep overall wage increases for a project or team well below the average individual raise. IT services teams in India, whether they are focused on development, testing, support, infrastructure management or other services, typically include a large number of junior employees and increasingly smaller numbers of employees as you go up the ranks or, if you draw it, a pyramid. Refreshing this pyramid on a regular basis – by moving out some experienced employees and bringing in junior employees – mitigates the impact of individual raise increases at the higher levels, while stabilizing the team’s total years of experience.

In the example below, we show a sample 20 person team where two mid-level employees are replaced with two freshers. Without making any changes to the team composition, average raises of 18% translate directly to an increase of 18% in the total team costs, and average experience is increased by one year. By refreshing the team, we can keep the increase in labor costs in the 20 person team to 3%, even while giving a raise of 18% to the other 18 team members, and keeping the same average years of experience across the team. (Note that this is an illustration only, and does not include other costs such as benefits, office space, travel, or training.)

Exhibit 2: Managing the Pyramid – Illustration of Impact on Average Experience and Costs for a Sample 20 Person Team

Managing the Pyramid - Illustration of Impact on Average Experience and Costs for a Sample 20 Person TeamSource: Red Bridge Strategy Analysis

Effective management of the team pyramid may also bring advantages of improved career paths, employee satisfaction, and organizational knowledge building. U.S. managers sometimes see all employee turnover as negative, but that perspective is rooted in the experience of managing the U.S. IT workforce, which often has smaller teams of more experienced employees and, for legacy IT systems, limited documentation. With a young, ambitious workforce at a time of rapidly changing technologies, frequent changes in assignments may have a positive impact on the team and larger workforce. India’s IT services providers usually work in a “factory” model of software development, with high levels of process controls, documentation and testing, and the best and the brightest employees may seek new assignments to build business knowledge and client skills. We do not advocate an increase in turnover, but effective pyramid management yields planned “turnover” that is more productive than unplanned attrition resulting from attempts to hold ambitious staff in place for long periods of time.

Reality: Recent changes in the exchange rate for Indian rupees to U.S. dollars have offset inflation in India, resulting in lower costs for U.S. buyers

The discussion of wage costs in India should include not only the absolute wage levels, but also inflation and exchange rate expectations and their impact on costs for U.S. buyers. Any analysis of inflation expectations must also include an analysis of exchange rate expectations because of the relationship between them, even in cases like that of India where they have not behaved as expected for long periods. According to the World Bank, the U.S. price level increased by approximately 25% between 2000 and 2010, while the Indian price level increased by approximately 78% fn1 . Theory suggests that, as a result, dollar/rupee exchange rates should have changed by approximately the difference in these rates, or 53%. However, the dollar/rupee exchange rate was largely unchanged over this period at about 46 rupees to the dollar fn2 . The expected relationship between these indicators did not hold.

This outlook changed recently in that exchange rates have finally acted more like one might expect: The exchange rate of India rupees to the U.S. dollar is now about 53, or 15% lower than 15 months ago. The result is that absolute costs in U.S. dollars today are now 15% lower than in 2011, largely offsetting increased wages in India.

For American buyers whose outsourcing contracts have some level of protection related to currency exchange rates, this change may not have resulted in direct cost savings and negotiations for lower rates may be in order.


Analysis and Opinions by Matthew Sullivan and Cindy Carpenter.

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