Myth #3: The cost savings from labor arbitrage in India will be lost in the very near future

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 #3 and explains how outsourcing professionals can leverage the truth to improve decision making and negotiations.  We explained Myth #1 here, and Myth #2 here.   

Myth #3: The cost savings from labor arbitrage in India will be lost in the very near future

Based on media coverage highlighting huge annual compensation increases for Indian IT employees, one could easily think that wages for Indians will not be significantly different than those for Americans in the very near future.

Reality: Opportunities for labor arbitrage remain into the foreseeable future

Businesses should not buy into the myth that the labor arbitrage opportunity between the U.S. and Indian IT workforces is in imminent danger of disappearing. As we showed in Exhibit 1, even if Indian IT employees continue to receive raises of 15 – 20% per year while U.S. workers continue to receive 3%, it will take more than a decade before the difference for employees hired today narrows to less than 20%. If, as seems likely, U.S. inflation or compensation rates increase at more than 3%, or the rate of Indian salary increases declines, the labor arbitrage opportunity will remain for even longer.

As we’ve discussed, the growing supply of entry-level and experienced IT employees will likely result in continued entry-level wage stability and lower salary increases in the near future. In addition, the rate of increase in the demand for India-based IT services is slowing, due primarily to the economic downturn in the U.S. and Europe, and perhaps due to some level of market saturation. In addition, service buyers are diversifying their labor sources to include more lower-cost countries and lower-cost populations within higher-cost countries (e.g., rural sourcing in the U.S.).

There are some signs that salary increase rates in India are already slowing. Infosys announced reduced incentive compensation at the beginning of 2012, primarily due to company-specific issues, and because Infosys is the second largest employer in the Indian IT industry, its actions ripple across the industry. Industry insiders also say that they are seeing significantly lower rates of employee turnover in the current year compared to 2011, indicating a lower demand for experienced employees.

The Bottom Line

India offers an IT workforce with a breadth and depth beyond any country with comparable labor costs, and continues to be financially attractive for IT services in the foreseeable future.

In the short-run, buyers of IT services can better manage labor costs and turnover in India by understanding the fundamental differences in the U.S. and Indian IT business environments. Buyers who understand the demographics, career paths, and employee motivations of the Indian IT services workforce will find it easier to plan for and manage attrition, team reconfiguration and knowledge building.

  • Build and maintain knowledge of Indian market dynamics through systemic relationship building between U.S. business/IT managers and India team managers.
  • Encourage managers to work with their Indian teams to understand their career aspirations and goals.  Buyers may be able to offer non-salary incentives that encourage retention including new learning opportunities within existing teams or opportunities for rotations to the U.S. (or exemptions therefrom for employees with family needs in India).
  • In Captive Centers, work with local management to offer key employees new responsibilities and new titles. Increasingly, Indian employees are comfortable with some performance-based pay, so consider management and team incentives for projects with high, critical standards or impossible deadlines.
  • Accept that one downside of tapping a young, dynamic workforce is  higher levels of turnover among teams, and improve processes to mitigate the impact of team member changes. Improved software documentation and tighter process controls will also mitigate the effects of attrition among more experienced American employees preparing to retire.

In the long run, regardless of current quantitative projections, businesses should mitigate economic and other risks from international locations by diversifying locations and workforces.  Recognize that absolute wage levels, inflation, and exchange rates are inherently difficult to predict, and develop workforce location portfolio strategies.  In particular, companies should

  • Diversify across locations where the economies are not closely aligned through currencies, trade policies or geographic regions.

For example, companies with strong bases in India or the Philippines (or other fast-growing Asian economies), should consider diversifying locations through additional centers in Mexico and Latin America.  Location diversification is especially important for companies that are making long term investments in their own facilities.  Diversification can also be improved by adding new kinds of locations within India and the U.S., such tier II cities or rural areas respectively.

When U.S. businesses first began to utilize offshore services, they achieved not just cost savings, but also a diversification of risks from their in-market workforce locations. For companies that have developed strong global management and distributed work processes, the costs of adding new workforce locations have gone down, while the risks of having a large portion of the workforce in a single country remains high. We recommend limiting exposure to any one country with concentration limits that constrain the difference between revenue and expenditure in any one country to a client-determined risk threshold. As wage levels, inflation and currencies fluctuate, companies with a portfolio of workforce locations will be able to shift work among them and manage overall workforce costs more effectively.

Analysis and Opinions by Matthew Sullivan and Cindy Carpenter.

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