Business Accent

Improving the profitability of Indian Software

This is a look at the problem of linear growth in the Indian software industry and how it can handle this problem effectively and increase its revenues.

Neeraj Verma

The Indian software industry started in Mumbai in the late 1970s but the real turning point for the industry was the establishment of a US company, Texas Instruments’ (TI) design centre in Bangalore in 1986 which created a snowball effect and Bangalore became an IT software hub with Indian and international companies clustering in and around the city. Large Indian companies such as Infosys and Wipro are headquartered in Bangalore. Opening up the Indian market to foreign players and the economic reforms of the early 1990s acted as a catalyst for the Indian software industry. Today, most top international computer and software companies (HP, Digital, Compaq, IBM, and Intel etc.) have wholly owned subsidiaries or joint ventures with Indian companies based in Bangalore and other cities. This impressive rise and growth of the software industry has spawned “Silicon” metros such as Bangalore, Hyderabad, Mumbai, Pune and Chennai. In addition, smaller cities like, Bhubaneshwar in the East, Pondicherry, Thiruvanantpuram and Mysore in the South, Gurgaon and Chandigarh in the North are in a strong position on the map of Indian Software today.

Balance sheets of Indian software companies indicate that they are going through a metamorphosis. The three behemoths in the market—TCS, Infosys and Wipro—as well as others have shown impressive growth potential. In financial year 2005-06 TCS made a net income of Rs 11,282.81 crores a sharp rise of 38.90 percent from the previous year, Infosys secured a net income of Rs 9,028 crores with a 31.60 percent rise from last year. Wipro’s net income was Rs 10,625 crores with a rise of 30 percent over the previous year .The most fascinating thing is that top five players (Tata, Wipro, Infosys, HP, HCL) in the Indian IT market accumulated a gross total of Rs 49836 crores and are moving towards the remarkable landmark of $5 billion.

The Indian software industry increased their headcounts in India and abroad last year either by recruiting or through mergers and acquisitions. In the previous year 2005-06, TCS had a net addition of 21,140 employees which brought its total strength to 62,832 employees. Infosys added 12,500 new employees increasing its organisational strength to 44,658 (excluding Infosys’ BPO subsidiary previously known as Progeon). Wipro had 55,000 people in the last financial year.

The Indian software industry uses two different models for revenue recognition. The first is the Time and Material (T&M) Contracts model in which customer are billed on the basis of hours worked by the employees of supplier software companies. Hourly rates are agreed on by both parties and are applied to the total hours worked to arrive at the revenue that is to be recognised. The second is the Fixed Price Project Model (FPP). Under the Fixed Price Project Model, the total contract price is agreed upon between the parties. Billing may be done either at the end of the contract or over the period of the contract on the basis of the agreed milestone for billing.

India’s competitiveness in the software industry is of world class quality, cost-effectiveness, high reliability and rapid delivery to the customer. The software industry in India has matured as compared to earlier days. The industry has moved beyond ‘Body Shopping’ to ‘End to End delivery of business solutions’. It is easy to interpret from historical data that the Indian software industry depends heavily on its human resources for revenue generation. The greater number of employees provides the capability to fetch more work thus generating more profit and growth. In other words a company’s headcount and revenue are in direct proportion. Availability of a large pool of skilled labour in the Indian market makes it easy for software companies to leverage the demand for IT in the global market. This business model is effective and successful to a certain extent. The biggest question for the Indian software industry is how far a company can scale only in terms of headcount. The linear model of growth is not justifiable in the current global market and top global players are already demonstrating this. For example, IBM’s headcount is currently approximately 330,000. In the terms of manpower it is nearly six times larger than any of the top three Indian players but in terms of revenue the gap is 45 times. The total revenue of IBM in 2006 was $91.4 billion. In context of a product development company like Microsoft which is operating currently with around 71,172 employees, the revenue is 22 times higher than the top Indian players. The combination of Offshore-Onshore development is working as a panacea for the Indian software industry but companies like IBM or Accenture are moving fast in the same direction and the day is not far when the competitive advantage of the global delivery model will start eroding for Indian software companies. Indian companies need a new strategy for growth which should not be completely based on linear growth patterns.

Profitability on the service front: global

India is the undisputed leader of the software services market at the global level .The magic mantra of offshore-onshore development is the key factor behind the success of Indian players. According to a fact sheet currently published by NASSCOM on the Indian IT industry the total combined Indian IT services and IT enabled services export market in fiscal 2005 was nearly $18 billion. A report published by NASSCOM-KPMG in 2004 indicated that total Indian IT and IT enabled services market export is expected to grow to $49 billion by 2009. Significant cost benefits to customers, availability of low cost skilled professionals and labour, ability to effectively integrate onsite and offshore execution capabilities to deliver seamless and scalable services and increase in depth and breadth of the services offered to customer are some of the key factors which are responsible for the sustained growth of Indian software. Top Indian players are moving up the value chain and providing a range of services to customers. Indian companies also understand that they can not scale up only in terms of adding manpower and they will have to develop models that will not be based on the linear model of people, revenue and profit. Top players are coming out with new business models in the current scenario. One such business model is the ‘Risk Reward Model’, in which companies take a joint stake in the development of a product with technology companies. Software companies are combining efforts and resources with technology companies and sharing the benefits thereof. They are partnering with companies operating in the field of telecommunications, data communications, semiconductors etc. Wipro is the leader in this area making an average of three times the normal service business in the segment. More than 10,000 employees are working in the product development stream in Wipro. The limitation in this kind of business model is that Indian software companies do not own the product i.e. they do not have the intellectual property rights for the product. They are only getting incentives from the owner company to make a successful product.

Indian companies are also implementing intellectual property (IP) components. They are not end products but are a vital part of the end solution. These components are basically related to networking and telecommunications for example wireless LAN components which will be used by most telecom-vendors. The limitation with this model is that companies are getting a one time service fee only not the licensing fees as they would if they owned the product. Another common predicament with these models is the concept of ‘Branding’. The customer is seeing the partner technology company’s name as the brand and not the Indian company’s name; in the long run this may hinder the overall growth of Indian companies as they lack name recognition for putting effort and resources as far as the brand awareness with the end customer is concerned.

‘Do the work where it makes the most sense’ is the success formula for the Indian software industry and to effectively enable the onshore-offshore development model, Indian companies are increasing their local presence in the global market. This provides a competitive advantage over others in cost. Moreover it helps companies widen their domain expertise. Mergers or acquisitions will certainly expand a company’s knowledge pool and expertise in different verticals. Furthermore acquiring a well managed company with less employees and great business can undoubtedly help tackle the problem of linear growth.

Over time big players in the Indian market have understood the problem of linear scalability and every one of them is trying to get out of the situation. Every one is building capacity, a business model and expertise. For example, Wipro is building expertise in Product Engineering, Technology Infrastructure, and Enterprise Platform implementation. Infosys is concentrating on the global market of consulting on the lines of bigger players like IBM and Accenture. TCS which has a larger global footprint and is the biggest among the three is taking the middle path by concentrating on a technology-centric approach. In 2005, TCS announced a relationship with CollabNet, the leading provider of on-demand (SaaS) distributed software development solutions. TCS has adopted CollabNet Enterprise Edition 4.0, the company’s flagship solution for distributed application lifecycle management and software development, for its internal projects. TCS also earned three patents in the US and one in India during fiscal 2005-06 and applied for 13 new patents in various technology areas during the same period. Infosys alone generated over 82 invention disclosures and filed over 20 patents last year. Another model dubbed the ‘Long Term relationship Model’ is one of the best ways to reduce cost and increase profitability. It substantially reduces the cost of marketing and sales and provides enhanced revenue visibility. Indian companies are recognising the benefit of long-term relationships with customers but still the model is in a nascent stage. If we will leave the big players and concentrate on the mid-sized and small players then it can be seen that a significant part of revenue is coming from small projects ($1- $10 million). Not only small and mid-sized but even bigger players in India find it uncomfortable to compete with the global players in the case of billion dollars projects. Indian companies are on the verge of developing ‘Partnership Models’ which are helpful in dealing with bigger projects. Competition is intense in the global arena and everybody is bidding for the same project. Instead of losing out to bigger players, companies are coming with joint ventures with other Indian or foreign companies. Once a contract is won, work is divided on the basis of area of expertise. It is like a symbiotic relationship between two or more players that helps grow revenue without raising headcount.

Profitability on the services front: domestic

Changes in economic policy and deregulation of key sectors have driven IT adoption in the country. The amount of global competition is the largest in banking and telecom due to presence of global competitors in the market and that is the reason these segments account for 35-40 percent of Indian domestic IT spending. Similar competition can be seen in the Insurance and Airlines sector and the Retail sector is booming. Several e-governance plans launched by Indian government under the National e-governance Plan (NEGP) are expected to provide sustainable growth in the domestic IT market. According to a forecast by IDC, the Indian domestic IT market is projected to be worth Rs 238 billion in 2009 as compare to Rs 103 billion in 2004 (IDC-2005). Some key challenges for the Indian software industry in the domestic market are low government spending and stiff tender mechanism. In 2004-05, Indian spending was 0.13 percent of GDP in IT investments as compared to 0.24 percent in Russia and China, 0.34 percent in the US and 0.49 percent in the UK. Domestic projects are fixed price projects (FPP) without clear specifications. Tenders are awarded to companies on the basis of proposed cost of projects not on the basis of proposed solution. Even in the private sector IT is not high on the agenda. SMEs are still in early stages of adopting full fledged IT solutions. To tap the market, some Indian software companies are now coming with customised solutions for the public and private sectors. India is a big country with 15 different official languages and 500 dialects. Indian companies are providing multilingual solutions to domestic clients at an affordable price. According to recent research, done by Gartner, the Indian economy will surpass the US economy by 2050. This statement may be a forward looking statement but it is sufficient enough to express the opportunity in the domestic market for the Indian software industry. Currently software is ‘made in India’ but it is not ‘made for India’. The software industry will have to recognise the difference between the Indian market and the global market and that will be a big leap for revenue recognition. The verticals will be the same even in the Indian market (Banking/ Finance, Retail etc.). The only difference is going to be the cultural difference and Indian companies are in much better position to study and implement it. That said foreign players are far ahead in understanding the Indian market and catering to a large portion of market when compared to Indian players.

This is the first part of a two-part feature. The conclusion will appear in our next issue.

The author is an MBA (Systems) from Symbiosis Centre for Information Technology, Pune