Climbing the offshoring ladder

The falling value of the dollar has hit the export-driven Indian IT industry. The way ahead is to mitigate losses on this account by adopting sustainable strategies and focusing on offshore product development, writes Kushal Shah.

“If we are growing, we are always going to be out of our comfort zone….”

The above statement reflects what is the case with our ever growing economy in general and the IT industry in particular, which is going through an uncomfortable phase thanks to the falling dollar and the appreciating rupee. In little over a year, we have seen the rupee appreciating by over 14% hovering around Rs. 39 per dollar. To a large extent it has been more of a case of the dollar falling against all currencies, contributed to by subprime losses in the US economy. Combine that with a surging Rupee fueled by rapid economic growth in India and you have a recipe for trouble as far as our US-dependent software exporters are concerned. This rapid change in the currency has been instrumental in fomenting concerns across the boardrooms of leading IT companies. Business heads have been putting their noses to the grindstone trying to find the right approach for this export driven business where the bulk of revenues accrue as dollars.

According to NASSCOM, revenue from the Indian IT software and services sector (including the domestic and exports segments and excluding hardware), touched nearly $40 billion during FY 2007 and is expected to grow by nearly 27% to clock $49 to 50 billion in FY 2008. Of this, software services remains the mainstay of the sector contributing $31.3 billion during FY 2007, beating forecasts to register a 33% growth. This high dependence on exports and almost 70% billing in dollar terms is a matter of deep concern for the industry, even the giants, and will force them come up with long-term solutions.

There is a need to take a fresh look at the business models adopted by IT companies and the way in which they are headed to ensure that they are relatively unaffected by changes in global and local scenario such as currency fluctuations and the cost of labor. Primarily, in terms of IT software exports, we see two trends—Offshore Product Development (OPD) and Offshore Software Development (OSD)—two distinctively different terms, but part of the same industry. These need to be looked at and the future approach for better positioning globally has to be determined based upon that evaluation. “Due to the rise in rupee value, Indian IT companies have lost about 2 to 4% in margins and are becoming less competitive on the global front and with respect to MNCs in India. They will now have to restructure their pricing models,” said Arup Roy, Senior Research Analyst, Gartner. There are many ways in which the entire industry needs to evolve to stay competitive globally—the key being leveraging on the availability of higher expertise (and not on lower costs).

OPD vs. OSD

Simply put, Offshore Product Development (OPD) refers to transferring design, development, testing and other related services of the product development life cycle to a third-party service provider. The third party does most or all of the work and the final product is marketed and its IP owned by the original company that farmed out the work. “The work could include product conceptualization, architecture and design, implementation and development, enhancements, and support—helping the client or sometimes even the product’s end users in optimally generating value from the software product,” said Praveen Kankariya, CEO, Impetus Technologies. Work and definitions vary from company to company. Some companies make a part of a particular product; some do re-engineering work, while a few develop an entire product.

OSD, as we all know is third-party customized application development or services for a company’s own usage and is usually non-distributive in nature—this could be customized application development, application migration, software functionality testing, packaged software implementation, etc.

OPD differs from OSD in terms of its development methods. OPD needs teams that have a vastly different set of skills that are, in some ways, more skilled than those that work on vanilla OSD for which according industry folk only knowledge of a programming language and syntax is sufficient. OPD also provides better operational efficiency due to its automation capabilities. In terms of development, OPD is far more difficult. “Usually, in the case of OPD, your customer is not the end-user and you are not aware of the end-user’s preferences and platforms. So you have to make your product flexible enough that it can be used by a wide gamut of users,” said Ramanan RV, Chief Software Architect, Hexaware Technologies. In case of OSD, you know your users well and can interact with them, this makes the job a lot easier for the developers involved. With the maturing of the Indian talent pool, more companies are jumping into OPD and heading towards the dream of making their own IP one day. Some of the large organizations are already generating about 30% of their revenues through OPD and some new and small companies have focused their entire business on this strategy.

OPD came to Indian shores even before software services did, but could not capitalize on its early entry due to the high demand for IT services across the globe. Now it is ready to strengthen its position in the country. The rising popularity of offshore product development and engineering services is supplementing India’s efforts in IP creation. According to NASSCOM, this segment has grown by 22 to 23% to touch $4.9 billion in export revenues.

OSD—Marginally higher

Apart from differences in the mode of development and definition, these two categories also vary in terms of business.

OPD needs greater expertise and is skilled work and can offer superior profit margins. “I feel that if you are an efficient product developer then, yes, it does provide a 4 to 5% better profit margin than generic software development. As it revolves around architecture, design and engineering, there are not many companies offering such services and hence the margins go up,” said Ganesh Natarajan, Deputy Chairman and Managing Director, Zensar Technologies.

At a time when margins are the biggest problem for the dollar dependent industry, even a marginal improvement in profits will come as a relief.

Some in the industry believe that there is a flip side to this cost advantage. They feel that OPD is equivalent to OSD when all factors are taken into account including manpower costs which are higher in the case of the former. “A product development team needs to harness the ‘brightest of the bright’ engineering skill sets, and ‘engineering expertise’, which costs more money to hire and develop. So, profit margins tend to be equal to that of the OSD companies as of now,” said Bhoovarahan Thirumalai, President–US Operations, Aspire Systems.

That said, most of the people we talked to believe that OPD provides marginally better profits.

On the other hand, owing to its simplicity and ease of work compared to OPD, OSD comprises the biggest chunk of any big software company’s business. Over the years, Indian IT companies have created a niche and dominance in this business across the world. Indian companies have become the world’s software factory for services and software development. On the other hand, attracting customers for OPD involves proving a company’s worth for product development capabilities and that takes time.

The Rupee and the IT sector

Arguably the biggest problem faced by the IT industry as a whole, be it OSD or OPD, or any other segment, is that of the rising rupee. This problem is totally dependent on location and the currency used for billing the client. As almost 70% of India Software Inc.’s clients are from the US, billing in dollars has had a deleterious impact upon business.

In the midst of all this, Indian IT companies might lose their long held advantages. According to Roy, apart from losing ground due to a higher asking price, they will face tough weather while hiring and retaining employees as they have to optimize their resource utilization.

There are many factors that lead us to believe that OPD relatively unaffected by the dance of the Rupee and the US dollar. The primary reason for this is the inherent nature of OPD work. In the case of product development, companies often get the work of making a new version of an existing product. In such scenarios, most of the work is automated and this involves minimal human intervention, which, in turn, saves a lot of operational cost mitigating the impact of currency instability.

In some cases, due to the importance of the work and value of the end product, OPD is less affected by currency fluctuations. “The product development companies that are offshoring their product development work have higher profit margins so that they can pay well in comparison to those involved in application development,” said Eddie Chandhok, President -Global Delivery, Infogain Corporation.

On the other hand, some feel that it depends on how you can get the best rates even in tough situations. “The impact is probably same. However, in some cases such as OPD, you are able to manage impact of a rising rupee a lot better as royalties and AMCs can be worked out in OPD,” said Edwin Moses, Senior Vice-president (Products), Sasken Communication Technologies.

With the Indian economy growing steadily at 8 percent plus, the rise of the Rupee is inevitable. There has been a demand from certain quarters for RBI intervention to keep it down. This demand seems short-sighted and does not take into account the enormous opportunity that the rising rupee presents to change business models and strategies.

Managing change

India’s software exporters have to come up with different solutions to deal with the situation. According to Roy, most IT companies are now charging a premium of 4 to 5% when signing a new contract and are renegotiating existing contracts for a 3 to 4% hike in pricing. This trend and support from clients would certainly ease the pressure. In order to be more market worthy and to enjoy inorganic growth despite Rupee problems, companies are looking to move up the value chain by providing consulting services.

There are more ways than one to fight this problem and the industry seems ready. “Apart from increasing the asking price by 4 to 5%, we are going to tighten utilization and productivity. We are still able to maintain profit due to higher realization and better productivity,” said Natarajan.

Companies need to set their pricing keeping in mind some aspects which can be beneficial in the long run for the industry as a whole. IT companies need to demand because ‘we know better’ and not because ‘we are cheaper’. The Indian IT industry needs to leverage its talent pool which will put it back in the driver’s seat.

There are a few more ways to deal with this problem. One is by changing the billing currency to a more stable one, which seems difficult but some companies have started doing this. Another mechanism is to resort to hedging wherein a company can hedge its anticipated risk of a loss in margins by investing in another instrument. These are some of the common practices to deal with currency fluctuations.

Whichever strategy a company chooses, the combination of different options can help mitigate the problem. As far as OSD and OPD are concerned, OPD will continue to rise in popularity as Indian companies look to starting their own ranges of products which will eventually make them independent of currency issues to a great extent. Then, we can surely expect some world class products out of our own backyard for ‘us’ to sell and not for the ‘US’ to sell.

kushal.shah@expressindia.com