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Offshore and beyond

McKinsey finds that while companies are exporting back-office functions and service jobs, they are mistakenly leaving billions of dollars in savings behind.

Offshoring and beyond
From the McKinsey Quarterly
Special to CNET
November 8, 2003 6:00 AM PT

The enticement to companies of a worker who earns $2 an hour in India as against 10 times that amount for a worker in the United States is obvious. For years, such wage differentials have attracted leading manufacturing companies to low-wage nations.

More recently, businesses of all kinds have also exported back-office functions such as data entry, payroll processing and call centers. Business-process offshoring is all the rage, and the hundreds of companies that have taken this route often cut their costs by as much as half.

Yet as impressive as these achievements may appear, new research by the McKinsey Global Institute (MGI) finds that companies are leaving billions of dollars in savings behind when they "offshore" back-office functions and service jobs. Such companies are merely replicating what they do at home, where labor is expensive and capital is relatively cheap, in countries in which the reverse is true.

What is needed? Nothing less than a total transformation of business processes to harness the new environment?s potential. And by undertaking such a transformation, many companies will find that the resulting lower cost structure releases massive new revenue opportunities even more valuable than the savings.

Halfway to global
The first wave of globalization began a hundred or more years ago, when companies were lured abroad by the prospect of new markets. Even today, we estimate, the age-old motivation of reaching vast new customer pools explains perhaps 80 percent of cross-border investments. Many of them, such as Wal-Mart Stores? operations in Mexico and HSBC?s in Malaysia, are in service sectors that require a local presence by definition. Others are in industries such as automotive, in which high tariffs and other trade barriers effectively force foreign companies to set up shop locally if they want to do business.

Despite the fits and starts of progress in world trade talks, the policy barriers that limit foreign investment and trade have fallen significantly over the past 10 years. The result has been a second wave of globalization, in which companies from North America, Europe and Japan build plants in low-wage countries to take advantage of enormous wage differentials and then export the finished goods back to the home market. These companies have substantially cut their costs for a variety of products, particularly labor-intensive ones such as textiles and toys, even taking into account the extra expense of transportation and overseas management and training.

What is needed? Nothing less than a total transformation of business processes.
Companies in a few industries have gone further, specializing in component production and final assembly in the countries or regions with the strongest comparative advantage. Nowhere is this third wave of globalization more evident than in consumer electronics. Business-process offshoring, made possible by the dramatic fall in telecommunications costs and the ability to transform paper-based activities into digital ones requiring only a telephone and a computer, is just the next logical step. A broad range of service jobs and back-office functions can now be performed remotely in India, for example, or in the Philippines. Low-skill work such as data entry and transaction processing, real-time customer support, and research services are obvious candidates. But even high-skill activities such as customized software development, the design of automotive and aerospace components (CAD/CAM), and pharmaceutical research are increasingly undertaken outside the United States.

Many of the jobs sent offshore may be considered undesirable and lacking in prestige in developed countries yet are highly attractive in developing ones. So offshore workers not only cost far less but also are often more highly motivated, which means that they perform better. One British bank?s call-center agents in India, for instance, process 20 percent more transactions, with 3 percent more accuracy, than their counterparts do in the United Kingdom. Some companies set up their own "captive" operations in offshore locations to take advantage of these benefits, while others outsource to local companies, particularly in India.

Companies in the United States and Britain account for roughly 70 percent of the market of companies that are moving their business processes offshore. Relatively liberal employment and labor laws give such companies flexibility in reassigning their activities and eliminating jobs, and they can take advantage of the sizable English-speaking populations in many low-wage countries, such as India, Ireland, the Philippines and South Africa. With a shared language, errors are far less likely and functions that require voice interaction or text-based work are straightforward. The opportunities for continental European and Japanese companies are thus more limited.

Business-process offshoring is still a nascent industry. By our estimates, in 2002 it was worth $32 billion to $35 billion, just 1 percent of the $3 trillion worth of business functions that could be performed remotely. Because of the significant benefits already being realized through offshoring, the market is projected to grow by 30 to 40 percent annually over the next five years. This prospect may cause consternation over job losses in the United States, but it will make offshoring an industry with well over $100 billion in annual revenue by 2008.

Getting more from offshoring
Merely replicating processes developed at home, however, is not the way to realize offshoring?s full potential. Wages represent 70 percent of call-center costs in the United States, for instance, so these operations are designed to minimize labor by using all available technology. But in low-wage India, that makes little sense, since wages represent only 30 percent of costs, and capital equipment (to provide telecom bandwidth, for example) is often more expensive than it is at home.

The way to reduce the cost of offshore operations even further is to reorganize and reengineer operations to take full advantage of these differences. In a low-wage country, the capital infrastructure?including office space, telecommunications lines, and computer hardware and software?should be used as intensively as possible. For a call center, this approach can reduce costs by an additional 30 percent to 40 percent, boosting total savings to as much as 70 percent of the cost of onshore operations. The potential value for other functions moved offshore, like data entry, payroll processing and financial accounting, is similar.

Companies can boost their capital productivity in low-wage environments in three ways:

• Round-the-clock shifts
The most obvious way to use the capital infrastructure more intensively is to run round-the-clock shifts, even if they mean higher wages for odd hours. This option simply wouldn?t exist in a high-wage environment, where wage premiums offset any capital savings. We estimate that just by increasing the number of shifts, companies can reduce their operating costs by 30 percent to 44 percent for many types of offshore work, including financial accounting, procurement, call centers, transaction processing, and more complex functions such as knowledge services and R&D. But in India, we found that even the most efficient third-party providers run only two shifts a day, and most of the captive operations set up by multinational corporations are running only one.

• Cheaper capital equipment
Some service providers in India are using cheap local labor to develop their own software instead of purchasing more expensive branded products from the global software giants. American Express, for instance, hired programmers to write software to reconcile accounts, and the software now reconciles over three-quarters of them, or more than half a million every day. The company, which paid only $5,000 to develop this solution, estimates that licensing more sophisticated database software would have cost several million dollars. The Indian carmaker Maruti Udyog developed its own robots for its assembly lines; the robots, on average, cost a small fraction of what similar ones cost its partner Suzuki in Japan. In this way, companies maintain the level of automation that prevails in high-wage countries, but at a distinctly lower capital cost.

• Reduced automation
Some companies have gone a step further and used workers for tasks that would normally be automated at home. A payments processor, for example, might employ people to input checks manually into a computer system instead of using expensive imaging software. A telemarketing firm that would use expensive automatic dialers in a high-wage country might have workers make their own calls instead.

Manufacturers, too, can use this approach. Certain automotive original-equipment manufacturers (OEMs) in China use robots for only 30 percent of the welding in car assembly, as compared with 90 percent or more in U.S. or European operations. (BMW?s plant in South Africa employs the same line of attack.)

In India, domestic car companies have reduced the need for automation throughout the manufacturing process: They use more manual labor to load and change dies in pressing, to weld bodies, handle materials and do other functions?while suffering no discernible loss of quality in the finished product. In this way, these companies manage to cut their assembly costs by 4 percent to 5 percent or even more and save themselves millions of dollars annually.

Ultimately, companies might completely redesign the sequence in which tasks are performed, in order to leverage the opportunities above more fully. Consider the simple example of a call-center agent who manages customer accounts. In high-wage countries, each customer call is routed to an agent who listens to the request, opens up a computer database, and updates the account in real time. Neither the computer nor the telephone is used efficiently, since the agent is either talking or typing but not both.

Offshore, an agent equipped with only a telephone could write the customer request by hand into a tracking log and move on to the next call. Telecom costs are reduced because the agent spends less time on calls and customers less time on hold. Another agent, working at a computer station used around the clock, could enter the information into the database.

While the new process requires more agents to handle requests, expensive computer hardware and software and telephone lines are used more intensively. Added wages are more than offset by savings on computers, software licenses and telephone connections. The economics of an Indian call center suggest that this simple change could actually boost current profit margins for offshoring vendors by as much as 50 percent.

Re-engineering offshore functions makes sense only if wages stay low. Over time, they will rise and technology costs will continue to fall. As this happens, companies can adjust their operations to reflect changing factor costs.

But in most low-wage countries, labor is so cheap and the labor pool so large that rising wages are unlikely to be a problem for decades. India each year produces 2 million college graduates?more than 80 percent of them English speakers?while China produces 850,000, though with minimal English skills. Even a small country like the Philippines annually produces 290,000 college graduates, all English speakers.

By reaping offshoring?s full potential, companies will find that their new, lower-cost structures open up a variety of opportunities to boost revenue growth. These opportunities will often far exceed the annual cost savings.

The potential to create new markets and redefine industries is enormous.
Some companies, for instance, can now chase delinquent accounts receivable they formerly had to ignore: one airline carrier is capturing $75 million in previously lost receivables on top of the $50 million it saves each year by operating its accounts-receivable department in India. Meanwhile, a leading U.S. personal-computer manufacturer created telephone- and e-mail-based customer service centers in India to provide technical support. In addition to saving more than $100 million annually, it has significantly increased the proportion of customer problems it resolves.

The company thereby reduces the number of follow-up calls it receives and the amount of merchandise it must replace while simultaneously boosting its customer satisfaction levels. And a financial-services firm has extended to customers who have lower account balances services previously limited to high-net-worth clients, thus opening up large new customer segments in its home market.

The new cost position can also be used to develop cheaper products for consumers in emerging markets. Consider the experience of one of India's own local companies. The Indian automaker Tata Motors (formerly Telco) designed the low-cost Indica car for the domestic market. The Indica sells for roughly 10 percent less than cars from global OEMs and breaks even on a volume of 150,000 units, a fraction of the number global companies need. That Indicas have fewer features accounts for a small part of the cost savings.

Most of the savings come from a lower level of automation in assembly, a reengineered process, and the use of very low cost local labor to develop the car (at a quarter of what a global OEM would have spent to develop something similar). As a result, the company has grown from virtually nothing to capture a quarter of the Indian market in its segment during the past four years?displacing Suzuki Motor, Hyundai and other global brands?and is now under contract to export 100,000 Indicas to the United Kingdom and Continental Europe.

As companies go further down the road to globalization, the potential to create new markets and redefine industries is enormous. Consider how the dramatic price reductions made possible by globalizing production have changed the market for televisions in the United States. Just 25 years ago, almost a quarter of U.S. households had no color TV. Since then, prices have declined by roughly 40 percent in real terms. Now 98 percent of U.S. households have at least one, and many families have three or more. At the new price point, color televisions have been transformed from luxury items into nearly disposable goods that most of the population considers a necessity. And as color TVs have proliferated, they have given rise to an industry that produces television content and television-based games worth more than $30 billion. Although the detractors of globalization fear that it has already gone too far, we believe that it has barely begun.

For more insight, go to the McKinsey Quarterly Web site.

Copyright © 1992-2003 McKinsey & Company, Inc.

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