We use cookies to customise content for your subscription and for analytics.
If you continue to browse the International Law Office website, we will assume you are happy to receive all of our cookies. For further information please read our Cookie Policy.

The Hidden Risks and Costs of Offshore Outsourcing - International Law Office

International Law Office

IT & Internet - United Kingdom

The Hidden Risks and Costs of Offshore Outsourcing

September 13 2005

Negative Factors
Location and Business Model
Hidden Costs
Comment


The practice of outsourcing IT functions overseas is growing rapidly as businesses seek to reduce costs, release capital, increase profitability and capitalize on the low cost structures of outsourced suppliers. Countries such as India, the Philippines and China are all popular destinations: their low labour costs offer the tempting prospect of immediate cost reductions and increased profits.

However, offshore outsourcing is not always a sure path to financial savings and a competitive advantage. While it may reduce some costs, it increases others. It also creates additional business risks associated with issues such as geopolitical stability and business continuity. Businesses contemplating the offshore outsourcing of their IT functions should consider certain key factors.

Negative Factors

The factors that are most likely to have a negative impact on the target business and the projected financial results are:

  • the supplier's geographic location and whether it has a presence in the United Kingdom;

  • the choice of business process outsourcing (BPO) model;

  • hidden costs;

  • the quality of the management team which will assess, negotiate and document the deal and subsequently manage the contract and supplier;

  • 'scope creep' - that is, the tendency of the task to spread beyond the original requirements of the contract, resulting in increased services and charges; and

  • other miscellaneous factors which limit financial success, including reductions in consumer confidence, quality of service, quality of business continuity plans and overall market perception.

Location and Business Model

For companies in the United Kingdom, India is the most popular destination for BPO. This is because India offers a low cost structure and a large pool of skilled workers, a significant proportion of whom are university graduates. However, firms must choose the location that best suits their overall business requirements; India's geopolitical climate and supply infrastructure may make it unsuitable for some.

Each BPO model has its own set of legal, commercial and financial advantages and disadvantages. With the help of experienced BPO consultants, advisers and investors should consider which of the common models is promoted in the business plan, as it may not be appropriate for the location or have the potential to deliver the expected financial performance.

Direct outsourcing
Direct outsourcing involves the business contracting directly with the overseas supplier. It has three main advantages:

  • It is a simple and cost-effective model to leave behind when the contract ends;

  • It involves a relatively low initial capital investment, as the supplier will already have its own infrastructure for providing outsourced services; and

  • Reduced human resources costs and favourable local tax regimes offer the potential for cost savings.

Disadvantages of the model include:

  • the potential for tension between the management and the control of the service;

  • the difficulty of finding ways to motivate the supplier to deliver a quality service; and

  • the supplier's lack of business presence in the United Kingdom.

Other models
Alternatives to direct outsourcing include the following models:

  • Indirect outsourcing, in which the business enters into a contract with a UK supplier, which in turn subcontracts to its Indian subsidiary. This model shares the main financial benefits and disadvantages of the direct model. However, the business has the reassurance of contracting with a UK supplier: the contract is therefore likely to be governed by English law, which is a distinct advantage when dealing with hidden costs.

  • A joint venture with an Indian BPO provider gives greater operational control. However, it is likely to be more costly to set up and manage.

  • A wholly owned foreign subsidiary - the so-called 'captive model' - is likely to offer more control and the benefit of favourable local tax and other regulations, but this solution does not achieve the aim of devolving risk to a third-party supplier. Without the expertise of local suppliers, service quality and profits may suffer.

  • Build/operate/transfer (BOT) is a hybrid model: a local supplier is used until a UK company is ready to take over and run the operation itself, normally as a wholly owned subsidiary of the UK business. This can be advantageous if the business wants to test the waters in the jurisdiction concerned, but only if a favourable deal can be negotiated with the supplier in relation to the supplier's ability to recover its set-up and exit costs.

Hidden Costs

The savings in labour costs resulting from any BPO plan - especially in countries such as India, the Philippines and China - are significant and are usually the main reason why a UK company turns to offshore outsourcing. However, the initial cost savings achieved by adopting an overseas BPO model can easily be negated, at the macro level by the additional expense of conducting business offshore and at the micro level through the adverse impact of local jurisdictional issues.

Both levels must be evaluated when assessing the accuracy of the projected cost savings and increase in profits. As in any investment risk assessment, the due diligence exercise should be commensurate with the size of the proposed investment, the quality of the financial information and the state of the market. Inadequate due diligence may result in the erosion of the projected savings and a failure to achieve the projected profits. Some existing costs associated with outsourcing are increased by moving offshore, while other entirely new costs may arise:

  • The transition and ongoing service management costs involved in physically transferring an operation from the United Kingdom to India are often more expensive than would be the case for a transition within the United Kingdom. An example is the management team's travel and time costs between old and new locations before the contract starts, during the implementation phase and during transition. More management time and expense is involved in overseeing offshore operations during the life of the contract. Costs are also higher when moving from one offshore supplier to another - or back to a UK supplier.

  • Unless staff attrition in the UK company is sufficient, redundancy costs are likely.

  • Sophisticated IT users and leading companies will usually have foreseen the likelihood of outsourcing IT functions and will often have managed to negotiate contracts with the third-party owners of the IP rights which permit and facilitate any outsourcing (eg, an appropriate enterprise-wide licence agreement). However, the contracts rarely cover outsourcing beyond the contract territory which, in the case of businesses in the United Kingdom, is usually the United Kingdom or Europe. Obtaining the required consent from third-party owners can add costs and delays to the process.

  • Telecommunications links between the United Kingdom and offshore operations will be required. Extra bandwidth may be needed to ensure that there is no loss of quality in the outsourced service.

  • Inflation and foreign exchange fluctuations can eat into cost savings

  • Many of the countries popular for offshore outsourcing present greater risks to business continuity because of their location or geopolitical situation. They may, for example, be more likely targets for terrorism or have tensions with neighbouring countries. They may be more prone to natural disasters which affect business-critical services. Some countries lack a robust services infrastructure; power outages may be more frequent.

  • Corporate social responsibility is increasingly important to UK companies. Offshore outsourcing can be viewed negatively as taking advantage of developing countries and economies at the expense of the UK economy. Negative publicity may damage a company's brand and reduce its share value.

  • Robust contractual provisions and a clear expression of the agreed price, limiting additional charges, are vital if costs are to be contained. At present, labour rates are significantly lower overseas. However, it is predicted that staff shortages will cause the cost of application development in India and China to increase. Service providers often see the business benefit of pleasing a potential outsourcing client and are eager to do so. This eagerness can lead to a tendency to promise too much. Coupled with a desire to avoid confrontation, this may lead service providers to make commitments which they are unable to honour, which in turn delays implementation.

  • Forming the right BPO management team is essential and careful planning is required. At a macro level, the business plan should provide for a key management team to handle the assessment, planning, negotiating, transition, service delivery and service management of the outsourced service. It may also be necessary to form a team of external advisers with the necessary expertise - including consultants, lawyers, financial and tax experts and, most importantly, local experts - to review the business proposal and the projected financial return.

Comment

Offshore outsourcing of IT functions can realize significant cost savings and give UK companies a competitive advantage. However, many factors can erode the projected gains. Investors and investment advisers must examine the business model supporting the forecast figures to determine whether the gains are likely to match the predicted level.


For further information on this topic please contact Craig Rattray at DLA Piper Rudnick Gray Cary UK LLP by telephone (+44 8700 111 111) or by fax (+44 20 7796 6666) or by email (Craig.Rattray@dlapiper.com).


Comment or question for author

ILO provides online commentaries as specialist Legal Newsletters. Written in collaboration with over 500 of the world's leading experts and covering more than 100 jurisdictions, it delivers individually requested information via email to an influential global audience of law firm partners and international corporate counsel. Please click here to register for the service.

The materials contained on this website are for general information purposes only and are subject to the disclaimer.

ILO is a premium online legal update service for major companies and law firms worldwide. In-house corporate counsel and other users of legal services, as well as law firm partners, qualify for a free subscription. Register at www.iloinfo.com.