Exerpt from An Overview of Offshore Software Development, by Dr. Bernard L. Palowitch, Jr., President & CEO of Incoda Corporation.

Background

“Offshoring”, or “offshore outsourcing”, generally means moving the physical location of information technology (IT) services delivery from a developed nation with high wage rates to a developing country with lower wage rates.

The offshoring of IT services began in the mid-1990s when companies outsourced their Y2K and euro conversion initiatives. The IT labor market in the developed countries was very tight at that time and offshoring was often their only option. The work performed proved to be very successful. India, in particular, has become well known for its high-quality application development and maintenance work. “Y2K legitimized the offshore marketplace and gave the Indian providers traction,” according to Rita Terdiman, vice president of Industry Services at Gartner. [1]

Since the beginning of the global economic downturn in 2000, offshore outsourcing has become one of the major sources of IT cost savings. Although legacy application development and maintenance projects still represent the majority of work moved offshore, companies are increasingly relying on offshore suppliers for custom application development, call center, and business process outsourcing services as well.

Market Size

In 2000, the annual total global IT services market was estimated to be roughly $400 billion. North American companies spent approximately $114 billion on in-house software development, contracting, and purchases. [2] The global offshore IT services market is valued at between $9 billion and $10 billion annually, and therefore, represents about 2 to 2.5 percent of the global IT services total.

The United States, which accounts for about 45 percent of worldwide IT services spending, is the largest customer of offshore software services. U.S. companies accounted for roughly 60 to 65 percent of the total, European companies account for about 25 percent, and companies in the Asia Pacific region account for 10 to 15 percent. [3]

According to a recent report published by IDC, a Framingham, MA-based market research firm, offshore outsourcing is the dominant trend in the IT services industry. IDC states that 42 percent of the application management contracts have some offshore component and that the main reason for moving offshore has been lower cost. [4] Incoda, believes that the demand for offshore outsourcing of IT and IT-enabled services will continue to increase due to continued cost pressures, the anticipated global economic recovery, and to the trend of globalization of services.

Type of Service Offerings

The offshore outsourcing market has evolved over the last decade. In the mid and late 1990s, it was used almost exclusively for delivering highly commoditized, technical staff augmentation. Today, companies are relying on offshore software developers for a much broader range of IT services. The service offerings of offshore suppliers cover the entire spectrum of IT activity—from support and maintenance of legacy applications to complex custom applications and a variety of other higher value IT and IT-enabled services. Gartner Group places the types of offshore service offerings into three categories, based on the suppliers’ level of experience with those service offerings. [5]

• Most mature: application maintenance and management, application migration, and legacy application development.
  
  
• Medium maturity: new custom application development, enterprise application integration, implementation of application packages (e.g., ERP, CRM, SCM), and business integration.
  
  
• Least mature: call centers, business process outsourcing (BPO), infrastructure outsourcing, ERP services, remote network management, product engineering, embedded software, and technical services.

The two fastest growing segments of the offshore services market are application management and business process outsourcing (BPO). BPO is capturing the attention of many executives as a way to reduce the costs of business processes such as customer care, billing, collections, claims processing, and various other back office functions. Gartner points out that call center and transaction processing markets are more mature than the outsourcing of more complex, back-office processes.

Offshore providers will strive to create or extend differentiated capabilities and continue to expand their services portfolio offerings to include higher value add project-based services. Given the growing level of competition in the services outsourcing market, companies that don’t have unique capabilities will be subject to downward pressure on billing rates.

Customers

Large multinational enterprises have been the largest users of offshore software services suppliers. In 1999, more than 185 of the Fortune 500 companies outsourced at least part of their software needs to India [6]. Today, the majority of the Fortune 500 use offshore development services through third-party suppliers or have wholly-owned development centers established offshore. Some well-known companies utilizing offshore software development include General Motors, American Express, 3M, Cigna, DuPont, Weyerhaeuser, ING Group, Motorola, Accenture, British Airways, Intel, Deloitte Consulting, British Telecom, Amazon.com, Home Depot, Shell, Sprint, Nortel Networks, EDS, Aetna, and MasterCard. Major hardware and software giants like Microsoft, IBM, Apple, Oracle, Novel, Sun, IBM, Compaq and Texas Instruments all have extensive offshore operations. Not surprisingly, the largest industry sectors using offshore software development are those that are heavily dependent on information technology, including banking, insurance, and other financial services, communications, media, and software.

The successes of large multinational companies have generated strong interest in offshoring by small and medium sized companies, including an increasing number of technology start-ups. More than eighty percent of the software companies surveyed are shipping work offshore today or will do so in the next year, according to the Sand Hill Group, an investment and research firm based in San Francisco, California, who published the findings of survey of 51 software companies in July 2003. The study found that 63 percent of the responding companies are currently involved in offshore initiatives and an additional 21 percent are in the process of sending work offshore and will have such processes in place within a year. [7]

Drivers

Three primary drivers have produced the rapid growth in offshore outsourcing. They are:

1. Difficult economic conditions around the globe. Companies are being forced to investigate any and all opportunities to reduce their cost structures.
   
   
2. The large, wage-rate differences for similar skills that exist around the globe. The larger the differential between domestic wage rates and offshore rates translates directly into larger cost savings in both direct and indirect labor costs.
   
   
3. Demonstrated outsourcing successes by well-regarded companies. Numerous articles and case studies have been published that document the benefits achieved from offshoring by respected global corporations.

Incoda believes that businesses will continue to focus their attention on core business priorities and will increase their offshore outsourcing of non-core IT systems and processes. Potential customers for offshore services will continue to look for cost savings and are gaining a level of confidence with the delivery capabilities of offshore suppliers. Many of the today’s offshore projects will expand from discrete assignments to multi-year outsourcing engagements.

Enablers

Three enablers support the move to offshore outsourcing.

1. The increasing capabilities and falling costs of telecommunications worldwide, including high-speed Internet, instant messaging, web conferencing, and VoIP. These telecommunications advances, along with numerous productivity tools, such as collaborative project management software and knowledge management applications, enable businesses to leverage highly qualified workforces anywhere in the world.
   
   
2. Tax and other financial incentives offered by governments to nurture the growth of the IT services sector. For example, in India, the government plays an active role in promoting the software export industry, with initiatives such as the Software Technology Parks of India (STPI) and the Special Economic Zones (SEZ), which offer income tax exemptions until 2010. Other developing countries are also supporting their domestic software export industry through specific policies and tax incentives.
   
   
3. Availability of educated, technically skilled, and motivated workers in countries around the world. Long-term trends predict a shortage of IT talent in the world’s developed economies. In many countries, open technical positions remain unfilled because of a lack of applicants with the requisite technical and non-technical skills. On the supply side, India alone graduates roughly 110,000 computer professionals annually from its more than 1,800 educational institutions.

* * *

To learn more about Incoda's perspectives on offshore software development, please see:

• Benefits and Challenges of Offshore Software Development
• OSD Delivery Models
• Key Differences Between Local and Offshore Software Development
• Comparison of the Leading OSD Countries

To download the entire Incoda white paper, An Overview of Offshore Software Development, please visit the Resources Section of this website. Registration is required.

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This page describes the offshore market, the IT services performed offshore, and the drivers and key enablers behind the offshoring trend for custom application and web software development.