Over the last five years or so the dominant direction of business process outsourcing has been to India, with other countries like the Philippines and China lagging behind but still taking a fair chunk of work from US and European professionals.

And the biggest reason was the chance to lower costs, mainly on the back of lower wages in these countries. The wage differential remains substantial but the case for pushing ever more work to these countries looks to be weakening.

A December 2008 report from TowerGroup points out that managers at some US companies are discovering that offshoring in India is not the cost-saver they imagined, especially for captive offshore operations, in which the US parent sets up and runs the outsourcing operation, usually employing local workers to staff much of the operation.

Reading this reminded me of a February 11, 2008 article in the Wall Street Journal –
Rethinking the India Back Office; Some Western Firms Weigh Selling Their Units as Costs Rise, Dollar Weakens. The author, Jackie Range, cited a study by McKinsey & Co. and Nasscom, the Indian tech and outsourcing industry group, which found that, on average, company back offices – “captives” – were less efficient than companies run by outsourcing firms that specialize in the business. For some types of back-office work, captives’ costs are 30% higher. The survey also found that the higher costs didn’t lead to lower staff turnover or better-quality work.

More recently, the September issue of McKinsey Quarterly had an article – Time to rethink offshoring? – that showed how shifting cost curves mean the US is becoming a more competitive place to manufacture high-tech products.

“The production of high-tech goods has moved steadily from the United States to Asia over the last decade. The reasons are familiar: lower wages, a stable global economy, and rapidly growing local markets. These factors combined to make nations such as China and Malaysia favored manufacturing locations. In the last two years, however, the favorable economic winds that carried offshoring forward have turned turbulent. The new conditions are undermining some of the factors that made manufacturers of every stripe, including those in high tech, move production offshore” – Ajay Goel, Nazgol Moussavi, and Vats N. Srivatsan, McKinsey Quarterly, Sept 2008

McKinsey’s argument rests mainly on higher wage inflation in offshore locations and transportation costs and here is their summary analysis:

Manufacturing high-tech products is obviously different from knowledge services, but it all goes to show that this change is affecting business across a number of fronts.

Also, since McKinsey complete its analysis the dollar has strengthened, especially against the Indian Rupee, and oil prices have collapsed, so their findings wouldn’t be as compelling today. But these are likely short-term affects that won’t affect the longer-term view.

All up, clients will start to be more discerning when it comes to outsourcing and offshoring. One to watch.