The Road Ahead for Outsourcing Suppliers: Higher Costs

Cost increases are squeezing margins for outsourcing companies providing software and call center services to U.S. customers from popular international destinations. No immediate price increases for U.S. customers are possible for suppliers that are locked into fixed-term contracts in U.S. dollars, but price changes could be sought in contract renewals, extensions, and in the pricing of new contracts.

Prices for call center and e-mail support services provided by facilities in the Philippines, South Asia and the Persian Gulf have remained relatively constant since the end of 2004,as detailed here. That is likely to change for new and renewed contracts because of cost increases for suppliers.

There are three factors behind cost increases for suppliers:

• Currency exchange fluctuations
• Wage increases
• Tax increases

Declines in the value of the U.S. dollar are impacting suppliers in India, the Philippines and Canada by lowering revenues in comparison to local currencies. The Philippines has had a tight labor market forover two years, especially in the call center sector. Tax increases are confined to India, which is also experiencing the highest wage increases in Asia.

We begin by looking at Canada, followed by the Philippines and India. One of the effects of rising costs for suppliers of outsourcing services in India is continued industry consolidation. A recent casualty is India’s oldest commercial call center, described below in reference to the historical preservation of its original workstations.

Canadian Dollar Approaches Parity

The Canadian dollar has gained 50 percent in value in the last five years. It is now within striking distance of parity with the U.S. dollar for the first time in over 30 years, reaching just short of the psychologically important benchmark of 95 US cents in trading last week. Wage rates for skilled customer service agents in major cities in Canada are now higher than wages paid in many second- and third-tier U.S. cities for comparable work.

Parity between the currencies could be realized before the end of this year.

The falling U.S. dollar is creating problems for the Canadian call center industry, but not yet panic. Three factors serve to cushion the Canadian call center industry. These factors create unique competitive advantages compared to competing outsourcing destinations in Asia, Africa and the Middle East.

First, the industry enjoys support from government agencies and educational institutions eager to promote the creation of export-oriented jobs. Financial subsidies are often available at the beginning of a call center’s lifecycle and are helpful in reducing debt load. Canadian governments and educational institutions are implementing coordinated educational and labor market policies to help ensure that staff with requisite skills are ready and able to meet expected job requirements, especially in the Maritime Provinces.

The second factor cushioning the Canadian call center industry is the shift in the last three years away from a reliance on outbound business-to-consumer telemarketing work. This was prompted in part bya shrinking client demand for outbound work, by the implementation of a nationwide do-not-call (DNC) list system in the U.S., and by consumers shifting to wireless lines that are off limits to telemarketing calls.

In place of outbound telemarketing, we see more inbound customer service and technical support work that is higher paying and more stable. Inbound work at Canadian centers is based less on pure labor arbitrage and more on the availability of quality personnel with minor accent issues.

Thirdly, U.S. clients accept that Canadian facilities cost more than other international destinations, which puts Canadians in a different negotiating category than other outsourcing destinations providing voice services in English. Business managers and program managers at Canadian centers are seen in the industry as having good contract management and business management skills with U.S. clients.

Philippine Peso Rises

The Philippine economy is booming. Exports have increased by 13 percent so far this year. Foreign direct investment increased by 26 percent in 2006. Along with economic growth has come a stronger local currency.

The Philippine peso has gained 6.7 percent in value against the U.S. dollar this year. Outsourcing service providers locked into contracts negotiated when the peso was low are now looking for ways to cut costs. Last June the peso traded at more than 53 to the dollar. It now trades at 46.6 pesos to the dollar.

Longstanding cultural ties between the U.S. and the Philippines and the accent advantage that agents in that country enjoy over other Asian destinations enable call centers in the Philippines to charge higher rates than facilities elsewhere in Asia. Indian managers of merchant call centers in Dubai and elsewhere in the Persian Gulf generally prefer to hire agents from the Philippines than from India, except forwork that requires tenaciousness or conformance to precise performance and procedural requirements.

The outsourcing industry in the Philippines received a scare on the evening of May 21 when the Amber Creek call center in Taguig received a bomb threat sent by SMS text message. Two thousand employees were evacuated from the facility.

No one has taken responsibility for the bomb threat. Speculation has ranged from a terrorist group to a disgruntled employee to the possibility that another call center company is seeking to disrupt a competitor. Freelance journalist Mike Cohen, based in Manila, said that private security firms at the scene confiscated cameras and sought to prevent media reporting of the incident.

India Rising

In India, the rupee has gained 8.7 percent against the dollar during the first quarter of this year. It now stands just a few paise bits above the psychologically important threshold of 40 rupees to the dollar.

The customer service industry in India has been consolidating for more than two years. The larger players enjoy profit margins of 20-30 percent and will be able to absorb currency fluctuations in the short term. Smaller players generally have profit margins of 10 percent, with lower profits often due to a reliance on telemarketing projects rather than stable inbound work. Indian firms of all sizes will likely push for price adjustments in contract renewals and in price proposals for new contracts.

India is experiencing the most rapid wage increases of any country in the Asia-Pacific region. Wages in India are influenced by regional factors, asInternationalStaff.net found in thissalary survey of call center agents in major metropolitan areas.

Kolkata (formerly Calcutta) continues to be the lowest-wage metro area for both call center and technical staff. Rolta India Limited announced on June 6 that it is building an IT park there with 5,000 seats, primarily for the provision of engineering and software development services.

Wage rates in India as a whole are forecast to climb from between 12 percent to almost 16 percent this year, with professional employees and middle managers expected to be at the higher end of that scale. Increases for technical employees are expected to average around 12 percent, or 7 percent after inflation. Overall wage increases topped 14 percent in both 2006 and 2005.

Nationwide data on wage increases can obscure spikes in locations with tight labor markets for particular skills and experience levels. Wage increases for talented software engineers in Bengaluru (formerlyBangalore) are the highest in India, coming in at more than 30 percent annually, twice the national average. In comparison, annual wage increases for software engineers in the U.S. averaged 3 percent from 2005 to 2006.

Wage increases for software development talent are more difficult to absorb for captive (noncommercial) facilities, especially those with small economies of scale, fast-moving development and integration targets, and the need for experienced developers located in tight labor markets where competition from competing employers is high. Large software outsourcing firms or those with slower, less complex or larger development projects can afford to hire low-skilled talent and then provide training as needed.

The wage advantage for U.S. firms setting up captive software development facilities in the more expensive metro areas of India has shrunk from 1 to 5 down to 1 to 3. Additional shrinkage is expected, leading to predictions that in the first half of 2008, significant numbers of U.S. firms with captive operations will be scrambling to either pull work back to the U.S. or seek alternate destinations elsewhere.

The problems that many U.S. firms experience by locating in high-cost areas of India could be repeated if relocation decisions are made without regard tolabor market analysis considerations.

However, for high-tech firms in the U.S. to receive venture funding, many feel that it is a requirement that they set out a strategy for either going to India or Russia for captive development resources.

High-cost locations in India have gained broad recognition and acceptance by U.S. venture capital firms. Lower-cost Indian options such as Kolkata have not, nor have the underutilized and low-cost talent pools of Pakistan and Sri Lanka.

Commercial software service providers with outsourcing facilities in India are in a better position to adjust to cost increases than captive development operations located in that country. Software outsourcing firms are also in a better position to absorb cost increases than commercial call centers in India.

Call Centers Less Able to Absorb Cost Increases

Commercial call center service providers are less able to absorb wage increases and currency fluctuations than software firms and remote computer system administration service providers, in part because of the way billing and payment arrangements for call center firms are tied to labor hours. A company whose business model is based purely on labor arbitrage will be immediately impacted by currency fluctuations and wage increases.

A company that bills on a task basis without defined headcount requirements may be able to grow without adding large numbers of new personnel. A company that bills on a task or project basis can also raise its prices quietly by simply adjusting the formulas used to submit price quotes and bids for new work.

Companies that bill on the basis of task or project performance may be able to absorb currency changes and cost increases by becoming more efficient. For a company that provides remote computer system administration services, for example, as long as service levels are met, then a client may not need to know how many people are assigned to provide support.

Pressures for price increases will therefore be greatest for firms that operate purely on the basis of labor arbitrage.

For the software sector in India, a tightening labor market is driving major outsourcing firms to look elsewhere for new facility locations. Tata Consultancy Services (TCS) launched a new facility in Guadalajara, Mexico, on May 31 to serve clients in both the U.S. and Mexican markets. TCS said in a statement that this is the first major investment by an Indian information technology firm in Mexico. It plans to start with 500 positions this year in Guadalajara with the option to ramp up to 10 times that number in Mexico as a whole.

TCS already employs 5,000 professionals elsewhere in Latin America. TCS shows that buyers of software and CRM (customer relationship management) services looking to outsource to Indian companies may find that they have more destinations to choose from than just India.

Indian Taxes

India’s current national budget includes a minimum alternate tax (MAT) to be applied to Indian IT firms and call centers on revenue from work done for clients outside of India. These firms had enjoyed tax exemptions from standard corporate income tax rates because of their status as export-oriented IT operations. This 10-year period of exemption comes to an end in 2009, when full corporate income tax rates are scheduled to be applied.

The 10-year exemption was established under the Software Technology Parks of India initiative. Some IT firms are lobbying for the government to grant them tax-exempt status after 2009 under India’s system of incentives for firms located in special economic zones.

The MAT will be assessed for the fiscal year that began April 1 at a rate of 12 percent of profits on income earned from clients outside India. In addition, a tax of 12 percent on office rents is also being levied this fiscal year.

The regular corporate income tax rate for domestic Indian corporations is 35 percent of profits plus a 2.5 percent surcharge. The rate for foreign corporations doing business in India is 40 percent of profits plus a 2.5 percent surcharge.

There is an additional surcharge of 2 percent on corporate income taxes due by both foreign and domestic companies that pay corporate income taxes in India. This surcharge is called the “education cess.” A wealth tax of 1 percent is assessed if a company’s net wealth exceeds 1.5 million rupees, which is US$34,000 at current exchange rates.

U.S. and other non-Indian firms with software development, back-office or call center operations in India were pulled into the regular corporate income tax system in 2004. Corporate income tax rates are set on an annual basis and have increased since 2004 to the rates described above. The Indian tax system has not deterred any U.S. company advised by InternationalStaff.net from establishing operations in India.

Indian companies that serve both domestic and international customers are already paying corporate income taxes on income from their domestic operations. Companies locked into multi-year contracts with clients outside India will be under pressure to pass those tax increases along to customers.

No Indian company is known to have reached an agreement to pass tax increases along to their clients. Variabilities in Indian companies’ business structures and internal accounting systems could lead to different MAT pass-through costs for the same type of work conducted at different facilities under identical outsourcing contracts.

The profit margins earned by IT and customer service firms in India are generally high enough for them to absorb new taxes without price increases. Operations with low profit margins will be under pressure, as we see in the case of GTL, which announced earlier this month that they are placing their call center business up for sale.

Historical Importance of India’s Oldest Call Center

Originally known as “Global Telecom Limited,” GTL owns commercial call centers in Mumbai and Pune. Despite the best efforts of GTL’s sales office in New York City, the facilities’ combined capacity of 1,500 seats was often not fully or efficiently utilized.

The Mumbai facility has 760 seats and was established in 1999. Call center equipment has a lifespan of roughly seven years. GTL’s Mumbai facility is currently dark, according to Mahesh Iyer, who manages the nearby Purple Support Services call center.

GTL’s Mumbai facility was the first commercial call center built to serve U.S. customers from India. It also served as a model facility that was shown off to customers of GTL’s call center construction and equipment provisioning business. No other call center in South Asia has as much historical importance.

The obsolescence of this closed facility’s equipment and the process of de-acquisition provides a unique opportunity for the preservation of artifacts from a critical moment in history. Many of the 754 original work stations could be sent to historical institutions and museums in India, with others offered to museums elsewhere around the globe.

Economic globalization is significant enough and has been going on long enough for issues of historical preservation to arise. Nowhere are they more important today than in regard to an aging collection of office furniture and equipment that the people of GTL used to change India, the world and themselves.