Characteristics of Software Markets

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Hidden Costs in Offshore Outsourcing of
Application Services Talk at NYU-IBM workshop on
Global Sourcing on January 26, 2007 at the NYU
Stern School of Business
Jens Dibbern ? Universität Mannheim
2
Overview

• Extra (Hidden) Costs of Offshoring
• Theoretical Framework for Explaining Variations
  in Extra Costs
• Offshoring Case Study
• Conclusion
• Questions

3
The Mystery of Hidden Costs

• If wage discrepancies are so high between client
  and vendor in offshore outsourcing, why do so
  many offshore projects fail to deliver the
  expected economic benefits?
• Answer There must be hidden or extra costs in
  offshore outsourcing that are often overlooked or
  underestimated when calculating the business case.

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Research Question

• What types of extra costs may arise from
  offshored software projects?
• How and why do these extra costs vary between
  offshore projects?

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Calculating the Business Case
Based onClient-VendorAgreement
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Extra Client Costs in OffshoreSoftware Projects

• Possible extra costs for the client
• PC Production costs
• TC Transaction costs

Focus of Study
PC
Contract Adaptation costs
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The Divided Offshore Software Development
Lifecycle
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Theoretical Framework
KBV
TCE (Opportunism)
KBV ( Knowledge asymmetry)
KBV
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Offshoring Case Study Research Design

• Positivist case study research
• 6 offshore projects of a German bank to Indian
  vendors
• 3 software development and 3 maintenance projects
• 27 interviews with project participants from
  client and vendor (onsite und offshore)
• Qualitative data analysis (Text coding,
  cross-pattern matching)

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Offshoring Case StudyOverview of Projects

• Development 1 (FORNTEND)
• Consolidation of two historically grown account
  systems into one new system (Reengineering)
  offshoring of the front end development of the
  system (spec., design, programming, testing).
• Development 2 (CORPORATEPAY)
• European system for flexible billing of high
  value payments of corporate customers (e.g.
  multi-tier conditions or rebates) development
  incl. functional requirements specification
  offshored.

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Offshoring Case StudyOverview of Projects

• Development 3 (WEBPORT)
• Design, programming and testing of a web portal
  for corporate customers (information about
  capital market products of FINANCE)
  requirements specification partly by German
  consultant
• Maintenance 1 (INTERCHANGE)
• maintenance and support of a legacy payment
  platform for domestic and cross border payments
  first testing then maintenance followed

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Offshoring Case StudyOverview of Projects

• Maintenance 2 (SUBSIDPAY)
• .. of a software package that ensured the bulk
  payment processing in one of the European
  subsidiaries. The application processed
  transactions for local clearing procedures, i.e.
  credit orders and direct debits. The core product
  was US standard software that was significantly
  enhanced and customized.
• Maintenance 3 (CORPACCESS_M)
• .. of two of the main applications regarding
  electronic payments processing for corporate
  customers - previously outsourced domestically.

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Offshoring Case StudyQualitative Data Analysis

• Coding of text with NVivo
• Assigning text passages to constructs
• Determining instances of constructs for cost
  types and asset specificity (low-medium-high)
• Pattern matching between projects
• Comparison with propositions

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Offshoring Case StudyQualitative Data Analysis

• Illustration of Coding Procedure Matching text
  passages (quotes) with theoretical constructs

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Offshoring Case StudyQualitative Data Analysis

• Exemplified Quotes for Extra Costs

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Offshoring Case StudyQualitative Data Analysis

• Number of quotes for extra costs

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Offshoring Case StudyQualitative Data Analysis

• Exemplified quotes for Required Client specific
  Knowledge
• Development 1 (FORNTEND) - High
• Throughout the entire project you need a lot of
  business understanding. We touch a system that is
  older than 25 years, where are large number of
  business rules are implemented.
• It was such that you assumed, we deliver XXXX
  the program and they run an analysis and learn
  out of the source code how the system works.
  That, I would say, has not yet worked out. It is
  simply too complex. (Project manager FINANCE)

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Offshoring Case StudyQualitative Data Analysis

• Exemplified quotes for Required client specific
  knowledge
• Development 3 (WEBPORT) Medium-Low
• This is a portal. This is a pure technical
  project, actually. It is more technology then
  functionality. ... As I said, you should have a
  basic knowledge about the data that is displayed.
  Beyond that, you are not expected to understand
  how the rates are calculated. (Offshore
  provider)
• Development 3 (CORPACCESS) Medium
• Lets put it this way, in terms of specific
  knowledge you need functional knowledge.
  Functional knowledge in a sense that you
  basically know about the payment types, that
  there are statements of accounts, you need to
  know something about the bank clearing system
  (BCS) concept. (Project manager FINANCE)

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Offshoring Case StudyPattern Matching
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Offshoring Case StudyQualitative Data Analysis

• Results of cultural differences
• Strong power distance between Indian team members
  and supervisor
• No questioning of specified task
• Little independent working, pure implementation
  of instructions
• Yes saying
• Little cogitation of alternative solution
  approaches
• Different criticism behavior

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Offshoring Case StudyQualitative Data Analysis

• Exemplified Quotes for Cultural Differences
• When you talk to two Indian persons, it is
  obvious who sits in the drivers seat. (Team
  member, FRONTEND)
• They implement what you tell them. But merely
  what you tell them, partly they do not look one
  step ahead. (Team member, CORPACCESS)
• When they presented us some alternatives, we
  said what do you think?. And you could tell,
  they did not expect that question and seemed to
  be surprised and unprepared for an answer. (Team
  member, FRONTEND)

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Offshoring Case StudyQualitative Data Analysis

• Impact of cultural differences
• No asking of questions, Yes saying ? High
  effort for knowledge transfer
• Pure implementation of instructions ? high effort
  for specification
• Strong power distance between Indian team members
  and supervisors as well as client project
  manager, no questioning of specified task, little
  independent working ? High coordination effort
  since problems are not addressed independently/
  by their own.

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Offshoring Case StudyQualitative Data Analysis

• Exemplified Quotes for Impact of Culture
• we recognized, in the direct contact there
  will be no such feedback as I do not
  understand. We have to organize the feedback.
  That means we have to establish measures in order
  to oblige those who have absorbed information to
  re-explain it. (Project manager, FRONTEND)
• After having completed one phase, we had a bad
  awakening. The functional specifications which
  the vendor was responsible for were inspected
  and a lot of gaps were identified. This is
  related to the Indian culture. What they get
  as an input, they do not question at all. Of
  course it is also the lack of knowing the
  business. You can only ask questions if you know
  the context. It is the mentality of the
  Indian professionals to always say yes and to
  scrutinize. (Team member, CORPORATEPAY)

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Offshoring Case StudyQualitative Data Analysis

• Impact of geographic distance
• Particularly problematic in service delivery
  phase, when the Indian team works mostly offshore
  and it is recognized that specifications are
  incomplete and that there is a lack of knowledge
  ? knowledge transfer easier through face-to-face
  meetings in particular for highly specific
  knowledge onsite-Team members are helpful but
  costly.
• In addition, coordination and control becomes
  harder. Necessity for offshore visits.

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Offshoring Case StudyQualitative Data Analysis

• Exemplified Quotes for Impact of Distance
• Sometimes they business team say it is
  difficult, had the team been here, we could have
  resolved this in one day and now we have to make
  two or three rounds of telecons telephone
  conferences or video cons to explain and review.
  Yes, it is true. That is the pitfall of offshore
  outsourcing. (Vendor, WEBPORT)
• Instead of sending a slide and explaining
  difficult things during a telephone conference,
  it would be a lot easier and faster to explain
  things on a piece of paper. That is why it is not
  a bad idea to have one or two people supporting
  the team onsite in order to clarify things that
  are difficult to resolve on the phone. (Team
  member, FRONTEND)

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Offshoring Case StudyQualitative Data Analysis

• Impact of Turnover of Vendor Staff
• Developers with client and project experiences
  are scarce resources in India and hence highly
  wanted in India ? Turnover high ? Costs of
  knowledge transfer high, coordination costs high
  (Consequence is that German managers get involved
  in personnel recruitment of the offshore provider
  and they put high effort in motivating them
  during the project in case of substitution there
  are also high extra administrative costs for
  setting up new vendor personnel)

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Offshoring Case StudyQualitative Data Analysis

• Exemplified Quotes for Impact of Turnover
• We have almost every year a rotation of the
  current onsite coordinator, because they want to
  return to India. (Project manager, CORPACCESS)
• We struggled with the usual things such as
  extremely high employee turnover. (Project
  manager, CORPORATEPAY)
• Every time a new onsite coordinator enters the
  team, this is related with an incredible amount
  of administrative work making sure he has
  passwords and access to a variety of systems.
  (Team member, CORPACCESS)

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Offshoring Case StudyQualitative Data Analysis

• Impact of deficits in absorptive capacity
• Lacking experiences and creativity lead to higher
  effort for knowledge transfer since there is
  little pre-understanding of business processes as
  well as the interdependencies in the client
  application system.
• To compensate for lacking creativity the client
  increases the level of detail of specifications ?
  Specification effort increases, control effort
  increases for checking whether spec. where
  correctly implemented, effort for team building
  (coordination) increases as well.

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Offshoring Case StudyQualitative Data Analysis

• Exemplified Quotes for Impact of Lack of
  Absorptive Capacity.
• Precise requirements are realized. But if you
  ask them to present a solution developed by
  themselves, you will encounter limits. If
  creativity is required, there will be problems.
  They Indian vendors are not yet at that stage.
  (Project manager, WEBPORT)
• Because of these difficulties, we have to invest
  in team building, which was underestimated. We
  also thought that the Indian professionals would
  be able to analyze the program with their tools
  by their own, and to acquire the business
  know-how with the help of these tools, but that
  is also not the case. They highly depend on our
  help. (Project Manager, FRONTEND)

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Offshoring Case StudyAdapted Framework
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Conclusion

• Offshoring does not automatically lead to reduced
  costs
• High client extra costs arise in projects with
• A high level of required client specific
  knowledge,
• low level of absorptive capacity of vendor
  personnel,
• high personnel turnover at the vendor side.
• In addition cultural differences and geographic
  distance aggravate communication and mutual
  understanding between the personnel of the
  offshore vendor and the client personnel.

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Conclusion

• Projects with high asset specificity should not
  be offshored
• When selecting the vendor the client should
  impact the personnel recruitment
• Contractual regulations need to be implemented to
  safeguard against fluctuation at the vendor side
• Cultural differences need to be addressed and
  managed actively, e.g. intercultural workshops at
  both sides and with both parties involved.

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Conclusion

• Knowledge based reasoning dominates
• Transaction costs arise independent of vendor
  opportunistic behavior
• Specification and knowledge transfer costs are
  particularly high when high level of specific
  client knowledge required
• Client response to difficulties in knowledge
  transfer through knowledge substitution, I.e
  increased effort in specification appears
  counterproductive in highly specific projects

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Implications for Future Research

• Additional research questions
• Can specification and knowledge transfer be made
  easier through innovative IKT ?
• ? Impact of knowledge management and
  collaboration tools on distributed software
  development (virtual prototyping)
• Can propriety client systems be standardized
  without loosing their ability to reflect
  individual client business processes and systems
  requirements?
• ? Replacement by component based and service
  oriented solutions?

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Conclusion

• The main challenge still lies in increasing the
  division of labor in software services processes
  (both technically and organizationally) while
  allowing for client individual solutions.
• Innovation at the technological level of division
  of labor (componentization and SOA) as well as
  innovation at the organizational level of
  division of labor fertilize each other.
• Componentization may actually make outsourcing
  easier.

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Questions

• Is high vendor turnover a form of opportunistic
  behavior?
• Is it opportunistic behavior to staff the project
  with inexperienced personnel?

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• Questions

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Offshoring Case StudyPhenomenon

• Until 2008 estimated offshore market at 300 Bill.
  US (in 2003 ca. 54 bill. US.) (Allweyer et al,
  2004)
• Germany largest IT outsourcing market in Europe
  (ca. 10 Bill. in 2003), but only 4 offshore.
  Growth rate ca. 11 - 40 (Pohl Onken, 2004)
• Germany ca. 71 see Offshoring as an important
  topic (Deloitte Touche, 2004) mainly large
  size companies make use of offshoring (ca. 6),
  e.g. Allianz, Deutsche Bank, Siemens,
  DaimlerChrysler, SAP (e.g. at Siemens, 10 of the
  entire number of software developers (ca. 3000)
  are located in India Deutsche Bank ca. 1000
  Software developers in India)
• USA Overall more aggressive offshoring

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Offshoring Case StudyPhenomenon
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Offshoring Case StudyPhenomenon
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Software Industrialization
Standard Software
Individualization
No. of Clients
n 1
Input
Require- ments
Unique (e.g. company, end user)
Trans- formation
Output