Calculating the Real Cost of Offshore Outsourcing

Vendor rate does not equal buyer cost

A universally accepted belief in the business press and blogosphere regarding offshore outsourcing is that reducing labor rates should not be the driving force behind it. Of course rate is a factor, but the bottom line is this:  however you manage your software development, you need to create a model that produces the best possible software at a financially sustainable cost--in other words, the best value.

The fact is that if you only shop rates when looking for an offshore resource, you may end up sabotaging your own low-cost goal. Experts suggest that labor’s contribution to the total cost of outsourcing falls between 60% and 80%, and there is an inverse relationship between low rates and additional costs.

The first thing to consider when entering into an outsourcing relationship is transition costs including:

• The cost of vendor selection. This includes effort to screen and conduct due diligence on vendors including effort to create and evaluate responses to an RFP, if applicable; and/or operate a pilot project to vet capabilities.
• The cost of transition and ramp-up. Companies should understand that during the transition period, which can take up to a year for complex applications and domains, total costs may increase rather than decrease.  Costs to consider in this phase include internal personnel to facilitate onboarding and knowledge transfer; costs to implement and manage systems and processes across distributed teams; and travel costs for members of both teams to get comfortable with each other.   Transition costs can be exacerbated by outsourcing firms with high turnover.
• Cultural Costs. At first there can be a loss of productivity based on cultural/communication barriers – both offshore and onshore particularly if the company relies on relatively junior H1-B resources for local coordination and front-end services.

Long-term Productivity is the Key

Clearly, starting an outsourcing relationship can be pricey.  More important than this, however, is the long term productivity of the outsourcing team itself because this will dictate on-going costs.  Rates reflect a vendor’s unit cost of labor, but are not the same as the buyer’s cost.  Buyer cost can only be calculated by multiplying rates by team productivity.

Not all outsourcing teams are created equally.  A less experienced team that is only 80% as productive as a more experienced one effectively imposes in excess of a $5/hr “tax” on its quoted rates.  Teams that produce poor quality or require re-work of items due to misunderstanding of requirements or failure to clarify work direction only add to these costs.  Generally speaking, higher rates imply more competent personnel who provide better results and drive greater cost savings for the buyer.  Any outsourcing program should start with a goal to create excellent software.  You cannot accomplish this by hiring inexpensive, offshore developers with limited experience and little oversight. 

At its core, outsourcing is a way to manage and grow your business. It can provide needed flexibility to ramp up or down as well as expertise you don’t have in-house.  When looking for an outsourcing partner, whether onshore or offshore, your goal should be to find a partner who can provide the best value upon which you can reliably grow your business.

Small to mid-size organizations, in particular, worry that the risks of working with an offshore resource will be unacceptably high. These organizations do not have deep pockets for prolonged start-ups or major missteps. Many have discovered, however, that they can do it with the help of an experienced provider who offers transparency, scrupulous attention to communication, and high quality resources thereby minimizing transition and ongoing management costs and maximizing the productivity of the team.

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