The Hindu Business Line : These frills must go

Software majors doing offshore work face the threat of `revenue eating into revenue' or revenue cannibalisation. Here's what they must look out for.

AS global software majors transfer more work offshore, there's something happening that isn't catching the eye quite so obviously - the `cannibalisation of revenue' of these software companies.

And what exactly is revenue cannibalisation? Simply put, it is the money lost by a company when it moves a job from onsite to offshore at the behest of the client. And this is cause for concern, say industry watchers.

According to industry estimates, Cap Gemini Ernst & Young (CGE&Y) has indicated that only 10 per cent of offshore work cannibalises its core revenues while EDS puts the figure at 30 per cent.

As offshoring gains momentum, analysts believe that a significant part of this `revenue eating into revenue' starts happening at the source, that is when a deal is inked. Although clients are selectively pressuring high-cost vendors to deliver services, that are currently onsite, to low-cost offshore locations, this may not be a large portion of the incremental revenue currently coming offshore. "But this is sure to swell as clients squeeze vendors for more bang from their bucks," says a software analyst with a European brokerage. "This could force some of the big MNCs with delivery bases out of India to reassess their cost structure in their bid to retain efficient global delivery capabilities," he says. The eating up of revenue gains prominence in the backdrop of large software MNCs ramping up their offshore presence in India rapidly. Firms running their Indian operations as `cost centres' are showing a stronger ramp-up, compared to global companies operating the local presence as profit centres, say analysts. Accenture has increased its India headcount from 1,400 in February 2003 to close to 7,000 while Convergys has increased its numbers from 2,700 to 7,500 in the same period. It is understood that both these companies have treated their offshore operations as integral parts of their global delivery networks and kept them as pure cost centres. In contrast, companies such as CGE&Y and EDS run their local operations as profit centres or have a stipulated transfer pricing mechanism. (Transfer pricing is the sale, licence, or lease of a product from one affiliated company to another.)

CGE&Y has a sales team of close to 12 people who internally sell to the parent's sales engine and participate in joint bids with them.

It is believed that though operating independence and profit and loss independence result in a more cost-efficient operation, it also restricts growth in a profit centre approach. On the other hand, the cost centre approach, while catalysing strong scale-up, results in an inefficient cost structure. Strapped by a bloated employee bill, global majors also suffer from expatriate costs and lack scale economies, though some are trying to correct that through local acquisitions, which in turn helps in compressing the wage bill. Many of these global vendors, while enjoying similar billing rates as the Indian vendors and having a higher offshore ratio, typically earn low double-digit margins from their offshore operations, say analysts. Interestingly, while the operating margin of these companies may be equal to or even higher than that earned by their core operations, the absolute profit per employee will be significantly lower, they say. Given that most of the offshore business currently is new (not cannibalised), analysts believe these companies are comfortable with the current margin structure. However, going forward, as offshore starts nibbling into their core revenues, these companies will need to improve their cost structures to make the same profit per employee earned onsite."Otherwise their value proposition to new clients will be diluted if not lost", a Singapore-based technology analyst with a foreign brokerage says. "They (these companies) need to localise cost if they need to scale up offshore volumes like Indian vendors. Low-margins and high volume is a function of size... now what is important is retain margins in a positive price-environment, perhaps through greater productivity".

abhrajit@thehindu.co.in

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