Cost Competitiveness of Global In-house Centers (GICs)

r e s e a r c h . e v e r e s t g r p . c o m

2012

Cost Competitiveness of Global In-house

Centers (GICs)

The Reality of Wage Inflation and the

Sustainability of Cost Arbitrage

Nikhil Rajpal, Partner

Salil Dani, Practice Director

Anurag Srivastava, Senior Analyst

Copyright © 2012, Everest Global, Inc. All rights reserved.

AN EVEREST GROUP REPORT

EGR-2012-2-R-0664

http://www.nasscom.org

http://research.everestgrp.com


COST COmPETiTiVENESS Of GlObAl iN-hOUSE CENTERS (GiCS)

r e s e a r c h . e v e r e s t g r p . c o m 2

Foreword

GICs have played a crucial role in the growth and development of the global

services (i.e., outsourcing and offshoring) industry in India. Key to the success of

the outsourcing model has been the fact that GICs have been consistently able

to deliver significant cost savings as compared to source locations, enabling

them to drive home the value proposition of the model, associated benefits and

added capabilities.

NASSCOM and Everest Group conducted joint research to understand the

extent of cost savings achieved, levers for driving cost savings, and future

sustainability of the same. Research showed that GICs continued to deliver

40-70 percent cost savings even from a Total Cost of Ownership (TCO)

perspective that includes costs associated with setting up and management of

GIC operations, in addition to the operating costs. Wage inflation in India is

often touted as one of the drawbacks, but research shows that actual salary

bands have historically increased at a much lower rate than what headline

numbers suggest. Further, GICs have been able to contain the impact of wage

inflation by modifying the employee pyramid and using alternate talent pools.

Additionally, lower growth of non-wage operating costs has ensured further

moderation in overall cost inflation. Arbitrage-driven cost savings in India are

likely to sustain for 12-15 years.

A number of people and organizations have assisted in the preparation of this

study. In particular, we would like to thank the senior executives of the GIC

member organizations of NASSCOM who spared their valuable time to share

insights on the cost arbitrage scenario. Special thanks to Deena Harapanahalli

(Invesco), Aveek Mukherjee (Wells Fargo), Nitin Seth (Fidelity Worldwide

Investment), and Sriram Dhanyamraju (Dell) for their guidance in the project.

A special acknowledgement to the NASSCOM research team for their efforts

and contribution towards this report.

We trust you find this report useful, and we welcome your feedback and

comments.

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Executive Summary

Captives or Global In-house Centers (GICs) are an important component of the

global services market. Initially set up in low-cost locations (particularly India),

for supporting technology and contact center operations in the 80s and 90s, the

model is now firmly established and continues to grow and diversify across

multiple dimensions. While India continues to be the leading GIC location,

adoption of the model has spread to newer regions such as the Philippines, East

Asia, Eastern Europe, Latin America, and, most recently, Africa. Trends on recent

set-ups also indicate adoption of the GIC model across a wide range of industry

verticals (e.g., manufacturing, healthcare) and functions (e.g., engineering

services / R&D).

GICs have largely delivered on their mandate of providing meaningful cost

savings and adding capability to the parent organizations. Our analysis

indicates that the GIC model continues to deliver typically 45-75 percent

savings over source costs, on an operating cost comparison. These savings

continue to be significant (40-70 percent) even from a total cost of ownership

(TCO) perspective that includes costs associated with the setting up and

management of the GIC operation.

Contrary to popular perception, wage inflation is not likely to wipe out GIC cost

savings in the near term. Our experience with GICs in India indicates that the

impact of inflation on their wage bills is typically much lower than often

perceived. This is because a large part of the individual increases that are often

reported (12-18 percent per annum) are merit-based while the actual salary

bands only move upwards by 4-5 percent per annum. Further, the high pace of

growth and high attrition levels of many of these GICs allow them to pro-actively

manage the pyramid and keep their costs down by recruiting large numbers of

lower-cost, entry-level talent to back-fill promotees and job-leavers. As a result,

net wage inflation experienced by GICs is closer to 6-8 percent per annum.

Our analysis further indicates that arbitrage-driven cost savings in key offshore

locations (India, the Philippines) are likely to sustain for 12-15 years. The above

is based on a relatively safe set of assumptions of macro-economic projections

that most experts agree on. In reality, the arbitrage may sustain for 17-20 years.

On the other hand, even the worst case scenario projects arbitrage sustainability

of 8-10 years. The above results are reported from a U.S. perspective but the

range is largely similar for other source geographies (i.e., UK, Continental

Europe, and Japan).

It is important to note that while the timeframe discussed above holds true for a

majority of the work offshored today, there will be meaningful exceptions. On

one hand, there will be locations (e.g., Brazil, Czech Republic, and Ireland), or

functions (e.g., technology research and development) where a combination of

smaller starting cost differential, shortage in talent or macro-economic trends

could erode the arbitrage faster. On the other hand, GICs have several

EGR-2012-2-R-0664

Over 3,000 GiCs have been

established across the world.

GiCs have been delivering

40-70 percent savings from a

TCO perspective.

Cost inflation in GiCs ranges

between 7-8 percent after

factoring in real wage inflation

and increases in other cost

elements.

india’s and the Philippines’ cost

arbitrage is likely to remain

sustainable for at least 12-15

years.




operational levers at their disposal to further improve their cost position and

prolong the cost advantage.

Additionally, while direct cost savings will always be important, many mature

GICs realize that they can harness the platform they have built to deliver

significant business value to the parent organizations. These organizations have

started to make investments in their engagement and delivery models to

reorient towards this goal that will define the impact GICs have in the long

term.

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Background and Context

Captives or GICs are an important component of the global services market.

GICs were initially set up in low-cost locations to support technology and

contact center operations in the 80s and 90s.

While GICs have largely delivered on their mandate of providing meaningful

cost savings and adding capability to the parent organizations, questions

continue to be asked around the actual impact of cost savings and their

sustainability. These are driven by multiple issues and concerns (e.g., cost

inflation, exchange rate fluctuations, and labor market uncertainties) facing

GICs and their parent entities.

In this context, Everest Group conducted a study of leading GICs in terms of

their cost competitiveness. This study is based on inputs and perspectives from

leading GICs, supplemented with Everest Group’s proprietary knowledge and

information base. This study covered the dimensions outlined below:

State of the GIC model with growth and adoption trends

GICs’ current cost savings – taking an operating cost and total cost of

ownership (TCO) view

Sustainability of GICs’ cost savings and impact of wage inflation and

exchange rate fluctuations

Additional operational levers available to GICs to further optimize costs

This report describes these aspects in detail with supporting examples and

illustrations, as relevant.

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i keep hearing and reading

about 15-20 percent wage

inflation in india. i am not sure

about how much increase in

wage bills i should build in our

plans for the india center…

– Global Sourcing Head of a

large BFSI company

“

“



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The GIC Model is Established, Growing, and Continues toDiversify across Multiple Dimensions

Initially set up in low cost locations, primarily for supporting technology and

contact center operations, the GIC model is now firmly established, with nearly

3,000-4,000 GICs of leading companies globally.

GICs continue to grow across multiple dimensions. While India continues to be

the leading location, recent years have also witnessed new set-ups in locations

such as the Philippines, East Asia, Central and Eastern Europe, Latin America,

and Africa (Exhibit 1).

In addition, adoption of the GIC model is spreading to “new” industry verticals

such as manufacturing, retail, and telecom. In terms of functions, new set-ups

indicate diversification of the model to support higher-order and/or niche

functions such as analytics and engineering services / R&D support.

for quite some time, we have

been hearing noise around the

GiC model being dead… but

anywhere you look, you see

GiCs expanding in scale and

responsibilities, new GiCs

getting set up, and rare

instances of closures/sell-offs…

– Head of India GIC, leading

global healthcare company

“

“

Recent years have witnessed

GiCs in multiple locations

beyond india

E X H I B I T 1

Source: Everest Group

Number of set-ups of offshore GICs of leading global companies2009-11; Number

Central andEastern Europe

East Asia

India

Middle East& Africa

LatinAmerica

2009 2010 2011

7 4 5 2009 2010 2011

22 20 24

2009 2010 2011

22

3626

2009 2010 2011

213 9

2009 2010 2011

12 1120




GICs in Offshore Locations Continue to Offer SignificantCost Savings to Their Parents

Typical TCO savings of 40-70 percent over source costs

Operating cost analysis is often used to assess GICs’ current cost

competitiveness. However, this may not reflect the ownership costs of GICs

(such as costs of transitioning, governance, and knowledge transfer).

Everest Group leveraged its proprietary total cost of ownership (TCO)

framework to compare the cost of owning and operating a GIC to the parent

cost. The TCO framework undertakes a comprehensive assessment of all costs

and includes the following cost items:

Operating costs include people costs as well as expenses related to facilities

and other miscellaneous items (e.g., telecom and equipment)

Set-up and transition costs incurred in establishing the center and transfer of

processes from parent to GIC

Ongoing governance costs incurred by the parent for managing the GIC

operations

Exhibit 2 below, illustrates the TCO analysis of IT Applications Development

and Maintenance (ADM) function for a GIC based in a typical tier-1 city in

India. It is noteworthy that people costs contribute towards 60-70 percent of the

operating cost and typically 45-55 percent of the TCO.

Our analysis indicates that the GIC model continues to deliver typically 45-75

percent savings over source costs, on an operating cost comparison. These

savings continue to be significant (40-70 percent) even from a TCO

perspective. Exhibit 3 below, depicts the cost comparison for a U.S.-based

parent and a GIC supporting transaction processing BPO function from a

typical tier-1 city in India. While most of the cost savings are on account of

labor arbitrage, GICs also provide meaningful savings on facilities costs.

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People costs contribute towards

60-70 percent of the operating

cost and typically 45-55 percent

of TCO

E X H I B I T 2

Source: interactions with GiCs;Everest Group

Percent ofoperatingcost

Costcomponent

Total cost of ownership (TCO) for IT-ADM | U.S.-India2012; US$ 000s per FTE per annum

Peoplecosts

60-70% 10-15% 7-10% 10-15% 100%

Facilities Technology Miscellaneous Total operating cost

Setup andtransition

Governance Total cost of ownership

(TCO)

25-30

35-40

Operating costs Other elementsof TCO

Other operating costs

IT-ADM




Differences in TCO savings are driven primarily by functions and

locations

TCO savings vary by functions as these determine the skills requirement,

thereby, impacting people costs. For instance, savings are typically higher for

transaction processing and IT applications work and usually lower for complex

and judgment-oriented business processes (Exhibit 4).

TCO savings are also dependent on GICs’ locations owing to differences in

people costs, facilities, and other expenses. For instance, current savings are

lower in locations such as Brazil, Czech Republic, and Ireland (typically 10-25

percent across functions). On the other hand, savings are higher in locations

such as India and the Philippines (typically 55-70 percent across functions).

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GiC model continues to deliver

typically 40-70 percent savings

over source costs from a TCO

perspective

E X H I B I T 3

Source: interactions with GiCs;Everest Group analysis

TCO savings for BPO – Transaction Processing | U.S.-India2012; US$ 000s per FTE per annum

60-75% 65-75%

Other expenses

Facilities

People costs 60-70

4-8

4-8

70-80

18-21

13-18

2-32-3

2-3 1-2

21-27

U.S. parentoperating cost

India GICoperating cost

Set-up andtransition

Governance TCO

TCO savingsOperating cost savings

Note: Costs for U.S. corresponds to Tier-2 cities, whereas, costs for India correspond to Tier-1 cities

BPO-TRANSACTION PROCESSING

U.S.-INDIA

TCO savings depend on

function(s) supported by the GiC

E X H I B I T 4


IT-ADM

90-100

32-40

55-70%

Typical TCO savings between India GICs and U.S. across functions2012; US$ 000s per FTE per annum

BPO-Transaction processing

70-80

21-27

65-75%

BPO-F&A (Judgment-intensive)

100-110

Parent-U.S.

35-45

GIC-India

55-70%

U.S.-INDIA EXAMPLE

Note: Costs for U.S. and UK correspond to Tier-2 cities, whereas, costs for India and the Philippines correspond toTier-1 cities




However, savings do not vary significantly across industry verticals for the same

location and function. The nature of the processes and work remains largely

similar for supporting the same function across verticals, and hence does not

notably impact TCO.

In summary, GICs in most offshore locations continue to deliver cost savings

even after incorporating a “comprehensive” TCO view that includes additional

expenses besides operating cost of delivery.

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r e s e a r c h . e v e r e s t g r p . c o m 1 0

Arbitrage-Driven Cost Savings in India and ThePhilippines are Likely to Sustain for 12-15 Years

While GICs are delivering significant savings today, confusion remains around

the sustainability of these arbitrage-driven savings. The issue is fairly complex

given the multitude of macro-economic and operating variables affecting the

outcomes, such as:

Wage inflation differential

Inflation differential in other cost elements such as facilities, equipment, and

telecom

Exchange rate

These factors significantly impact the cost differential between the parent and

GIC.

We assessed the sustainability of GIC savings by adopting the following

approach:

A) Understand drivers of change in costs, and historical trends in these drivers

B) Build potential scenarios based on a range of possible macro-economic

and operating possibilities

C) Project sustainability of cost savings across scenarios

Our analysis suggests a higher confidence in projections on cost inflation

(wages and other TCO elements). This is a result of higher predictability

associated with availability of talent and other factors such as facilities, telecom,

and equipment. On the other hand, currency exchange rates are difficult to

predict and sometimes fluctuate in a wider range.

Our scenarios on exchange rate movements and TCO inflation reflect this

trend. These scenarios impact cost sustainability of locations and are described

below in case of India (Exhibit 5).

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forward-looking scenarios of

TCO inflation and currency

exchange rate movements in

india

E X H I B I T 5


Scenarios Description

U.S. India

TCO inflation(percentagep.a.)

TCO inflation(percentagep.a.)

Currencyexchange rate(2020; INR/USD)

Worst case Longer economic recovery in the

West

Supply side constraints in offshore

location (such as talent employability,

infrastructure)

0% 10-12% 35-38

Base case Most common view of experts and

analysts

TCO inflation similar to current levels

(i.e., moderate market growth)

Exchange rate levels broadly

maintained

1-2% 7-8% 42-44

Best case Faster economic recovery in the

West

Easing of supply side constraints

(such as talent employability,

infrastructure) reduce pressure on

wage

2-3% 4-6% 48-50




We analyzed cost competitiveness of GICs in India across the scenarios

described above, the results of which are indicated in Exhibit 6 below.

Our analysis further indicates that arbitrage-driven cost savings in key offshore

locations (India and the Philippines) are likely to sustain for 12-15 years. The

above is based on a relatively safe set of assumptions of macro-economic

projections that most experts agree on. In reality, the arbitrage may sustain for

17-20 years.

On the other hand, even the worst case scenario projects arbitrage

sustainability of 8-10 years. The above results are reported from a U.S.

perspective but the range is largely similar for other source geographies (i.e.,

UK, Continental Europe, and Japan).

Moreover, the above analysis does not account for any savings due to

operational excellence initiatives. In reality, GICs have several levers to improve

their cost competitiveness. Exhibit 7 below, provides instances of GICs

leveraging efficiency levers to optimize costs.

These measures can help GICs further prolong their cost advantage by 4-6

years.

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Cost savings in india are likely

to sustain for 12-15 years

E X H I B I T 6


1. Hurdle rate refers to the maximum wage ratio of the destination/source country, which still allows for meaningfuloffshoring. Hurdle rate is estimated as approximately 60-70%

2. Base case currency appreciation is considered as the average growth rate during the last two years 3. Cost inflation includes multiple factors such as wage inflation, inflation in facilities and real estate costs, and

miscellaneous costs including equipment, telecom, and attrition

8-10 years

12-15 years

17-20 years

Worst case scenario INR 35-38 per USD (2020)TCO inflation @ 10-12%

Base case2 scenarioINR 42-44 per USD (2020)TCO inflation3 @ 7-8%

Best case scenarioExchange rate continuingat INR 48-50 per USDTCO inflation @ 4-6%India Tier-1 @

35-40K

Hurdle rate1 @60-70%

U.S. Tier-1 @90-100K

TCO (in US$) U.S. inflation: 0-3%

IT-ADM EXAMPLE

Time

india’s and the Philippines’ cost

arbitrage is likely to remain

sustainable for at least 12-15

years

GiCs have several levers to

improve their cost

competitiveness

E X H I B I T 7


Efficiency levers Examples

Efficiencyimprovement

Significant impact of this efficiency lever on TCO. Many leading GICs have achieved

significant savings with this initiative

Increaseresourceutilization

GIC of leading U.S. financial services firm introduced cross-training programs to counter

skewed utilization across processes – achieved meaningful improvement in utilization ratios

through flexible staffing

Leverage lower-cost locations

GIC of leading U.S. bank with large operations in Metro Manila recently expanded to Cebu

(tier-2 city in the Philippines) for transaction processing and voice work; overall reduction in

operating costs by 10-15 percent. Some GICs have also expanded their operations in tier-2

cities in India (e.g. Jaipur, Vizag) to diversify access to talent pool and reduce facility costs

Reducinggeneral andadministrativeexpenses

GIC of leading U.S. bank streamlined transport operations across its offices in India and

reduced per FTE expenses on employee transportation by more than half. This included

reengineering transport modes and facilities, and streamlining transport operations

TCO savings sustainability for India GICs as per three scenarios2012




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The curious case of wage inflation

Media reports in most emerging economies, especially India, talk about high

wage inflation rates and the apparent impact on savings offered by GICs. On

the other hand, GICs claim lower increases in their wage base year-on-year,

as compared to the reported wage inflation numbers.

Everest Group analyzed this aspect of operating costs in detail; key findings

are detailed below:

Merit-based salary raises at the individual level (arising from promotion/

growth) decrease with increasing seniority as depicted below – although

numbers reported in the media are for the junior levels.

Consequently, wage inflation netted for the entire pyramid is much lower, at

around 11-12 percent per annum.

Further, salary bands at the same level in GICs do not change significantly.

For example, entry-level salaries (for junior and senior programmer roles) for

the IT-ADM function have changed only by 3-8 percent per annum over

recent years.

Further, the high pace of growth and high attrition levels of many of these

GICs allow them to pro-actively manage the pyramid and keep their costs

down by recruiting large numbers of lower-cost, entry-level talent to back-fill

promotees and job-leavers. As a result, net wage inflation experienced by

GICs is closer to 6-8 percent per annum.

Managerand above

Team Leader

Senior Programmer

Junior Programmer

Form ~20-25% of the overall delivery workforce

Lower individual raises @ 4-8% p.a.

~75-80% of the overall delivery workforce

Higher individual raises @ 10-15% p.a.




While the Sustainability Analysis is True for a Majority ofthe Work Offshored Today, There Will Be MeaningfulExceptions

It is also noteworthy that there are meaningful exceptions to the analysis

presented in the section above. There are locations (e.g., Brazil, Czech

Republic, and Ireland), and functions (e.g., technology research and

development) where a combination of multiple factors could erode the arbitrage

faster. Some of these factors are:

Lower cost differential: Some locations may lose their cost advantage given

lower cost differential (e.g., Ireland costs are only 20-30 percent lower than

UK for most functions).

Skills shortage: Impacts cost competitiveness compared to functions where

skills are more readily available. For instance, the arbitrage sustainability

time horizon is relatively lower for technology R&D compared to F&A

transaction processing work.

Unfavorable macroeconomic movements: Abrupt unfavorable

macroeconomic movements related to currency movements and

hyperinflation also impact arbitrage sustainability as in the case of Brazil.

Exhibit 8 indicates the base-case arbitrage sustainability horizon for multiple

geographies in Asia-Pacific, Latin America, and Eastern Europe. While India and

the Philippines have a longer arbitrage sustainability window, locations such as

Brazil, Ireland, and Czech Republic have much smaller arbitrage sustainability

time frame, particularly for certain functions.

Additionally, while direct cost savings will always be important, many mature

GICs realize that they can harness the platform they have built to deliver

significant business value to the parent organizations. These organizations have

started to make investments in their engagement and delivery models to reorient

towards this goal that will define the impact GICs have in the long term.

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Arbitrage could erode faster in

certain locations and functions

E X H I B I T 8


India

The Philippines

China

Poland

Chile

Malaysia

Czech Republic

Ireland

Brazil

>8 years 5-8 years <5 years

Current arbitrage sustainability (base case)

GIC location IT – ADMBPO – Transaction

processingBPO – Judgment

intensive IT – R&D

Parent/source location – U.S.

TCO savings sustainability across functionsand locations2012




About Everest Group

Everest Group is an advisor to business leaders on the next generation of

global services with a worldwide reputation for helping Global 1000 firms

dramatically improve their performance by optimizing their back- and middle-

office business services. With a fact-based approach driving outcomes, Everest

Group counsels organizations with complex challenges related to the use and

delivery of global services in their pursuits to balance short-term needs with

long-term goals. Through its practical consulting, original research and industry

resource services, Everest Group helps clients maximize value from delivery

strategies, talent and sourcing models, technologies and management

approaches. Established in 1991, Everest Group serves users of global

services, providers of services, country organizations and private equity firms, in

six continents across all industry categories. For more information, please visit

www.everestgrp.com and research.everestgrp.com.

EGR-2012-2-R-0664

for more information about Everest Group, please contact:

+1-214-451-3000

[email protected]

for more information about this topic please contact the author(s):

Nikhil Rajpal, Partner

[email protected]

Salil Dani, Practice Director

[email protected]

Anurag Srivastava, Senior Analyst

[email protected]


http://www.everestgrp.com/


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Cost Competitiveness of Global In-house Centers (GICs)