According to some reports, China is just a few years away from catching up with India as the destination of choice for companies looking to outsource all or parts of their operations. Others say, no way! Too many barriers sit between it and success. The important question right now is what recent developments in China mean to your organization and its outsourcing strategies.
Taken at face value, China’s presence in the service provider world is good news, since much of the impetus to outsourcing is cost management, particularly in the area of labor. China’s cost advantage -- which can translate into as much as a 70% savings over US salaries -- sounds compelling.
But, of course, there’s more to consider than simply hourly labor cost. Quality of work, reliability, efficiency, flexibility, ease of communication and cultural issues are just as relevant in laying out an outsourcing strategy, as are macro factors such as geopolitical risks. Accordingly, this multi-part report begins with an overview of the current IT outsourcing landscape in China. We follow this with a quick discussion on the issues every decision maker and manager should think about before sending work to China.
Shortly, we’ll publish interviews with people on the ground in China who offer their practical advice for working with China-based service providers.
Low Labor Costs as Pull Factor
The most outstanding virtue of China as an outsourcing destination is the cost. In fact, China is often mentioned breathlessly as “cheaper than India.”
According to Bryan Huang, president of BearingPoint Great China, an engineer costing $4,000 a month in the U.S would cost only $500 in China. And that’s for an engineer in Shanghai. According to ChinaHr.com, the salary level of an engineer in places like Xian or Dalian is closer to $250 a month. In short, the cost can be said to be between a sixth to an eighth of what it would be in the U.S., the variances being accounted for by regional differences.
Though there are analysts who argue that China is, on average, on par with India in terms of cost -- Ian Marriott, Research Vice President of Gartner being one of them -- the fact is, in monetary terms, China’s pull will increase as salary inflation drives cost up in India, the current dominant offshoring destination. India’s IT industry, blessed by high demands but beset by lagging human resources, experienced a 14% salary inflation in 2003. The trend is set to continue, which means that, based on a 13% compound annual growth rate, Indian programmers’ pay will nearly double by 2010. Already, according to JP Morgan, some Indian companies have put in place offshore floor rates of $23 to $24 an hour.
This labor cost advantage will be sustainable for a time to come. China has a large, expanding and sustainable pool of IT workers. Chinese universities, which matriculated 140,000 students in 2003, are predicted to churn out IT workers at an annual rate of between 150,000 and 200,000. The 2,000 Chinese universities (with current enrollment of just about 10 million students) can easily increase the numbers when the government decides there’s a need.
The ultimate testament to the importance of this virtue comes from India, whose firms, looking to continue their dominance and growth, have decided to make China part of the solution. Nandan Nilekani, CEO of Infosys Technologies, declared that the company needs “a deep reservoir of talent as well as an alternative low-cost center like India as we continue to grow -- and only China can match up.”
A Background and History of China’s IT Outsourcing Industry
The software outsourcing business in China is still in its infancy. Most of the growth and attention is recent.
Cyrill Eltschinger, who started I.T. UNITED in 1998, before China was on anyone’s map as an IT destination, attests to it: “I can tell you for a fact that pitching China-based high-end engineering services was -- up to the 2003 timeframe -- a hard sell and a long shot.”
The numbers show it. China’s software exports, which include software outsourcing, was a miniscule $250 million in 1999. It grew to $2 billion in 2003 and is estimated to be $3.2 billion in 2004, according to International Finance Corp.
Since China didn’t open up until 1979, there was little industry to speak of before that. In the 1980s and until the mid-1990s, much of the limited pool of engineers’ talents and energies were spent on reverse-engineering key hardware technologies. “It was driven by the government and focused on things such as circuit design and technologies with mixed civilian-military importance,” explained Thomas Brizendine, a senior partner at market consultant GCiS China Services in an article published in China Business Review.
In the ’90s, as China developed and IT needs expanded, the industry diversified and shifted in focus. It developed a large number of relatively basic information systems involving, typically, simple manipulation of databases. These systems were developed independently with little thought on integration or overall design issues.
In the late ’90s, thinking about software integration began to emerge in some quarters. But the Internet bubble became a major distraction. When that floated into the sunset, it left in its wake an industry that is still -- on the whole – new to systems thinking, component-based design, true objected oriented design, and development capabilities and best practices.
The recent flurry of activity that helped put China on the outsourcing map came about partly as a result of government support and promotion, partly because of Japan’s push to move much of its software development work to China, and partly because a number of large foreign companies -- GE, Microsoft, Dell, SAP and HP, for example -- started up R&D centers in China.
Nevertheless, presently, non-domestic outsourcing business accounts for just 10% of the industry’s total revenue (compared with around 70% for India). Of this, according to McKinsey & Company, about 65% is contributed by Japanese companies demanding low-value application development work.
Growth in the outsourcing business presently is still driven by domestic demand, where customers are primarily small and midsized Chinese enterprises that want their software customized to their needs. The reality of the domestic market is that many projects are below optimal scale and that suppliers often compete on price (and not necessarily quality).
(We should point out that the sophistication of the domestic software companies is also directly related to fact that Chinese enterprises do not, in general, rely on IT for competitive advantage. The game is about price, distribution and relationships, even though there are a few companies with fully integrated ERP programs.)
This is changing. China’s industries and institutions are starting to spend more on IT and are going beyond basic systems. “The longstanding habit of burying software costs inside the hardware costs, while still common, seems to be coming to an end as clients become more sophisticated and system demands increase beyond what is available from simplistic software solutions,” according to Mr. Brizendine.
The Vendor Landscape
This backdrop explains the fragmented vendor landscape. The Chinese software industry is awash with small companies. Of some 8,000 IT services companies in China, about three-quarters are small operations with fewer than 50 employees. Only five companies have more than 2,000 employees, according to McKinsey. Although the data is a bit dated, in 2002 the China Software Industry reported that the average revenue of its members was a modest $600,000.
McKinsey also noted darkly in its publication, The McKinsey Quarterly, that “The top 10 IT-services companies have only about a 20% share of the market, compared with the 45% commanded by India’s top 10.” Currently, there is no company in China with a status and recognition in the global market synonymous with that garnered by India’s Tata Consultancy Services, Infosys or Wipro Technologies.
This fragmentation feeds into and explains why many of the Chinese software companies haven’t been able to amass the kind of higher level skills needed to handle projects larger than one-off contracting work.
Though there’s a rush towards capability maturity model (CMM) certification, as of the beginning of 2005, only six of China’s 30 largest software companies are certified at levels four or five.
The implication for any company looking to outsource to China is that, though the landscape is crowded, finding the right partner can be difficult.
The challenge in working with smaller companies is that they make for riskier partners in terms of reliability and on-going viability. They have difficulty retaining the best people or gaining experience in large, complex projects. Scalability may be an issue. Also, because projects and resources are limited, so is training. In fact, though the universities are graduating thousands of engineers a year, competition for the most talented and experienced people is high. Bigger shops such as IBM and Nortel Networks, which are establishing their own development centers in China, are gobbling up the top talent.
Of course, large size isn’t a stamp of validation either. The major Chinese software firms often started out as or are engaged in hardware distribution, corporate network system integration, software/hardware systems integration and software development. These companies expanded into the outsourcing business because of increased competition in their original industries and new opportunities in the services market.
The result, noted a report by International Finance Corporation (IFC), is that “in many cases, the largest, most well known software groups in China will conduct several (or perhaps all) of the above IT business lines along with software outsourcing, displaying little focus compared to IT companies in more mature markets.” Using Digital China as an example, the IFC report critiqued the “giant with revenues of RMB 15 billion (USD $1.8 billion)" to “lack a clear business focus.”
The IFC report also questioned the ability of companies primarily skilled in product-oriented software development processes to transition smoothly to service-oriented software outsourcing.
Then, there is always a danger of conflict of interest when a company is not a pure-play outsourcing vendor. There is more risk of intellectual property infringement if a vendor is also in the business of building and selling software.
Still, it is not mission impossible to find a good medium sized service provider. Affiliated Computer Service, Inc. (ACS) outsources application development to I.T. UNITED, which currently has 125 employees. ACS, which is itself a large business process and information technology outsourcing player, says it is happy with the work I.T. UNITED has done.
In fact, with more media attention and effort on the part of the Chinese government to promote the industry, it has become easier to identify some of the better and larger players.
For example, Managing Offshore newsletter and NeoIT, an offshoring advisory firm, identified a “Top 10 to Watch in China” in its first Offshore 100 study. It also included six China-based service providers on its "Meet the Offshore 100" list.
However, not every company on the list is actually ready for English-speaking foreign business. For example, Sichuan Yinhai Software Limited Liability Company, number seven on the list, was unable to answer inquiries from this writer because there was -- we were informed -- no one ready to communicate in English. (The company Web site, Yinhai.com, is entirely in Chinese).
Zhonghua Qu and Michael Brocklehurst, coauthoring a paper published in the Journal of Information Technology, titled, “What will it take for China to become a competitive force in offshore outsourcing? An analysis of the role of transaction costs in supplier selection,” concluded that the search for the right service provider and subsequent due-diligence can be incredibly time consuming “It is also very difficult to find trustworthy information about Chinese suppliers, particularly in English through the Internet or other media,” the authors wrote. As compared to India’s NASSCOM, the government-managed China Software Industry Association provides little helpful information for offshore customers.
The good news: The seeming difficulty of finding a service provider can well help you separate the chaff from the wheat. RedPrairie Corp., a global supply chain software solutions company, sent five RFPs when it was looking for a company to help set up and manage a 100-person offshore development center. Only one replied. The CEO and founder of Bleum Inc., Eric Rongley, recounts the story with a chuckle of how his then-young company clinched the $5 million contract: “Because only we were ready to do business.” The relationship is on-going.
A Questionable Talent Pool
Another risk factor is the talent pool available in China. Though the supply of workers is abundant, the quality of this supply is, in fact, still questionable and hence something to consider before outsourcing to China.
Bleum, one of the top IT outsourcing services firm in China, alludes to it on its Web site. “As an emerging market, it is hard to find employees with ten years experience, however, what a developer might lack in experience is made up for in intelligence and work ethic.”
Joseph Hsu, chief executive of Symbio Group in Rockville, Md., which has operations in Beijing and Wuhan, put the number of architecture-level IT engineers in China to just 1,000 and compared that to the 200,000 currently working in India. Far Eastern Economic Review reported “only about 10% of China’s IT workers have experience in complex programming tasks. Organizational ability is another stumbling block.”
It is an issue that is acknowledged as potentially deleterious to the development of China’s software outsourcing industry. For example, a 2004 article in the English language weekly Beijing Review reported: “The lack of capacity to explore the high-end market and the absence of senior software project managers could hamper rapid development of Chinese software exports, experts observed at the two-day Global Outsourcing 2003 held in Shanghai on Oct 14.”
But the lack of experienced project managers isn’t the only skills gap, if an experiment done by GCiS is any clue. The company tested over 400 programmers over four months in Unix operations, Unix programming, C programming, C++ programming, Java programming, Oracle operation, Oracle programming, component design, and documentation practices.
GCiS had three people -- one American, one Swiss and one PRC national -- averaging over 15 years of software development and management experience each design the tests. The programmers were tested with basic, intermediate and advanced questions in all of the subjects. The programmers were asked to take the test that corresponded with his or her resume.
Not a single programmer passed the intermediate or advanced Unix tests and -- according to Mr. Brizendine -- “only a very (very) few have passed the advanced C, C++, Java and Oracle tests.” Forebodingly, Brizendine also noted that “component design mystifies the vast majority and documentation practices are horrible.”
GCiS doesn’t claim the experiment is scientific, but it was conducted in Beijing, where the better engineers presumably reside. The company concluded that Chinese programmers are short on technical skills.
It’s also extremely difficult to find individuals with experience working on specific business applications such as PeopleSoft, SAP, or Siebel Systems, according to Marc Herbert, executive VP of Sierra Atlantic, a Fremont company specializing in offshore software development.
This is not to say that China is a complete wasteland where talent is concerned. Where’s the silver lining? Though Chinese programmers are short on technical skills, they’re long on intelligence. The trick, said Mr. Rongley, is to know how to “discern what is the cream,” and then to train them, which is what companies -- the good ones -- often do.
The cream, according to Mr. Rongley, is astoundingly good. “What amazed me when I first came to China and to Capital One was the pool of geniuses out here. They can catch up really quickly if you can get the top of the talent pool.”
However, this kind of a landscape means that “China is right now better at projects where experience does not matter a lot and where raw intelligence is everything.”
Intellectual Property Concerns
There’s just one way to describe the record of intellectual property (IP) rights protection in China: appalling. Pirated DVDs and fake branded goods are ubiquitous on the streets, and -- more relevantly -- up to 98% of software products sold in China are unlicensed or pirated copies. There’s almost no cultural awareness for IP rights. It’s been said that in China, anything that can be profitably copied will be.
The slightly promising news is that China has made great strides since joining the World Trade Organization in 2001. Today, its laws meet or exceed the standards set by the principal international IP treaties, and recent changes have lowered the threshold for bringing suit against an infringer. A number of recent cases resolved on the side of IP, setting legal precedents that buttress legal recourse as well as, presumably, help as a deterrent to would-be infringers.
Unfortunately, implementation and enforcement of existing laws are still lacking. “Though we have observed commitment on the part of many central government officials to tackle the problem, enforcement measures taken to date have not been sufficient to deter massive IP rights infringements,” according to a U.S. Department of Commerce guide on protecting IP in China.
Factors undermining enforcement measures include “China’s reliance on administrative instead of criminal measures to combat IP infringements, corruption and local protectionism at the provincial levels, limited resources and training for enforcement officials, and lack of public education regarding the economic and social impact of counterfeiting and piracy.”
It all boils down to is this: The risk of IP rights infringement is serious. It behooves any outsourcing manager going to China to take aggressive measures to minimize it.
This begins with proper due diligence. To state the obvious, the process begins with identifying companies with clean records. In this regard, the US Department of Commerce and the US Commercial Service is a great resource, though there is some value to the word-of-mouth methodology.
On its Web site one sizable company vouches that it will “obey all internationally accepted IP law in accordance with WTO agreement [sic].” But are the words backed up by competent and aggressive actions? Has the company adopted clear and robust physical security measures?
Bleum, for example, has a “shadow group” of developers who are given financial incentives to uncover vulnerabilities in software developed by the lead development team. It backs this up with staff education on property rights and ethics.
“Property rights and ethics are new concepts to them and they need to be made aware of them,” explained Mr. Rongley. “We try to make them understand that the nature of this business is such that just one security breach would destroy us. We tell them it is not just about one person, but all 100 people can lose their jobs if they do that. So they should think about that before making a quick buck of it.”
He advises: “Look at the precautions the vendor has [taken] to protect you. How good is their employment and IPR contract? What is their security framework? There is never perfect security. It is a matter of cost, but basically, the thing to do is eliminate all but the James Bond kind of heist... It is up to the customer [to determine] how much security they need. In the end, at the most basic level, the way to do it is to compartmentalize code and to prosecute aggressively.”
Companies can further protect themselves by building effective legal protections into their contracts to address egregious IP violations on the part of a service provider. Though not necessarily worried that Neusoft would act with ill intent, the Japanese clients of the Shenyang-based outsourcing vendor nevertheless have contracts that are designed to be enforceable in both Japan and China with an avenue for arbitration with a third party under Hong Kong law.
As a final risk-mitigation measure, don’t have the entire application developed in China. “We don’t give them every piece of the puzzle,” according to Sebastian Risse, director of product development of CommerceQuest Inc., who has outsourced to China through service provider Freeborders.
Wipro, which has established development centers in China, treads carefully along a similar line. According to Sudip Banerjee, president of enterprise solutions, the company passes on only what is absolutely needed and what is required for local implementation.
Lost in Translation
Different people say different things about the English language proficiency of Chinese engineers. No surprise that supporters of the wonders of the English skills of the Chinese citizenry tend to work in service providers; naysayers tend to be finicky analysts. But it is safe to say that English is still an impediment to the Chinese software industry’s expansion into English-speaking markets. It might be pointed out that though a project can get by well enough with broken English, documentation riddled with bad English has practical implications.
The language barrier isn’t insurmountable. The number of companies outsourcing to China can attest to it. And there are companies chockfull with project managers and programmers proficient in English. The key is establishing formal communication processes with workers in China -- as CommerceQuest did -- as a way to mitigate language issues.
And here’s a tidbit that hints to the strength of the China as a future outsourcing destination: there are more people in China learning English than there are people learning it in the US. The education begins in the third grade and continues through college. The Chinese government is investing more than $5.4 billion in English education in universities.
Culture
Though the business culture is shifting towards one that is more recognizable to Western practitioners, there are still differences -- some more remarkable than others -- that can affect the workings and outcome of an outsourcing relationship.
This may sound extreme, but a longtime business entrepreneur once lamented that “in China, it is signal right, turn left.”
Laurence Brahm, author of numerous books on China, might be accused of being a Cassandra, but he was not exactly off the point when he wrote, “When Yes means No! (Or Yes or Maybe!),” that “’yes’ in China may be the first word of agreement, but is not always the last word in negotiations. ‘Yes’ is often simply another way of saying, ‘Let’s begin to talk seriously’... For the Western party, a contract is a contract and the obligations of the parties are those obligations spelled out therein. Western culture is goal-oriented. Negotiations are simply a process through which the final goal -- the contract -- is reached. Chinese society is process-oriented. Consequently, their negotiations often involve understandings and intentions which are not spelled out in the contract.”
Negotiations habits aside, cultural issues that can affect the work process include how it is -- in general -- inappropriate to question people with seniority. It’s not all negative, of course. If we can generalize, cultural traits that can be attributed to the Chinese include hardworking, resourceful, and quick of mind.
Supportive Government and Policy
The Chinese government has been playing the role of a handmaid and sometime-matriarch to the Chinese software industry.
It envisions software exports to increase to $5 billion in 2005, and it has targets to develop key domestic software companies with over $602 million in sales revenues. To this end, it established numerous software parks as company incubators. Other measures include: tax incentives such as zero duty on tax items related to IT products, enforcing with greater urgency IP laws, reimbursement of funds spent on acquiring CMM certification, and preferential income tax treatment for newly established software companies. Towards, the latter, companies don’t pay income tax for the first two years of their operation and enjoy a tax discount of 50% on standard tax rates for the three years after.
Aside from massive investment in the education system, it has also– in partnership with U.S. technology firms such as Cisco Systems, Microsoft and IBM -- established 35 national schools specifically for software training in technologies such as .Net, Linux, Java and Web services. The goal is to have 800,000 trained software professionals by the end of 2005.
It should be pointed out that the governmental support and involvement is not without potential pitfalls. Stephen Lane, an analyst at Aberdeen Group Inc. in Boston wrote that “government involvement in the traditionally wide open world of software development is a double-edged sword. “This is a government that shuts down Web sites, remember.”
The 2003 Government Procurement Law is a concrete example. The law, meant to boost the software industry, requires the government and its agencies to procure from domestic suppliers where possible for all software needs. This law, according to the US Information Technology Office, has deeply disaffected non-Chinese software companies.
Economic Environment and Outsourcing Relationship as Entry into Market
China’s economic environment is large, booming and for the most part stable. And there are great stakes in keeping it that way -- among them the fear that the country would devolve into anarchy if the government doesn’t deliver the economic goods.
Weaknesses in the economic sectors include a banking sector that is heavily burdened with bad debt, over-investment and overcapacity in some sectors in the economy and corruption that undermines the efficient allocation of economic goods. Also, further increase in foreign exchange holdings from capital inflows and trade surplus could complicate monetary management, according to the World Bank. None of these, for the purposes of IT outsourcing, are cause for great alarm yet.
In short, the economic environment is more a plus factor than a negative factor.
On the positive side, “another reason to consider China for IT service is the 1.3 billion people marketplace that China constitutes,” said Stefan Klotz in his study titled The future of China’s software outsourcing industry. “Some examples of sectors that need a remake of their IT-infrastructure are banking and insurance. This opens up further opportunities for foreign software vendors.” Domestic software sales in China is $17.3 billion (compared to India’s $3 billion).
A foreign company with established relationships in China has a better chance of getting lucrative Chinese contracts. There is no outright prejudice for foreign companies already in the Chinese market but it is not known to hurt. Also, a company that already has experience outsourcing to China might have a better understanding of the machinations of the Middle Kingdom. The reverse is true too. Those companies already outsourcing to China in the manufacturing sector will probably have greater success in sending IT work there too.
Also, as companies expand into China, outsourcing to a local vendor becomes desirable as ground support for operations there.
Cost: But is it Really Cheaper?
China’s reputation as the Mother of all bargain basements in the world of manufacturing has led many to assume also that IT services can be had from the country at similar prices. Much of it is not unfounded since China does have an enormous labor supply and, in terms of cost per unit of engineer, looks cheaper than India.
But is it -- when all is reckoned – really cheaper than India? This question is specific to India since the country is the frontrunner as an IT offshoring destination, and China is slated by many analysts and observers to be the primary alternative to India.
Generally, when somebody says China is cheaper, that typically refers only to the cost of an engineer or manager. This cost looks only at the dollar outlay. But China’s labor pool is, generally speaking, of the cheap and not-so-good variety. Factoring in the intangibles such as level of skills, quality, efficiency, experience and training period needed to get staff up to par, the differences between China and India begin to disappear.
Wipro’s Mr. Banerjee, which established a development center (with a staff “in the hundreds”) in Shanghai to implement software development activities for customers with a presence in China, would agree. He disputed the notion that it might be cheaper to do work in China, saying “I don’t believe it’s true.” By his own reckoning, China is about 10% to 15% less expensive in terms of programmer cost, but 25% more expensive when it comes to supervisory staff, project lead and project managers. Accordingly, he reckoned that the net cost between projects with a 10-person or 20-person team would be the same.
In fact, according to Bleum’s Mr. Rongley, getting the best in China won’t be as economical as people expect it to be. “Most companies hire the cheapest resource. I hire the best resource. If you want a company of superstars, you can’t pay them $3 (per hour) for a project manager or 50 cents for an engineer. Yes, sometimes they manage to get code developed for crazy low prices. They have interns working on their projects.”
The other issue is that of the cost associated with the project or transaction: management, communications, travel, legal counsel and the energies focused on enforcing IPR and other expenses that can occur should things go awry -- in other words, the total cost of engagement (using a phrase from Ian Marriott of Gartner).
For example, Wicresoft, a joint venture between Microsoft and the Shanghai Municipal government, according to an article in The Wall Street Journal, hired 10 email “polishers” to teach their Chinese co-workers about American email protocol and “help polish the wording to sound more colloquial.” The polishers account for 15% of the total personnel cost of the venture’s 100-person US online-service department.
This is not to say that China is not cheap nor fertile land to go for IT services. It simply means that its difficulty or cost should not be -- as with any other endeavors in China -- underestimated.
A Recap
If you add up the dangers and benefits of outsourcing to China, you get a fairly mixed report card.
(+) We score service provider availability a positive. There are some true diamonds with potential to grow, given the projects. The challenge is finding the company that’s appropriate for you to work with.
(~) We score personnel talent and experience neither a negative nor a positive. The right managers -- strong in staff development and retention skills -- can work wonders.
(-) Intellectual property rights gain a negative mark across the board. If your business is IP-sensitive, you’d better be IP savvy too, to protect what’s yours.
(-) Regarding English language skills, we give a negative rating because the results of all that educational effort are uneven. Until students have an on-going opportunity to converse with native English speakers, they’ll never achieve the proficiency in the language that most non-China companies need.
(-) Cultural issues gain a negative too, at least until US and European managers have more experience in working within the bounds of the Chinese culture.
(+) The Chinese government’s support in taxation and other areas is a positive. We give this a plus -- though with the caveat that governmental support in China can be fickle. One day they’re wooing your business; the next day, they’re turning a blind eye to vigilante justice, as the Japanese recently experienced in multiple Chinese cities.
What are we left with this year? Two positives, three negatives, and a neutral. The year of the dragon comes up next in 2012. And that’s the year we predict that China could become a mainstream operator in outsourcing. Until then, to pursue China with your services work, you’d better define yourself as a risk-taker.
