Finding the "right" shore: CEOs are getting savvier about choosing a location for outsourcing.

Reynaldo Gil couldn't afford to make a mistake. The founder and CEO of Commendo Software, a three-year-old startup based in Fremont, Calif., had just landed the first big customer--Mexican giant Cemex--for his company's patented virtual infrastructure technology. "They said, 'We're going to evaluate you the same way we evaluate Cisco,'" Gil recalls. "They wanted something absolutely bullet-proof."

Before he could deliver for this demanding client, his product needed thousands of hours of testing. So, with time and capital at a premium, Gil did what more and more CEOs are doing these days--he outsourced.

But he didn't find his software testers in India. Gil hired Sierra Atlantic, an outsourcing specialist headquartered in Commendo's own backyard. Sierra set up simulated environments for the Cemex application and ran the tests right there. Although Gil won't say how much he paid, he estimates that "it was a fraction of what it would have cost in time and hassles, plus spending valuable capital to create the software simulator lab." He shaved a year off his usual product cycle, and Cemex got bug-free technology.

It's just one example of how American business is getting savvier about outsourcing. Simply tapping pools of lower-cost labor in other countries is no longer the answer. While trimming the price tag for routine business processes remains attractive, U.S. executives increasingly look at speed, security, quality and cultural fit when searching for ways to improve efficiency.

Instead of thinking about "offshoring," they are looking at "rightshoring"--finding a mix of on-site, near-shore and far-shore outsourcers that can not only streamline functions but also enhance their clients' long-term business plans. "Outsourcing has changed dramatically over the last five years," says Brian Keane, CEO of Boston-based outsourcing firm Keane, which has 9,000 employees around the world and earned nearly $1 billion in revenue last year. "The most successful companies are using it as a strategic best practice--not just to save money but to increase organizational flexibility."

Keane's firm has development centers for information technology (IT) and business process outsourcing (BPO) in the U.S., the U.K., Canada and India, and its clients span the public and private sectors in industries from defense to health care. Location for outsourcing a particular operation should be carefully plotted. "It depends on the nature of the work and the maturity of the organization," says Keane. Tasks such as coding and testing can be done almost anywhere while functions like project management and business analysis are best done closer to home.

Take financial services institutions, which were among the earliest companies to embrace outsourcing. Because of their vast, information-intensive, back-office requirements, they have huge IT budgets, so lowering IT costs can have a powerful impact on their bottom lines. Banks, insurers and securities firms have long been comfortable sending routine chores abroad. But when work requires a high degree of supervision, many prefer to keep it on-site or at least in the same time zone.

Also, stringent U.S. regulations, from Sarbanes-Oxley to the Patriot Act, prohibit outsourcing for certain activities. One example: A brokerage firm may set up a captive operation in another country for securities processing, but hiring a third party to do that work is against the law. "Compliance and risk management are among the hottest topics we're seeing among financial service companies," says Keane.

Outsourcing models have been evolving for a decade now. It was almost 10 years ago that global corporate superpowers such as General Electric, Citigroup and American Express first set up captive BPO operations in India, giving that country a head start in experience. Smaller companies, eager to lower their wage costs but lacking the scale to justify maintaining their own subsidiaries abroad, hired local firms in markets from Canada to Ireland to the Philippines that could handle claims and billing, write software or provide customer support. Now, businesses of all sizes look at suppliers with tailored services and multiple locations, sometimes just a few miles away.

Provider names reflect the growing trend. Virginia-based consultancy Bearing Point's IT outsourcing business is called AnyShore, with more than 2,000 people in Brazil, Spain, China, India, Canada and elsewhere. Then there's Sierra Atlantic's NShore, with 900 employees in the U.S. and India. Growing at 50 percent annually, the company's customers include GE Capital and Hartford Financial, as well as upstarts like Commendo. "The programmer's hourly rate is a minor issue," declares Sierra Atlantic executive vice president Marc Hebert. "The big picture is that when you're a CIO and you're buying [an enterprise software package from] Oracle, you're thinking about managing and implementing and maintaining the system. Some components of that are better done onshore, others off."

To be sure, some functions--especially in IT, where personnel expenses account for the bulk of costs--are still streaming to distant shores. According to research firm Gartner Group, the $18 billion that global companies invested in 2004 to outsource IT services overseas will explode to $50 billion by 2007, accounting for 7 percent of total IT spending. And for now, India draws more of those dollars than any other single country, with China running second (see chart). The reason, experts say, is purely economic: While American software programmers make $100 per hour, their Indian counterparts make $30, and their less experienced Chinese counterparts even less.

But as companies get more sophisticated about outsourcing, they are factoring other considerations besides cost into the equation. Some want to expand into new markets; others want to consolidate scattered functions in a region where they already have a significant presence. "Clients are trying to build out their global footprint or take advantage of what they already have in various locations around the world," says Andrea Bierce, vice president at the Chicago consulting firm A.T. Kearney and co-leader of its BPO practice. "So it's part of their global operating strategy."

The strategic approach to outsourcing has worked well for Pratt & Whitney, the $8.3 billion aircraft engine division of United Technologies Corp. Headquartered in East Hartford, Conn., Pratt & Whitney does most of its engine-building in North America. But the company increasingly sets up joint ventures or outsources some types of engineering work in countries where it's seeking to grow market share. "With joint ventures, you set up a true partnership with the country," says president Louis Chenevert. "The goal is to keep finding the right strategic partners."

For example, Pratt & Whitney's world-class parts-making operation in Rzeszow, Poland, was a factor in Warsaw's decision to replace its creaky MiG fighter jets with Lockheed Martin F-16s, whose engines are built by Pratt & Whitney. The company also has a joint venture in Chengdu, China, a country where double-digit growth in the airline industry has "great upside potential for us," Chenevert says. India, another fast-growing aviation market, is becoming an important location for IT services as well as engine repair and even development.

In some cases, Pratt & Whitney is shifting operations from its traditional supplier network into such strategic partnerships. The company has saved some $80 million with innovative outsourcing, Chenevert says, "but more important, we're leveraging already established operations in [non-U.S.] markets, and it helps us win in those markets."

More and more companies are beginning to outsource high-end functions. In a recent A.T. Kearney survey of procurement practices at 275 international companies, two-thirds of respondents said they were looking to outsource value-added functions like product and service innovation, supply continuity, risk management and even research and development. That ratio was up from 28 percent in 1999. "These companies are in the second or third generation" of outsourcing strategy, says Bruce Caldwell, Gartner Group's principal analyst for IT management. "Their focus is on growth, rather than cutting costs to survive."

They often follow the "go global, think local" mantra; pharmaceutical companies and investment banks, for example, hire market research firms in countries where they're trying to build share, rather than sending their own marketing experts out to the field. In other cases, companies are leveraging an already reliable outsourcing relationship. For example, U.S. health care providers have for years been shipping bulky patient files of doctors' hand-scribbled notes and drug prescriptions to India for transcription; now, they also pay Indian diagnosticians to read and interpret X-rays, ultrasound film and other lab tests. "They started thinking, what else can India do for us?" says A.T. Kearney's Bierce.

One relatively new but fast-growing candidate for outsourcing is order-to-cash (OTC) technology, which automates business-to-business billing functions. In February, IBM bought Dublin-based OTC outsourcing firm Equitant, whose clients include Microsoft and Lucent Technologies--a sign, analysts think, that the market for such services is heating up.

As the outsourcing industry matures, providers are getting more specialized, and customers are learning--sometimes the hard way--to be selective about where they locate particular services. Perhaps the most frequently cited outsourcing horror story is that of Dell Computer, which in 2003 said it would reshift some call-center tech support for corporate customers back to North America from Bangalore after callers complained about language problems and scripted answers.

To avoid such scenarios, some U.S. companies are looking to other regions for customer care. The Philippines' work force may not be as technologically skilled as India's, but Filipinos' more Westernized accent and cultural orientation makes the country hugely desirable as a base for U.S. call centers. Northeastern China, where 500,000 speak Chinese as a second language and costs are 10 percent of those in Japan, is the favored outsourcing choice for Japanese companies (the region is also packed with Korean-speaking call centers). And Singapore is building a reputation for expertise in high-end BPO, such as disaster recovery services.

Still, outsourcing relationships are full of potential pitfalls no matter where the supplier is located, and industry watchers say many companies remain unprepared for hidden costs and management snafus. It's easy to underestimate the expenses and hassles involved in choosing a vendor, moving work to a new location, and resizing an existing work force.

In A. T. Kearney's procurement survey, more than half of the respondents said they didn't have adequate tools to manage outsourcing or to measure its impact. And the majority are still blindsided when basic but serious problems crop up. For instance, the average attrition rate at call centers is a steep 50 percent, and it can take four hours to get to meetings in traffic-snarled Bangalore. No wonder 10 percent of outsourcing customers terminate their deals. "A lot of people just don't do it right," says Gartner analyst Caldwell.

To improve results, the experts say, decision-making about outsourcing has to come from the top. Chief executives need a complete business plan, not just an ambitious projection of long-term savings.

Outsourcing companies themselves are under pressure to track not only system costs but elements like customer satisfaction and processing speed. These can have a big impact on long-term profitability. "If you want your cost per call to go down," says Steven G. Rolls, an executive vice president at Cincinnati-based outsourcing supplier Convergys, "that means you have to spend less time on the phone, but that could result in a less satisfied customer. Too many companies get caught up with the price per call, per agent and per minute."

Repetitive, back-office transactions and reconciliations can be performed just fine on far shores. But when more personal contact is required, or when questions deviate in some way from policy, clients prefer their own cultural context. For legal or compliance reasons, some functions need to be handled in-house, such as telephone hot lines for anonymous tips on fraud.

Unfortunately, even no-shore outsourcing has risks. In 2002, Florida Governor Jeb Bush signed a seven-year, $280 million contract with Convergys, announcing that he could save taxpayers about $93 million by outsourcing some personnel functions for its 189,000 employees, including benefits and payroll administration. So far, the project has been hamstrung by such glitches as disappearing records, missing paychecks and long phone call hold times.

Of course, governments have more leeway than corporations when it comes to the trials and errors of outsourcing. Making the right decisions about what work to send where requires in-depth planning, research and analysis. For CEOs accountable to their customers, employees and shareholders, that's the only way to ride the outsourcing wave--without wiping out.

Mexico           23%
Canada           19%
Brazil           20%
Czech Republic   13%
India            67%
China            35%
Philippines      10%
Australia        10%
Other            32%

WHERE CEOS ARE OUTSOURCING In a survey, executives at 115 companies told
where they locate outsourced functions. Respondents were allowed to
choose from more than one country.

Source: A.T. Kearney

Note: Table made from bar graph.

Jobs on the Move

The number of U.S. service jobs that will be going offshore.

2003  0.3
2004  0.4
2005  0.8
2006  1.0
2007  1.1
2008  1.2
2010  1.7
2015  3.4

Source: U.S. Dept. of Commerce and Forrester Research (June 2004)

Note: Table made from bar graph.