Outsourcing providers often rely on a limited number of geographic locations, exposing themselves to unnecessary risk. They can mitigate these risks.

The outsourcing and offshoring industry is at a turning point. What began as a small-scale sector dedicated to application development, accounting and payroll has become, as of 2008, an $80 billion global industry, addressing a range of business processes and technology services. As the IT services and BPO industry matures, however, challenges are emerging.

Our research finds that more that 70% of offshore delivery centers, including both wholly owned captive operations as well as vendors, narrow their global operations to just three locations, often situated in only two countries (most frequently India, China or the Philippines). This reliance on a limited number of geographic regions — historically driven by the availability of highly skilled, low-cost labor in these areas — is exposing providers to a variety of location-specific risks. These include abrupt currency and wage fluctuations, intense competition for employees and regulatory limits. While a narrow geographic concentration may result in lower labor costs at the outset, the overall risks are higher, according to our research. The same is true on a microlevel: Our data show that when a delivery center in a large Indian city grows beyond 3,000 employees, costs spiral and performance begins to deteriorate.

Offshore service providers can mitigate these risks in the way a financial manager would — by diversifying their holdings. While diversification has long been the rule for investment decisions, outsourcing providers were under little pressure to change their lowest-cost-country approach until recently, when rising volatility in many favored offshoring markets began to impair providers’ ability to predict costs and manage talent needs. As a result, many are looking to address these vulnerabilities while still reaping a cost advantage.

Offshore delivery centers can accomplish this goal by diversifying their operations in two ways: on a macro level, by expanding their global footprints to reduce overconcentration in any one region; and on a micro level, by broadening the range and scale of activities conducted in any one center. The result is a network approach to offshore delivery management that features centralized global delivery hubs and decentralized local or specialized service spokes. This next-generation model not only improves overall global delivery but also brings greater predictability to cost management while fostering better coordination, flexibility and responsiveness — characteristics that can give global companies a sharper edge in this period of rapid change. The remainder of the article and exhibits that follow illustrate the benefits inherent in moving to this new model.

The Benefits of a Portfolio Approach

The underlying volatility of today’s markets makes planning more difficult, particularly in the cost-sensitive IT and BPO service industry model. With increasing pressure on margins, service centers need to anticipate changes in costs — and avoid sharp movements in local market conditions (such as higher wages, labor shortages and inflation). Such swings have been particularly marked in preferred offshoring destinations such as India, where the economics of doing business were significantly altered in the space of the 15 months between January 2008 and March 2009. Over that period, the rate of wage inflation fell by 8 percentage points (to 4 percent), the U.S. dollar rose 32% against the rupee, and employee turnover declined by 15%. These double-digit swings would have wreaked havoc on any cost projections and have made planning quite tricky.

Delivery centers can ease the planning burden by adding other geographies to their portfolios — ones that offer more stable economic profiles or whose market movements counteract those of the original location. Doing so allows companies to hedge their exposure to risk and makes managing costs more predictable. Such considerations form the basis of strong portfolio planning.