Impact of new IRS tax regulations on outsourcing

I just read a very interesting article in the Business Standard on the impact of certain US tax regulation changes on the overall cost of service operations in India. Here are a few interesting quotes from this article:

Prior to the new regulations, multinationals had an option to club several inter-related services and levy a single charge for the entire gamut of services. The new regulations, particularly SCM, would necessitate maintenance of onerous documentation for low margin services. The captive Indian business process outsourcing and the knowledge processing outsourcing units shall be impacted the most.

India’s numerous R&D centres in pharmaceutical, engineering design and technology sectors catering to US parent would have to review existing contracts for development of intangibles.

Whether or not the newly introduced regulations meet IRS’s objective of reducing compliance burden for corporations is something that time would tell. However, the regulations would certainly bolster revenue collections for IRS, while making US services costlier for Indian subsidiaries.

The article is a bit dense, and I am not qualified to judge the accuracy of the tax implications discussed, so you will have to judge for yourself. The article is written by Mukesh Butani who is a partner with BMR & Associates. Based on BMR’s website, he seems to have held senior positions in firms like Ernst & Young India and Andersen, so I will give him the benefit of the doubt.

If Mukesh is right, how do these new regulations (which will become effective from January 2007) impact Rational Outsourcing? Rational outsourcing aims to ensure that the benefits of outsourcing are greater than the total costs of outsourcing. If the new regulations “necessitate maintenance of onerous documentation for low margin services” then that would increase the total cost of outsourcing, while not significantly affecting the benefits of outsourcing (except as noted below). Thus, outsourcing projects that were marginally beneficial may now fail the rational outsourcing test.

These regulations may also impact the benefits of outsourcing in complex ways. Some of the major benefits of certain outsourcing relationships stem from the complex tax benefits of structuring the relationship in a certain manner. Any regulation that modifies the transfer pricing of services provided by the parent organization may significantly affect these tax benefits. At the very least, both the parent and the captive organizations will have to review their contracts and accounting in light of these changes. These unanticipated expenses may become a source of conflict between the parent and the captive if their contracts do not clearly spell out who will have to pay for these expenses. Finally, the Ernst & Young 2005-2006 Global Transfer Pricing Surveys document notes:

The definition of stewardship expense has been narrowed, presumably resulting in more headquarters or management services costs to be charged to affiliates;

This may affect the “profitability” of certain captives that were not being properly charged for the stewardship services provided by the parent.

I have a feeling that we will end up discussing these regulation changes again over the next few months. In the meantime, here are a few other documents that touch upon this topic. Once I find the time to personally review them, I will post my comments on this blog.

• A press release from the IRS
• An article from Deloitte
• An article by Baker & McKenzie

Interesting article on BPO version 2.0

William Martorelli from Forrester recently wrote an interesting report entitled "Creating An SOA-Enabled BPO Platform: How Outsourcers Will Use Digital Business Architecture To Deliver BPO." In this report, Martorelli essentially envisions a future where BPO vendors leverage various service-oriented architecture (SOA) based technology platforms to serve their customers better and to increase their own profitability. Why do we care? Because, if he is right, BPO will fundamentally move away from labor arbitrage (who is cheaper) to technology innovation (who is smarter). This BPO 2.0 is a far more exciting world than the ongoing rush towards ever cheaper locations in search of low-cost labor.

Unfortunately, the report is not free (I am not sure about Forrester's fair use policy in such a case) and I was unable to find news articles that quoted this paper, so I will have to be satisfied with a couple of quotes from the paper's Executive Summary on the Forrester website.

Vendors seeking to deliver business process services must contend with diverse and complex customer environments, including disparate business process platforms, nonstandard business processes, and customizations. Faced with these challenges — and forced to achieve one-to-many customer leverage in order to make money — BPO (business process outsourcing) providers are adopting layered service-delivery architecture capable of isolating them from complexity.

Because technology leverage is becoming so critical to delivering on BPO engagements successfully and profitably, customers should make evaluation of this architecture a key part of their vendor evaluation criteria.

Why a US ban on offshore outsourcing is the best possible thing for India!

Perhaps I am imagining this, but the anti-outsourcing anti-free-trade crowd seems to be contorting the results of the recent election into an endorsement of their anti-free-trade beliefs. Perhaps they are right and perhaps the new Congress will be far more opposed to free-trade. In fact, today someone asked me, “So what will India do if we ban offshoring?” I would have just laughed if it wasn’t for the fact that I have been asked this question before. So, even though the question is somewhat unrealistic, let’s imagine a situation where the US magically manages to ban offshore outsourcing. What would this imply for India?

Companies like Microsoft, Oracle and others employ thousands of engineers in India. These highly trained engineers develop the code that gets shipped in software like Microsoft Vista. Microsoft’s profit margins on software such as Vista may be as high as 80%. Thus, the Indian engineer and the Indian economy capture a miniscule proportion of the value partially created by the engineer. The majority of the value flows into the US economy in the form of profits earned by Microsoft on the software partially created in India. McKinsey Global Institute (MGI) actually reported on this extensively in their “Offshoring: Is It a Win-Win Game?” report accessible at: www.mckinsey.com/mgi/publications/win_win_game.asp

Of the $1.45 - $1.47 of value MGI estimates is created globally from every dollar spend a domestic company chooses to divert abroad, the U.S. captures $1.12 - $1.14 while the receiving country captures on average 33 cents. In other words, the U.S. captures 78 percent of the total value [created when an activity is offshored].

So what happens when the US magically bans offshoring? Does the Indian software engineer go and start plowing the rice fields? Not very likely. It is far more likely that some senior manager in Microsoft India would reorganize the former employees of this now defunct organization into a new company called Microsoft Lite. These guys would then churn out similar software, but would be forced to move up the stack and sell high-margin packaged software rather than low-margin IT outsourcing. The cost advantage would however not disappear. Imagine new Indian companies churning out software pretty similar to those produced by US companies, but at a 30% lower price. There might be some quality differences, but these would be minor relative to the price advantage. All of a sudden, the revenues of the affected US companies would shrink and they would be forced to fire the exact same people they recently hired to replace the now illegal outsourced engineers.

The new Indian companies on the other hand would receive a much needed kick in the butt. Indians would no longer have the luxury of being satisfied with safe IT outsourcing jobs. They would be forced to learn how to compete in the global market for finished software. This is a much more high-risk market than IT outsourcing and for a few years these new Indian companies would go through many trials and tribulations. Eventually though, because necessity is the mother of invention, they would be forced to figure out how to compete in the packaged software market. Indian immigrants in America have started hundreds of successful software companies; there is no reason to believe they can’t eventually do the same in their home country. All of a sudden, the US offshoring ban would have kicked the Indian IT industry several rungs up the evolutionary ladder. India would start capturing tens of billions of dollars of packaged software profits instead of the billions of IT outsourcing revenues it is currently earning. To the Americans who sacrificed tens of billions of dollars of GDP to give India the much-needed boost by banning offshoring, all the Indians would say is, “Thank you America!”

An useful article on Outsourcing Performance Management

I was recently reading an article on Outsourcing Performance Management written by Sam S. Adkins in the Workforce Performance Solutions Magazine at http://www.wpsmag.com/content/templates/wps_article.asp?articleid=220. While I don’t agree with all his points, and especially with some of his prioritizations, this is a very useful article to read on this topic. My favorite quote is the following. I could not agree with it more.

Probably the most important component of an outsourcing relationship is trust. Trust is a two-way street and has to be cultivated by both parties. Trust is built by setting realistic goals and expectations and by having objective ways to measure success.
Building trust is a process. It occurs naturally when providers know that their service matters and that what they do is directly aligned to the customer’s business strategy. In an outsourcing relationship, trust is built by being willing to compromise and by being dependable, predictable and ethical.

The author also provides a list of “10 Ways to Be SMART About Outsourcing”. I have quoted the top three, you can read the rest at www.wpsmag.com.

1. Do your budget homework before you sign the contract. Outsourcing may not be cheaper, and cost savings may not occur. It is a common misunderstanding that outsourcing automatically cuts costs. It is possible that outsourcing will actually increase costs, but achieve one of your other goals.
2. Accept that outsourcing is usually a one-way street. Once you outsource a function, you will probably not be able to bring it back in-house. It is almost impossible to bring a function back in-house once your head count and operating budgets are reduced. If you become unhappy with your outsourcer, your only option may be to select another outsourcer.
3. Resist the temptation to change project deliverables in midstream. Cost is fluid while the project is fluid. Unexpected change, second thoughts and spontaneous creativity can be expensive. A really good way to frustrate an outsourcing partner is to constantly change requirements. While it is rare that an outsourcer decides not to negotiate a new contract based on this, it is common for them to bump the prices on the next contract in anticipation of constant change.

Rational Outsourcing Rule #1: No free lunches!

I was recently reading an article entitled "As the BPO Business Grows, There's a Greater Focus on Metrics and Measurement"
[Published on January 14, 2005 in Knowledge@Wharton]. The line that initially caught my eye was:

Ask companies why they outsource, and no matter what they say, their answers can largely be summed up in two words: cheap labor.

While I also believe that most outsourcing customers still feel that cheap labor is the primary reason for outsourcing, the reality today is far too complex to be "summed up in two words." I was concerned that this article would not have anything new to contribute and was about to move on to something more productive. Then I noticed that it quoted Wharton professor Ravi Aron extensively. I met Ravi when he presented at a Technology and Operations Management seminar at the Harvard Business School. Given his background and his research, I continued reading, looking for a nugget of true insight. Ravi did not disappoint:

The myth, says Aron, is that companies with spaghetti-like, poorly managed processes in the U.S. and elsewhere are those that get the most out of outsourcing. "Firms that get the greatest value from outsourcing aren't those whose operations shops can't deliver in America; it's the ones that already run a lean op shop here and know how to calibrate incentives to customer needs and reap gains from going to India. They achieve shorter times to market and can add on to existing product lines. It's no accident that companies like American Express and GE have benefited - they have a culture of measurement and submitting themselves to numbers. On the Indian side, the BPO providers that have done best are those that share this culture of metrics and measurement."

What Ravi points out is perhaps Rule #1 of rational outsourcing: “There are no free lunches.” Outsourcing is not a magic bullet where you outsource and your problems are solved. You have to align your vendors’ incentives with your own goals and your end-customer’s requirements. You also have to monitor the vendor in real-time and proactively manage the shared process: Ravi calls this the 'extended organizational form.'

Interesting push for considering the Total Cost while outsourcing

I am about to quote widely from two anti-outsourcing tirades. While I usually prefer not to link to extreme views, these two posts between them make a very important point: labor cost is only a small component of the total cost of ownership and if you make outsourcing decisions based on labor costs, you are setting yourself up for failure. If we are truly going to be rational about outsourcing, we need to acknowledge and learn from the truth embedded in the most extreme views. [Not that these posts are even close to being the most extreme views on this topic.]

The first post by Bill Waddell at www.evolvingexcellence.com/blog/2006/08/get_real_folks.html makes the point that companies do not have a clear sense of what their true cost is because they do not sufficiently account for factors such as the cost of lead time, quality, inventory carrying costs, supply chain risk, etc. I would tend to agree. In fact, in the Business Process Outsourcing space, I have often met customers whose cost of correcting errors is three times their outsourcing cost, yet they focus more on the labor cost differential than the error rate differential between their in-house operations and outsourcing vendors.

I have a better idea: How about if manufacturers figure out what their cost really is first. Forget about the cost of lead time and quality. Most companies have no idea what it costs to take widget materials A,B,C and D; put them together into sub-widgets E and F; slap those together into a final widget G; then put that into a cardboard box. Never mind the higher level questions of how long it takes or how many they get right.

When companies cannot figure out the cost of running and taking care of the widget making machines, or the cost of moving widget parts around their factories, the esoteric costs of such matters as lead time are the least of their worries. In most cases, 'cost' means the number they get when they add up the 2/3 or so of the direct labor time they can track plus the invoice price of the materials, then multiply the labor number by about six or seven and call that the cost of a widget. That number is about as accurate as calculating the temperature by looking at a lake and deciding that, since the lake isn't frozen it must be greater than 32 degrees, and it's not boiling so it has to be less than 212, so the temperature must be exactly in the middle - 122 degrees. Precisely 122 point 0, in fact.

For a company to take a manufactured cost that includes a 40-50% wildassguess factor and compare that to an fob Guangdong price, then decide to close a factory and throw people out of work based on the comparison is somewhere between insane and criminal. Deciding to outsource because the cost just couldn't be reduced any more, when the company never had a clue what the cost was to begin with is equally absurd.

The second post, by Kevin Meyer at www.evolvingexcellence.com/blog/2006/11/local_outsourci.html makes the point that companies can save much more money by eliminating waste than by reducing labor costs via outsourcing. Once again, I tend to agree that this lesson applies to Business Process Outsourcing as well. For example, at the Total cost of errors site we highlighted one company where a 0.1 percentage point change in error rates had the same bottom line impact as a 30% reduction in labor costs due to outsourcing. [The full case study is available at http://www.totalcostoferrors.com/atcecasestudy.]

But the bottom line is that there are really only two justifiable reasons to outsource, especially globally: to access unique capabilities and to be closer to the customer. Labor cost is not one of them. In the traditional financial world, labor cost happens to be one of the most controllable, therefore it's easy to go a few thousand miles away to save a few bucks an hour. But what about the total supply chain cost? How much cash is being chewed up in inventory on the high seas? What happens if a quality problem is found after a boatload of parts has already set sail? What is your new customer lead time? Not to mention intellectual property issues and the rapidly-rising labor costs in some outsourcing havens like China that is already forcing some companies to globetrot to another low labor cost location.

A 20% "labor penalty" is nothing compared to the internal process and methods waste at most manufacturing companies. Take the time to really use lean methods to streamline how the operation runs. Focus on one piece flow, respect your employees, and develop a high performance workforce... you usually get what you pay for. The savings from even a first-pass lean waste reduction kaizen or value stream mapping exercise will often be twice the cost of the labor of the process.

It works. That's why truly lean companies, such as Danaher, Parker-Hannifin, American Apparel, and others are building more plants in the U.S., to compete globally.

While I agree with several points raised by these authors, I do believe at least in the case of Business Process Outsourcing, the better outsourcing vendors are adopting lean practices and six sigma far more aggressively than their customers. Eventually, if the outsourcing vendors deliver truly lean processes that US companies still struggle to match, then the outsourcing vendors’ labor cost advantages will only be further enhanced by the additional financial benefits of the lean processes adopted by them. That day is not here today, but if American companies do not aggressively start improving the overall cost of their processes, soon the Indian firms will be by far the world experts in business process quality and innovation.