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The Hazards of Offshoring
October 22, 2005

When companies head offshore, they sail into uncertain waters.

Like the line "he doesn't know the territory" in the The Music Man, experts say the biggest mistake a company can make is failing to take time to get to know the region.

During a panel discussion in San Francisco, Ashish Gupta, a partner at the Woodside Fund, said U.S.-based managers can't rely on advisors and agents when contemplating a move offshore.

Even a quarterly visit to India, or hiring a scout for an overseas operation, often is not enough, he said. "In the first case, you get a cold, you get jet lag, and you lose money," Mr. Gupta said during Thursday's presentation. "The second gets more insecure over time, but might be a transitional model."

Approaches that work, he said, are hiring a trusted partner who will in essence be the CEO of the overseas operation, or making a commitment to having a first-class presence, with at least a core team of three or four individuals from the U.S. firm to set up operations. "These last two are the only stable models," said Mr. Gupta, who is based in Redwood Shores, California.

Vish Mishra, a senior venture partner at Menlo Park, California-based Clearstone Venture Partners, concurred, adding "It's much better to have a partner of your own on the ground."

Winston Fu, a general partner at Menlo Park-based U.S. Venture Partners, said the same rules of trusted partners apply to outsourcing in China. "If the CEO's here in the states, he has to trust the head of that operation to make the key hires in China," said Mr. Fu. "It's like having two CEOs."

Mr. Gupta added that companies frequently err by only using its outsourced operation to take care of back-end operations, rather than being a full partner in product development.

A recent study from McKinsey & Co. estimates there are roughly 1 million IT and business process outsourcing jobs being fulfilled on an offshore basis. It expects that could increase to 6 million to 8 million jobs in the next decade.

Hidden Costs and Red Tape

The panel uniformly acknowledged there are numerous cultural differences that can blindside companies and add hidden costs. It also warned that companies must consider varying levels of infrastructure.

"When you think about outsourcing to India or China, and you think about infrastructure, there's the ability to move money, information, and physical stuff. India is not so good at this last part," said Mr. Gupta.

From a governmental perspective, companies would do well to work with local entrepreneurs who know the ins and outs of India's legal, financial, and business systems. "India has got a lot of red tape," said Mr. Mishra. "But Indian entrepreneurs know how to work within those restrictions. And there are many, many entrepreneurs there, but not enough capital."

China has its own limitations to consider in terms of infrastructure and political stability.

"The infrastructure in China is OK for communications and travel," said Mr. Fu. "When it comes to getting financing for equipment, that's a big hidden cost," in part due to the fact that many financial institutions in China remain state-owned.

Another hidden cost is in getting Chinese operations audited successfully, due to different accounting practices and a shortage of lawyers trained in Chinese schools, a prerequisite to practicing law in China. "All I can say is, if you want to audit a Chinese subsidiary, good luck," he said.

When it comes to outsourcing to China, companies have a kind of faith-based decision to make as well. "You end up just having to believe that the Chinese government is committed to growing their economy," said Mr. Fu. "As for political stability, it depends on where you have your faith."