Balancing Offshore Cost Savings With Quality Concerns

Companies can save thousands of dollars by outsourcing the development of custom-software projects to low-cost, offshore locations such as India and China, say researchers at the University of Michigan Business School and the University of Pennsylvania's Wharton School.

In a new study, Michigan Business School professors Sendil Ethiraj, Prashant Kale and M.S. Krishnan and Wharton professor Jitendra Singh estimate the average annual decline in quality-adjusted price for software projects developed offshore is about 14 percent–or $56,000 per project.

This is a significant cost savings in an industry where software projects in the United States are normally expected to exceed budget and delivery schedule. However, there are tradeoffs between the low prices customers enjoy and the potential for increased dissatisfaction due to greater uncertainties associated with distributed development, the researchers say. Previous client surveys, for example, have indicated that fewer than 25 percent of customers who purchase large software solutions are satisfied with the cost and schedule performance of the project.

"The offshoring movement in software development is driven by a strong cost-saving motive," the researchers say. "In order to improve both quality and cost, some of the successful offshore software vendors have adapted and disciplined their development processes to squeeze costs out of the system. The success of this effort is reflected in the decline in quality-adjusted prices over four years. More than 50 percent of software vendors with CMM Level 4 and Level 5 certification are from offshore destinations such as India."

As the potential for further cost savings declines over time, reducing other sources of client dissatisfaction becomes more salient, they say. In addition to estimating the cost savings accruing to U.S.-based clients, their study sought to understand the potential sources of customer dissatisfaction and how the offshore vendors might address them.

As an example, more experienced development team members command higher wages and raise project-execution costs, so vendors have an incentive to staff projects with less-experienced members who are paid lower wages. Although this helps to reduce costs, it may also simultaneously increase quality problems and, consequently, customer dissatisfaction as well.

Ethiraj, Kale, Krishnan and Singh studied 160 projects executed by a large India-based custom-software vendor for 73 different clients between 1999 and 2002. To better understand the economics of custom software, they incorporated demand-side considerations, i.e., from the standpoint of the software user or client rather than the developer or vendor. In their results, they highlight possible ways to align vendor investments in improving product and process quality with their clients' needs.

"The problems of contracting in custom software are compounded when the development moves offshore," the researchers say. "While offshore locations such as India are a fertile source of low-cost labor, the cheaper labor available locally can also create incentives for the vendor to staff the project with less-qualified employees (to reduce costs and to train novice employees), which potentially can increase defects and schedule spillovers and may lead to significant opportunity costs for customers.

"Hence, some of the offshore locations such as India can also be a source of high variance in quality as local firms compete to bid the lowest price for overseas projects. Therefore, as global companies attempt to benefit from access to offshore resources, it is important to assess the process capabilities and the quality of training infrastructure of their offshore partners."

From their analysis of custom-software pricing, the researchers suggest that by identifying defects during the project-execution stage, vendors can minimize the likelihood of effort overruns and schedule slippages. This can lead to lower contractual penalties (if they exist) and yield higher prices–and, in the long run, improve client satisfaction. The researchers argue that the delivery of defect-free solutions may require investments in software-engineering processes to help identify and fix defects early on.

In addition, their study results indicate that staffing a custom-software development team with experienced people, particularly persons who have worked on prior projects for the client, can contribute to better overall results for customers who subsequently may be willing to pay a price premium.

"Clients attach greater value to experienced employees who understand their requirements well and can deliver software per specifications," the researchers say. "Thus, some customer dissatisfaction can be resolved by a better vendor re-allocation of resources geared to minimizing employee turnover, especially those workers who have valuable experience with executing projects for important clients."

Finally, one of the more interesting findings of their study was that the effect of learning over time (both cost reduction and quality improvement) was strongly specialized to the contractual regime. Transfer of learning and best practices from one contractual regime to another often did not yield the same results, contributing instead to cost overruns and quality declines. Since contracts shape incentives and incentives shape resource allocation, vendors and clients need to pay closer attention to their forecasts and estimates on both cost and quality dimensions, especially when new contractual terms are introduced.