Is IT Offshoring Actually More Expensive Than Domestic Sourcing?

The contention that the outsourcing of IT services to lower-cost countries may be more expensive than most buyers assume is not a new one. It's an issue we've been writing about at CIO magazine for years (see The Hidden Costs of Offshoring). There are the transition costs, the productivity dips, the management overhead, and the cultural implications (just to name a few) that have to be factored into the cost-benefit equation. It sometimes can be more cost-effective to send IT work abroad. But it's usually not as cheap as you think.

I came across a study last week, however, that takes that argument one (giant) step further. The new paper Service Offshoring: Same Old Trade with a New Label? is featured at VoxEU.org, a research and policy portal set up by the Centre for Economic Policy Research featuring commentary from European economists.

Boiled down to its essence, this paper asserts not simply that the offshoring of services may be more expensive than buyers think, but that the offshoring of services may be more expensive period. That is, they find that it may be significantly cheaper to source services work closer to home.

Professors Keith Head and John Reis of the Sauder School of Business at the University of British Columbia and Thierry Mayer of the University of Paris 1 Panthéon-Sorbonne began their research to investigate whether the geographic issues associated with offshore trade shield domestic workers from direct competition with their foreign counterparts.

The trio writes:

"We develop a model that envisions employers searching globally for the most suitable workers for any given task and posits that distance raises the costs of using foreign workers. These higher costs reflect travel, training, or translation time associated with using workers that reside far from where their services will be consumed. Firms choose workers that offer the lowest costs after adjusting wages for productivity and distance-based service delivery costs.

We use data on bilateral trade in services for a large sample of countries to infer the extent to which distance increases the relative costs of using remote workers. We focus on the service category called Other Commercial Services that includes service categories that are subject to the offshoring debate—professional services and call centers."

The results, if valid, are arresting. Applying economic theory and the distance effect, the researchers found that a services buyer based in London could afford to pay workers in Oxford anywhere from 99 percent to 373 percent more than workers in Bangalore and still come out ahead. Once service-delivery related costs and productivity-adjusted wages are taken into account, the Bangalore-based workers are actually more expensive, the professors write, because they are "100 times more distant from London than the Oxford workers."

The conclusion: geographic barriers protect high-wage workers domestically from the effects of low-wage competition abroad. However, the professors note, their estimates reflect only an average across a range of services. There may be some services where competition is more acute.

They also point out that service delivery costs associated with distance appear to have fallen over the last decade to a level slightly below the same deliver costs estimated for goods. "Unfortunately, the data do not clearly indicate whether distance costs for services will continue their downward trend or level off," the professors write. "We suspect that persistent cultural differences, as well as locally-biased social networks, will maintain distance costs at a high enough level to forestall the small, flat world envisioned by some journalistic accounts."

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