Outsourcing: Where to draw the line

Many U.S. tech businesses say they are adamant about keeping IP at home for now, even if they are considering some form of foreign outsourcing.

By Mike Ricciuti and Mike Yamamoto
May 5, 2004, 4:47 AM PT

SAN JOSE, Calif.—Like many technology executives, Rhonda Hocker saw offshore outsourcing as an ideal way to stretch her budget and speed the development of new systems.

The chief information officer at San Jose-based software maker BEA Systems contracted with an Indian outsource company six months ago to handle maintenance and support of internal enterprise software from PeopleSoft, Siebel Systems and Clarify. She then outsourced help-desk work and made plans to do the same for the development of Web services components.

But even Hocker, a fan of outsourcing by any measure, has her limits.

"We'll never outsource any of our IT architects," she said of her "rocket scientists," BEA's top information technology developers. "I would never envision putting them over there or outsourcing that to anyone."

Therein lies the dilemma for many technology executives confronting the issue of offshore outsourcing: U.S. companies are increasingly turning to other countries to reduce labor costs, but they must decide how far they can go without risking security breaches, communication lapses or operational breakdowns, when moving work thousands of miles away overseas.

R&D Funding chart At the heart of that decision is the elusive definition of intellectual property—the "secret sauce," or the proprietary knowledge that gives companies their competitive advantage. Although the threshold varies from company to company, the basic description of this crucial technology usually falls under one of two categories.

For businesses that maintain systems for other companies, it means the details of internal architectures that help their clients stay ahead of competitors. But for those that create technology such as software, hardware, chips and network gear, intellectual property is the vital research and development work that ultimately yields the new products capable of changing entire industries overnight.

"At a recent discussion we had, executives were unanimous in saying they are very, very careful about what they offshore and what they don't," said Rick White, a former Republican congressman and now head of industry lobbying group . "They tend to send things overseas that don't compromise their intellectual property, for obvious business reasons."

Many executives appear to support that assessment, for now. "I worry about security and intellectual property being compromised. You have other people coming into your house, if you will, so you have to extend your logical boundaries to someone else's organization," said Rafael Sanchez, the CIO at fast food restaurant chain Burger King.

The flow abroad
But as offshore outsourcing becomes more prevalent, and the skill level of foreign labor rises, economists and others say it is inevitable that higher-level work will move overseas.

Several U.S. companies declined to comment on their offshore plans, seeking to avoid the in this election year. However, programmers at some companies told CNET that the movement of higher-skilled positions overseas has already begun.

Speaking on the condition of anonymity, one developer at a large Silicon Valley software maker said his company has sent many programming jobs to India and is considering more-skilled positions for a potential move.

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"If they find smart people who can code and design well over there, why wouldn't they move the whole shebang?" he said. "Right now, they're keeping the 'rock stars' and hiring grunts overseas. But they know that overseas will have a decent amount of rock stars, too."

Indeed, the ambitions of other countries are not confined to servicing products made elsewhere. The success of outsourcing and other high-technology business has created more Western-style entrepreneurialism in many parts of Asia and Eastern Europe.

Many former Soviet republics have a wealth of physicists and mathematicians who were products of the military-industrial complex built up during the Cold War. , a New Jersey-based outsourcing company, maintains offshore software development centers in Moscow and in Minsk, Belarus.

"Eastern Europe has long held the reputation of producing high-caliber software with unmatched quality," said Bill Gargano, a senior vice president of sales and marketing at Epam. "At the heart of any successful organization is the ability to cultivate its internal knowledge base. Epam each year reinvests in its core technology."

Such reinvestment may have been made easier this year because of to allow state scientific agencies to grant patents and other intellectual-property rights to inventors. "We want to tell them that as a result of their work, they will be the ones—not the state—that will own it. It is a big motivation," said Andrey Fursenko, the nation's acting minister for industry, science and technologies.

That motivation is , where foreign companies have either set up their own research centers or are experimenting with advanced R&D offshore.

"In recent years, more and more foreign companies have realized the benefits of carrying out significant R&D work in India. According to a study conducted by the Administrative Staff College of India (), 77 global companies have established R&D centers as direct subsidiaries; several others have formed R&D alliances with or have contracted research to local firms," said Manoj Kunkalienkar, the executive director and president of , an outsourcing company based in Mumbai.

"What is surprising is the list of industries doing R&D work out of India is varied, ranging from telecommunications service providers and equipment manufacturers, chip designers and IT hardware companies to plastics and pharmaceuticals producers," he added. "I believe it's just a matter of time before India is recognized as 'the world's R&D center' or 'the knowledge hub.'"

A safe place
Still, many U.S. companies are wary of outsourcing high-level development, partly because they are not yet fully comfortable with their offshore partners. They do not want outsourcing businesses to "own too much of their competitive differentiation—their crown jewels, if you will," said Stephanie Moore, an analyst at Forrester Research.

Sanchez said Burger King outsources to Perot Systems between 30 percent and 40 percent of its IT operations, including data center management, hosting, help desk work and telecommunications management. None of that work currently goes offshore, but Sanchez said he's evaluating "how to take advantage" of the trend. "We think (offshoring) is something that can potentially give us benefits," he said.

The CIO said he can't foresee outsourcing his most important positions. "You will always need enterprise architects that understand all of the platforms," Sanchez said.

Security remains a to offshore operations, particularly in developing countries, where law enforcement standards can be dubious. Although trade secrets can theoretically be stolen anywhere, in physical or digital form, the U.S. legal system is believed to be far more rigorous than that of many of its foreign counterparts.

Allegations of attempted extortion by offshore workers have been reported in at least two cases in recent months—one in Bangalore and the other in Pakistan. The Indian case involved two Bangalore employees of an Ohio-based outsourcer who allegedly threatened to divulge confidential patient records, unless the company met their demands. In the Pakistani incident, a Karachi transcription worker was accused of threatening to expose files from the University of California at San Francisco's Medical Center, if she was not paid fees owed for her work.

"India has intellectual property and other security laws, but policing is not very effective," said Vamsee Tirukkala, the co-founder and executive vice president of , an offshore research and consulting firm with offices in Bangalore and Santa Clara, Calif. "Every company says they're secure—we all have BS77099 certification, which basically means you can't get a fly though your door, unless it's been cleared—but theft still occurs."

On a domestic level, the concept of technology outsourcing long predates today's offshoring controversy. In the technology business, it first came into vogue in the 1980s and 1990s, when large companies, hoping to shed expenses, contracted with services companies like IBM and Electronic Data Systems to handle their internal systems.

Those arrangements were essentially an exercise in "rebadging" employees: The affected workers often would stay at the same desks and work on the same projects—just under different supervision.

"Outsourcers would come in and take over the employees in IT," Forrester's Moore said. "So the employees still maintained the domain knowledge that they always had—they just now worked for IBM or EDS."

Offshore outsourcing is a different story. In those operations, that knowledge of how companies do business literally goes out the door—and across the ocean. That's the point of contention, when it comes to many outsourcing arrangements, that has kept top developers in-house.

Industry veterans compare today's situation with the construction of Japanese auto plants in the United States in the 1980s. The Japanese automakers sent work offshore to America but made sure to retain their core R&D back home.

"The Japanese recognized that you need to partner, so they came over here and created jobs. They opened plants," said Bob Denis, the chief information officer at Trimble Navigation, a positioning software company in Sunnyvale, Calif. "But they're not going to build their transmissions here, because that's the secret of their sauce."

Security concerns extend beyond those companies working on advanced R&D that is aimed at creating the next big thing. Others that maintain networks, databases and other internal systems are also concerned about confidentiality, especially if their outsourcing partners are working with rivals.

Some companies are exploring offshore expansion rather than outsourcing, either through or through partnerships with foreign businesses. Oracle, Sun Microsystems and many smaller companies have taken this route, though that approach has its downside, too.

Even though many technology makers and IT departments staff offshore operations with their own people, the link to headquarters can become strained by distance. And information that was once closely guarded within headquarters begins to flow across continents and onto the hard drives of overseas workers.

That's why many executives worry about the movement of high-powered, intellectual-property work overseas as a consequence of outsourcing arrangements. "You would never offshore unless you were sure you were going to get the same kind of quality as you would get elsewhere—and even then, you wouldn't do it if you weren't sure you could protect your intellectual property," TechNet's White said.

These issues of quality and security are among the chief factors weighed by Inovant, a subsidiary of credit card conglomerate Visa, in making decisions about offshore work. is the world's largest consumer payment processor, serving 21,000 financial institutions, almost 20 million merchant locations and 1 billion Visa cardholders worldwide.

The company has shifted 150 maintenance and support positions to India in the past few years and will probably continue that trend. But Inovant will keep close to home its most skilled workers: the system architects, technology experts and researchers that design and build the company's most important and complex software.

"Nothing that is critical in any way, shape or form will ever go overseas," Inovant spokeswoman Elvira Swanson said.

Besides worries over trade secrets, many companies are encountering basic problems, ranging from communication to operational knowledge. Programmers in Bangalore or the Ukraine often can't sit down face-to-face with business executives in San Jose to hash out problems—and that costs valuable time and resources.

"We found that we have to provide a lot of direction," BEA's Hocker said. "That's difficult over a long distance, through many times zones and in different languages."

Hocker notes that offshore technology workers have the education and programming skills but often have an inadequate knowledge of a company's internal business processes—what she, Sanchez and others call "domain expertise." That means that they are less efficient at building highly specialized new applications.

Whether it's handled within the United States or abroad, such extra "hands on" management that is needed to complete complex projects with outsourced workers can nullify any perceived cost advantage, Hocker added. "I cannot afford for that stuff to not work perfectly," she said.

For reasons such as this, analysts say, companies are beginning to reassess the value of outsourcing before rushing abroad.

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"As jobs and entire functions ebb further away from management's direct control, executives are becoming more aware of the inherent risks and complexities of managing outsourcing relationships," Tom Weakland of , a consulting and research firm, said in a March report. "Executives have become more realistic in their expectations and are now more likely to implement outsourcing initiatives incrementally."

But the lure of skilled workers earning a third or even a quarter of the salaries of their American counterparts could prove too hard for companies to resist, and not all IT companies and departments object to sending their most sensitive work offshore. As the skill level among Indian and Eastern European programmers increases, many businesses see moving high-level work overseas as a natural extension of the outsourcing agreements they already have in place.

General Motors outsources its entire IT process, a move that has enabled the automaker to trim its technology budget from roughly $4 billion in 1996 to $2.9 billion last year, according to Tony Scott, the chief technology officer of GM's information systems and services group. Some of that work is sent offshore by the company's outsourcers, which include IBM and Hewlett-Packard.

Doreen Wright, chief information officer at Campbell Soup, said she uses outsourcing wherever it fits, to give her company an edge. "We're a soup company, not a technology company," she said.

Development centers
For their part, the companies that create technology are taking a different approach to offshore work. Systems administrators are more likely to contract for routine maintenance with outsourced services companies, such as IBM and Keane in the United States, and Wipro Technologies and Tata Consultancy Services in India. However, technology manufacturers typically open development centers abroad and staff them, in part, with their own people.

Microsoft, the world's largest software maker, has an R&D budget that is also one of the world's largest—some $6.8 billion for fiscal 2004. It operates research labs in China and the United Kingdom, but the bulk of its work takes place in the United States.

"We will push some product development projects to India and China, but the lion's share will stay where it is, because we think the best work force is here," Microsoft's chairman and chief software architect, Bill Gates, said in an .

At the same time, Microsoft and other companies have shown far less reluctance to send entry-level jobs overseas. Opponents of outsourcing say this is a short-sighted practice that raises a difficult question for the future: If lower-level jobs move offshore, how will companies develop their next "rocket scientists"?

"One of the strengths of this country has always been innovation and creativity in the world of software," Denis said. "Now, companies are beginning to worry about intellectual-property drain."

The U.S. technology industry will lose the natural farm teams that have created architects, analysts and innovators for generations, critics warn, leaving companies little alternative but to outsource an ever-rising number of important jobs.

"Here's my biggest challenge," Sanchez said. "Let's talk about 10 years from now. Where am I going to get my systems architects? I work with a number of CIO organizations and with academia, and that is the No. 1 question. I started in code development on mainframes, on COBOL, Pascal and Fortran. If all of the entry-level jobs go offshore, where is the entry point? How do you become a good business analyst?"

Given the political opposition and , some industry veterans believe that the current wave of offshore outsourcing may already have begun to subside.

"Like any other good idea, at first, offshore outsourcing is getting pushed too far too fast," said Andy Oram, of technology publisher O'Reilly & Associates, who is a member of activist group .

"Until the right balance is struck," he said, "a lot of jobs will wash back with the tide." End

CNET's Dinesh C. Sharma in New Delhi and Michael Kanellos in San Francisco contributed to this report.

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