Duke-booz Ornreport Exec Summary

2006 SURVEY REPORT

Next Generation Offshoring The Globalization of Innovation

Arie Y. Lewin Vinay Couto

Booz | Allen | Hamilton

Contents Executive Summary

5

Structure and Demographics of the Report

11

Overall Findings from 2006 ORN Survey

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Drivers of Offshoring

25

Employment Impact of Offshoring

35

The Case of Engineering

43

Location Choice for Offshoring

51

Perceived Risks of Offshoring

63

Comparative Analyses by Industry

71

Comparative Analyses of U.S. and European Companies

83

Comparative Analyses by Company Size

93

The Offshoring Research Network

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Executive Summary

Executive Summary Introduction Offshoring is entering a new era. Companies offshoring white collar jobs have been focused primarily on increasing efficiency by reducing labor costs. The new generation of offshoring is about globalizing innovation activities that require highly skilled personnel and about learning to access and manage talent globally. To examine these trends, the Duke Center for International Business Education and Research (CIBER) has conducted the annual Offshoring Research Network (ORN) survey since 2004.* The 2006 survey results reveal that relocating core business functions such as product design, engineering, and R&D, represents a new and growing trend. Although labor arbitrage strategies continue to be key drivers of offshoring, sourcing and accessing talent is the primary driver of next-generation offshoring. A key reason for the new trend is the looming shortage of highly skilled domestic talent in science and engineering which is beginning to drive companies, in particular those dependent on technology, to search for talent worldwide. This shortage is affecting all the industrialized economies and is creating a global race for talent. This report presents the first in-depth analysis of why and how companies go about globalizing innovation and seeking talent globally, what challenges they face, which onshore jobs are impacted, and how offshoring innovation transforms business practice.

From Offshoring to Globalizing Innovation Until recently, offshoring was almost entirely associated with locating and setting up IT services, call centers, and other business processes in lower-cost countries. The 2006 survey results confirm that although IT application remains the most frequently offshored business function, IT offshoring is reaching the maturity stage. Next-generation offshoring shifts the emphasis to product and process innovation. From 2005 to 2006, offshoring of productdevelopment projects increased by 40 to 50 percent from an already significant base. Over the next eighteen to thirty-six months, growth in offshoring of product-development projects is forecast to increase by 65 percent for R&D and by more than 80 percent for engineering services and product-design projects. These trends suggest that the globalization of innovation activities will be the focus of nextgeneration offshoring. Surprisingly this is also evident for small technology-centered companies. Forty-eight percent of all small companies report that their first offshoring initiative involved product-development projects. Small companies discover that offshoring of innovation projects can significantly leverage limited investment dollars and greatly increase speed to market. Also, in contrast to large companies, small players make extensive use of Web-based technologies in coordinating and collaborating across the globe. A key driver for this new trend of globalizing innovation, however, is the looming shortage of highly skilled domestic talent in science and engineering which has forced companies to hunt for talent globally. * The Offshoring Research Network (ORN) survey was launched in 2004 and 2005 in partnership with Archstone Consulting LLC; it continued in 2006 in partnership with Booz Allen Hamilton.

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The Emerging Global Race for Talent Labor arbitrage and other cost-reduction strategies continue to be the most important drivers behind offshoring. However, the need to gain access to qualified personnel has greatly increased in importance as a driver of offshoring over the past three years. Seventy percent of all U.S. companies responding to the 2006 survey regard access to qualified personnel as an important or very important strategic driver. Companies with extensive offshoring experience that operate in technology-dependent (engineering and science) industries are especially sensitive to this challenge. In fact, U.S. companies with the most of offshoring experience consider access to talent as more important than cost efficiency. Further analyses suggest that the cutback of the H1B visa quota in 2003 served to expose a shortage of science and engineering graduates with advanced degrees in the U.S. that has been building up since 1995. This is a significant factor behind the efforts of U.S. companies to search for talent offshore. In effect, offshoring is no longer about moving low-paid jobs elsewhere; but about sourcing highly skilled talent everywhere. What used to be an exercise in tactical labor cost savings is now a strategic imperative of competing for talent globally. Sourcing qualified personnel offshore is becoming particularly crucial for innovation-type functions. Accessing talent is less important as a driver for companies offshoring non-innovation activities, such as procurement. However, when it comes to offshoring product design, engineering and R&D activities the importance of access to qualified personnel as a driver is very significant. The increasing pressure to access talent offshore and the deployment of offshoring strategies as a means to globalize innovation must, therefore, be seen as parallel, mutually reinforcing trends.

Offshoring Innovation Is Not Associated with Job Losses Onshore In the near term, contrary to various claims, fears about loss of high-skill jobs in engineering and science are unfounded. The Duke-Booz Allen Hamilton 2006 survey results suggest that as offshoring of higher-skill jobs expands, fewer jobs are being eliminated onshore. The percentage of offshore projects resulting in onshore job losses has decreased by 48 percent since 2005. More significantly, the number of jobs lost onshore per offshore project has dropped by 70 percent. In particular, 90 percent of all R&D offshore implementations created no job losses onshore. These results, however, reflect only partially what is happening. Higher-skill functions are offshored to support innovation-centered growth strategies, partly because of the cost advantage of sourcing talent globally and partly as a response to the perception of a longrunning shortage of talent onshore. To remain competitive in a world characterized by a global race for talent, U.S. and European companies will need to adapt to new organizational realities: innovation-centered activities will require the integration of knowledge-creation capabilities of globally dispersed teams and, increasingly, offshore workers will become responsible for and specialize in higher-skill functions. Companies will have to prepare their onshore employees to rethink their roles, learn to cross institutional and cultural boundaries, communicate and collaborate within international teams, and compete with remote counterparts. In effect, although fewer high-skill jobs will become redundant, the very essence of jobs will change as innovation activities are reorganized globally.

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Where You Offshore Depends on What You Offshore Reflecting the trend towards globalizing innovation, offshore locations themselves are becoming more specialized in providing the best conditions for particular offshore operations. Although India remains the most preferred offshore location across functions, other countries, such as China and the Philippines, as well as Canada and Eastern European nations, have developed certain comparative location advantages in the offshore space. China is emerging as the preferred location for offshoring procurement and productdevelopment projects, to a large extent because of its large and growing domestic and foreign manufacturing base. Thirty-one percent of all procurement projects and 18 percent of all product-development projects (mostly implemented in manufacturing bases) are located in China. Notably, taking together all offshore implementations in China, 41 percent involve product development. By contrast, the Philippines is emerging as a preferred location for U.S.focused contact centers and administrative business processes. Canada and Eastern Europe are the most preferred nearshore locations for U.S. and Western European companies, respectively, despite relatively high wage levels as compared with India or China. Canada is attracting contact centers, financial services, and other business processes, whereas Eastern European locations are chosen for product and process innovation. German companies, in particular, prefer Eastern European locations because of cultural and linguistic proximity and closer managerial control. U.S. companies, by comparison, have a preference for offshoring in India, Latin America, and the Philippines. This is because, these locations provide large pools of English or Spanish speaking talent in addition to cost advantages.

How Offshoring Transforms Business Practice The new management frontier of globalizing innovation-centered activities will fundamentally transform company business models and their organizational structures and processes. Three challenges stand out, which Companies are beginning to address: managing and controlling far-flung innovation processes, managing talent globally, and learning to collaborate and compete with a continually evolving mix of local and international service providers. 1. Managing and controlling globally dispersed innovation processes Loss of managerial control and operational efficiency are some of the most frequently cited risks and challenges. This is the case for both companies with offshoring experience and companies still considering whether to offshore their first project. Unlike many location-related risks, such as cultural differences and language, internal organizational process issues have surged in importance over the last three years. As offshore activities become more varied and complex, involving higher-skill product- and process-innovation type functions, direct managerial and operational control become more difficult to sustain. The leading-edge companies are experimenting with new organizational forms, Web-based collaborative tools, and with augmenting direct coordination with self-organizing locally adaptable structures and processes. All of this is intended to facilitate the work of globally dispersed organizational units and groups. It is clear from the 2006 survey data that companies with extensive offshoring experience have to some extent developed such capabilities, which is reflected by much lower concern with risk associated with loss of managerial control and operational efficiencies.

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2. Recruiting, developing, and retaining talent globally The coming global race for talent will challenge companies not only to learn how to source talent globally, but also to experiment with and develop new human resource strategies and practices. These practices are designed to continually develop the potential of individuals and teams, and provide longer-term career opportunities within the company or third-party providers. It is not an oversight that companies with extensive offshoring experience cite employee turnover as a new key risk. Rising employee turnover serves to signal that effective global human resource strategies and policies are difficult to set up and operationalize. Some managers recognize the importance of obtaining buy-in from investors regarding crucial aspects of managing commitment and loyalty, wage and career expectations, and identity and prestige within and across cultural boundaries. More than ever, companies need to nurture strong organizational cultures and identities that help integrate employees spread across diverse locations and find a balance between a globally integrated human resource policy and locally adaptable practices. 3. Collaborating with local and international service providers As offshoring becomes an integral element of the new business models and as offshoring practices disperse and become widely accepted, local and international service providers will also increase their professional capabilities and vie to become offshoring partners. Large companies experienced with offshoring are managing a variety of relationships with service providers and demonstrate a clear preference for locating innovation activities within captive offshore organizations. In contrast, many small companies rely on professional service providers to not only provide necessary capabilities, but also absorb many of the risks associated with implementing offshoring strategies. More than half of all companies considering offshoring intend to collaborate with international third-party service providers. This will necessitate the development of collaborative capabilities (e.g., the capability to assess and use the service-provider partner’s strengths and resources), the integration of service-provider partners’ employees into hybrid interorganizational teams, as well as the creation of new governance mechanisms for effective collaboration. In the longer term, companies in the industrialized economies will need to redefine the scope of their global operations and reassess their potential location advantages (e.g., in regard to accessing talent) as local competitors and service providers around the globe become both partners and competitors.

Conclusion The emerging global race for talent is driving companies to globalize innovation through offshoring strategies in order to sustain growth and remain competitive. To make the best use of location advantages across the globe, such as talent pools and innovative geographies or communities, companies need to establish new organization designs and practices for coordinating, managing, and integrating globally dispersed operations and teams. However, globalizing innovation through offshoring is only the next stage in what is destined to become a fundamental transformation process that will affect companies and regions alike. This report addresses key issues that are now emerging as this process unfolds.

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About the Offshoring Research Network (ORN) ♦ The Offshoring Research Network (ORN) is currently a joint effort of the Center for

International Business Education and Research (CIBER) at Duke University’s Fuqua School of Business and the global consulting firm Booz Allen Hamilton Inc. ORN represents the centerpiece of the CIBER effort to advance competitiveness of American companies. The ORN survey was launched in 2004 and 2005 in partnership with Archstone Consulting LLC; it continued in 2006 in partnership with Booz Allen Hamilton. The Booz Allen Hamilton lead corporate sponsorship made possible expansion of the ORN multiyear study to European countries in 2006 and to Japan, South Korea, and Singapore in 2007. ♦ The multi-year ORN survey and panel study collects firm-level data on the

offshoring experiences of companies across industries by offshored project • The survey sample includes companies currently offshoring, companies considering it, and those that have decided not to offshore • Research focuses on key performance metrics, sources of value, risks, reasons for offshoring, functions offshored, locations chosen for offshoring, and future plans • All the data in the survey is based on actual company experiences with specific projects or functions that have been offshored or will be offshored in the future • Survey participants are carefully screened and information provided by service providers and any outlying data is weeded out to maintain the integrity of the data • A new, separate service providers survey will be conducted in early 2007 ♦ Duke University maintains strict and total control of the raw data and the statistical

analyses to ensure the integrity of the entire process ♦ Together Duke University and Booz Allen Hamilton offer academic rigor and

practitioner relevance About the 2006 Annual ORN Survey ♦ The 2006 survey was released in June 2006 and completed in August 2006 • For the first time, the survey included companies in the United States and the European Union. Copenhagen Business School, Denmark; WHU University, Germany; Rotterdam School of Management, Erasmus University, Netherlands; IESE, Spain; and Manchester Business School, U.K., were partner educational institutions that helped conduct the study in Europe. • The online survey instrument includes detailed questions by specific function offshored, location, offshoring model, etc. ♦ The construction of the sample involves multiple strategies: • Fuqua and Booz Allen alumni were asked to identify individuals within their companies responsible for offshoring strategy or for offshoring implementations, and then solicit them to complete the survey • In addition, the following organizations invited their members to complete the survey: The Conference Board, International Association of Outsourcing Professionals, International Association of Contract Commitment Management, Shared Expertise, CIO Executive Council, Council for Entrepreneurial Development, Training Outsourcing, and the Enterprise Software Roundtable • Booz Allen Hamilton invited clients to complete the survey, and ORN partner universities reached out to their corporate and alumni network requesting participation in the survey • Finally, some participants found the survey via Internet searches

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academic rigor &

managerial relevance