Wage Inflation Sinks Offshoring for One Startup

The outsourcing and offshoring of software development work has become such an ingrained part of the technology industry in the U.S. that stories about it no longer rouse the public's interest as they did even a few years ago. That means the only way to gauge the growth of the phenomenon is by watching the bottom line of outsourcing giants like India's Wipro, which recently reported a 41 percent jump in revenue in its latest fiscal year, and the heated debate in Washington over the number of H-1B high-tech visas that the federal government grants.

But the runaway growth of offshoring has created its own problems in countries like India, where a substandard infrastructure and stiff competition for talented workers has changed the economics of setting up shop outside the U.S.

The decision to hire a staff in India "wasn't even a second thought" when Munjal Shah, CEO of Riya , was laying the groundwork for his visual search startup back in 2004. (Riya is part of InfoWorld's Month of Enterprise Startups feature.)

"At 30 percent wage rates [the ratio of an Indian salary to a U.S. salary], it still was worth the communication overhead, the travel, and the late-night conference calls," Shah recalls.

Those were the good old days. Today, wages in India have risen so much that maintaining development operations in Silicon Valley and India no longer made sense, forcing Riya to make what seems like an unusual decision: In April, the company nixed its Bangalore operations and consolidated operations back in the company's Silicon Valley headquarters.

In the end, the cost advantages of lower Indian wages did not outweigh the efficiency losses that came from maintaining some 35 employees in two offices, 12 hours apart, Shah said. 

Indian software development shops have been the workhorse for countless high-tech firms and U.S. enterprises for more than a decade. But steady demand for development talent is erasing some of the cost advantages that offshore development outfits have enjoyed, according to a report by Gartner. In fact, the wage rates for Indian software engineers will reach between 40 to 50 percent of Silicon Valley wages by 2008 with the gap continuing to narrow after that. 

Wage increases for Indian engineers averaged 15 percent from 2005 to 2006, compared with a 3 percent average increase for U.S. engineers, according to a recent Gartner report. That's not to say that things will be even-steven any time soon, though. "Even if Indian salaries continue to grow at 15 percent annually, it would take 16 years for Indian software engineers to catch their U.S. counterparts," the report says.

But wages among startup employees have been growing much faster than that, especially among top engineers in Bangalore, Shah said. A native of India, Shah paid a premium to hire experienced graduates of the prestigious Indian Institute of Technology. Unlike IBM or Infosys, a startup doesn't have the resources to train the brand-new graduates who would work for smaller salaries.

"Startups aren't places where you train people from the ground up," Shah said. "They're places where either you know what you're doing or you don't. We paid to hire the best."

To that end, Shah said, wage increases among his engineers in Bangalore tended toward twice the national average. "Salary increases have been 30 percent for more than a year now," Shah said; the engineers who lost a job when Riya decided to close the Bangalore office all have received multiple job offers with significant wage increases, he said.

Differences in the high-tech cultures of the U.S. and India also play a part. Indian workers are less likely than their Californian counterparts to be wooed by the prospect of working for stock options instead of cash. 

"In Silicon Valley, you see your friends from Google driving around in new Ferraris, and you think, 'Huh, occasionally this actually works,'" said Shah. "But there's no comparable value for options [in India]." 

And without the lure of options that might someday make a software engineer wealthy, money isn't just one reason for a Bangalore engineer to join a company -- it's the only reason. 

"If you can't build a core loyalty with options, then you're in for a tough time," said Keerti Melkote, cofounder of wireless LAN hardware company Aruba, which went public in March. Aruba tried outsourcing to India shortly after the birth of the company in 2002 but found that it slowed down operations too much for it to be worthwhile. 

"You need a critical mass for offshoring to work -- a whole project as opposed to part of one project -- and for a startup, offshoring might not make sense. Especially now, the loaded cost of all the late-night conference calls is high enough that it might not make sense."

Melkote said that with its growth in the last few years, Aruba can now afford to support a fairly autonomous Indian operations center in Bangalore. But startups don't have that option.

"We found that if you gave a guy less than a 30 percent salary increase every year, then he'd walk," Shah said. "By the middle of this year, we would have been paying [the Indian engineers] 75 percent of a U.S. salary, and at that point, it doesn't make sense because of all the other overheads that take away from productivity."

What kinds of overheads you ask?

"On average the power probably goes out three or four times a day," said Fran Karamouzis, a research vice president at Gartner who specializes in outsourcing issue.

"You get surges for 15 or 20 minutes, and if you don't have adequate power supplies, then that's a big issue." That's a big issue for startups, whose employees often work odd hours from home, Shah said. 

Of course, infrastructure problems are nothing new and are considered par for the course in India, but with competition from China, Russia, Eastern Europe, and even Vietnam and Africa, unreliable infrastructure is starting to cost India business, such as Intel's recent decision to locate a $2.5 billion chip plant in China.

The nature of work at a startup makes them even less tolerant of those kinds of risks than companies like Intel.

"If you're a startup and you're doing a lot of iterative design and you constantly need a higher level of agility, you might find it more burdensome than the cost differential is worth," Karamouzis said.

On the other hand, "If you can give the Indian team things that are clearly delineated that they can own and drive on their own, then it works out pretty well," said Pejman Roshan, cofounder and senior director of marketing at Agito Networks, a wireless technology startup in Sunnyvale, Calif. that outsources software coding to a services firm in Bangalore. Roshan acknowledged, though, that the wage gap is shrinking.

"I'd heard there was a five-to-one [ratio of Silicon Valley wages to Bangalore wages], and we were salivating at that notion," Roshan said. "We're seeing a three-to-one benefit, and we're still happy with that."

Riya's Shah is confident that moving the company's operations back to the U.S. was the right move and expects to see more companies doing the same in the months ahead. 

"We might be a little bit ahead of the curve in our decision -- maybe six to 12 months -- but I don't think wages are going to stop rising," said Shah, who detailed his decision in his CEO blog, Recognizing Deven. "I don't think we're isolated."

Still, despite wage increases, new startups aren't likely to rule out Indian operations any time soon, Gartner's Karamouzis said. In fact, they may have to consider such operations in order to get venture capital.

"More often than not, what I hear is that venture companies are almost demanding that [startups] leverage India or Russia both to optimize the cost structure and to maximize a 24-hour cycle to get things done faster," Karamouzis said.

This story, "Wage Inflation Sinks Offshoring for One Startup" was originally published by InfoWorld.

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