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Gurgaon, India: Over the last year, there has been an increasing buzz that wage inflation is spiraling out of control; in the last few months the buzz has reached a crescendo. Research reports, articles, suppliers, and other community participants have been increasingly sharing anecdotal evidence of 15-20 percent wage inflation in offshore locations like India and the Philippines. This has made buyers taking work offshore increasingly concerned about the sustainability of labor arbitrage, and consequently, offshoring in general, given the core importance of labor arbitrage to the offshoring value proposition.

The big question, then, is: will offshoring's success raise wages in offshore locations so high that it stops making economic sense to move the work there?

The Everest Research Institute collected, analyzed, and studied the data for six months to answer that question. Our April 2006 Global Sourcing Market Update report examined the sustainability of labor arbitrage in between five key locations offshoring work and six key locations receiving that work. The bottom line: the wage differential between the United States and European countries like the UK and France and their key offshoring destinations - India, China, and the Philippines - will remain large enough for offshoring to make economic sense for 20 years or more.

We came to this conclusion by approaching the issue from a holistic viewpoint, as opposed to most back-of-the-envelope analyses which typically analyze the longevity of labor arbitrage only by looking at the wage inflation in offshore destinations.

Reasons Not to Worry

Firstly, it is important to understand that while talking about wage inflation, we have to measure wage changes of the positions or the levels and not of individuals. As employees move up the organizational ladder, a part of their wage change is attributable to the level change. The organization pyramid, however, remains relatively constant over time, making the level inflation more relevant than individual inflation.

Secondly, we found that reported numbers often talk about the maximum wage inflation in an area rather than the corrected average numbers. For example, in Indian call centers last year, senior customer care executives enjoyed the largest rise in wages: 13 percent. But the vast majority of employees (over 60 percent) are entry-level staffers; their wages rose just six percent. So the average wage inflation at call centers was much more muted than widely reported.

Currency exchanges rate trends indicate that the movements are almost invariably in favour of offshoring. This makes sense as macroeconomics (and currency trading) dictates that the currencies of the developed countries will continue to strengthen against those of the developing nations over time and thus help sustain labor arbitrage.

Finally, we believe the offshoring value proposition will evolve beyond labor arbitrage to include elements such as quality and productivity improvements. This will help increase the hurdle rate, allowing for meaningful offshoring even when the wage gap reduces significantly.

Therefore, while wage inflation is happening in offshore locations, its impact on labor arbitrage is much lesser than widely reported. For example, while wage inflation is happening in India, our analysis showed that wages are increasing, on average, about 9-10 percent year over year, both in the IT applications space and the call center spaces, as opposed to the 15 percent-plus numbers often quoted.

Further, wages are increasing in the source countries too. For example, wages in the UK in the IT and BPO services sectors have been increasing at about three percent per annum. Add to that the depreciation of the Indian rupee against the British pound, and the net closure in salaries is reduced to a mere two percent per annum.

The Worst Case Scenario

We wanted to study the worst case scenario if a perfect storm of problems drowned the labor arbitrage advantage. What we discovered was that in such a situation the offshore advantage will dwindle far more rapidly than in the base case. A detailed and careful study of all the factors which can potentially create such a scenario, however, left us feeling confident that such a pessimistic scenario is very unlikely to be realized. Besides the detailed factors used for our analyses, a study of the macroeconomic conditions also strengthened our belief that offshoring is easily sustainable for a long period of time.

We are very optimistic. We believe the worst case scenario is unlikely to happen.

As Mark Twain famously said, "The rumors of my demise are greatly exaggerated." The same can be said for labor arbitrage.

Lessons from the Outsourcing Journal:

• The buzz about labor arbitrage is highly overrated. Except for a couple of destinations, the Everest Research Institute predicts the wage differentials will remain attractive for the next 20 years in most locales.
• Labor arbitrage is dependent on more than just wage inflation in the offshore location. An analysis of other factors led the Institute to predict offshore will make economic sense for quite awhile.
• While labor arbitrage is currently the core of the offshore value proposition, other factors--like productivity increases--will become increasingly predominant, and further increase the viability of offshoring.
• In the event of a large number of factors colluding adversely, the situation could turn against this hypothesis, but the Institute believes this scenario is very unlikely.

How the study was done: The Everest Research Institute developed a holistic framework to analyze the real labor arbitrage movements. The Institute collected data on wage inflation and other factors from multiple sources such as outsourcing buyers and suppliers, human resource agencies and country associations for IT and BPO sectors. Finally, we validated the analyses with a large number of the same sources.

Publish Date: May 2006

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Copyright © 2006 - Everest Partners, L.P.

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