ORIENT EXPRESS
Outsourcing to China and India is starting to go beyond IT services and into core tasks.
By Abe De Ramos

Cost cutting is the new religion for Alcatel, but the path to enlightenment has been a painful one. Following US$11 billion in losses in the two years since the technology bubble burst in 2000, the French telecommunications equipment maker adopted a regime of attrition and outsourcing as its road to sartori. The cuts had to be deep, and indeed they were: by the middle of this year management had slashed fixed costs by 35 percent to US$1.4 billion. But it is within the realm of outsourcing that the company has acted most effectively - and found ecstatic results. Alcatel devoted the relatively meager sum of US$100 million to build a brand new R&D center this year, employing 2,000 engineers. The move has saved money while simultaneously bolstering quality in one of the firm's core activities. If that sounds like a lot of bang for the buck, it is - and that's because the R&D center is based in China.

CFOs still wondering whether or not to send back-office functions offshore are already far behind the outsourcing vanguard. Many western companies have moved IT services and rote business processes eastward (see box below, "China Wants Your IT Jobs Too"). Increasingly, they are also migrating high-value technology functions that reside at the core of businesses - from the development of Banias, the next-generation mobile processor by Intel in Israel, to the wireless internet infrastructure by Nortel Networks in India. As expected, cost advantage and a vast talent pool are driving the trend. "China offers a very cost-competitive talent pool of R&D engineers," says Christian Gregoire, chief technology officer at Alcatel Asia Pacific.

Although estimates are scant, the movement of high-end jobs by Western companies to Asia - ranging from medical transcriptions to architectural designs to investment research - can only accelerate, says Partha Iyengar, a research director at Connecticut-based consulting firm Gartner. "In places like the US, manpower costs are becoming quite prohibitive," Iyengar says, "and in some [functional] areas, there is a realization that quality may be better in India than the company may be able to achieve [in the US]."

To be sure, there is also a strategic reason why Alcatel is locating R&D activity outside the West: it is betting on third-generation (3G) mobile infrastructure, and with about 235 million subscribers, China is the world's largest cell phone market. Although China will have a 3G standard different from Europe and the rest of Asia, Alcatel is developing 3G technologies for a global rollout rather than just tailored for the Chinese market.

"Our goal is to develop China as an R&D center not just for China, but for the rest of our global business," says Gregoire. In fact, the US$18 billion-a-year group chose Shanghai as its first site for 3G research outside Europe, where it has facilities in Paris and Stuttgart. This facility has access to Alcatel's global technology pool, and all projects in China are planned and performed under the same system, and with the same objectives, as other R&D centers worldwide, says Gregoire.

The trend is not restricted to large companies. California-based E.piphany, an US$83 million a year provider of customer relationship management software, currently outsources 15 percent of its R&D workforce to iNova, based in Bangalore. It expects to bring this to 40 to 50 percent by the end of 2004, possibly split between India and China. "What really led us there initially was our desire to have the most cost-efficient, quality R&D organization we can have," says CFO Kevin Yeaman.

This kind of outlook has fueled concerns in the US. Ron Hira, chairman of the R&D policy committee of the Institute of Electrical and Electronics Engineers USA, told lawmakers in a June testimony that the decentralization of R&D - away from the old-style Bell Labs and into global outsourcing - brought unemployment rates in the profession to unprecedented levels (7 percent in the first quarter of 2003). The rate eased in the second quarter, "but the raw unemployment numbers mask the shift that people are out of work for many more weeks, months, even years before they can even get jobs," says Hira.

No one has yet established that the R&D jobs being created offshore result in a one-for-one loss of the same positions in the US. Kathleen Walsh, senior associate at the Henry L. Stimson Center, a Washington, DC think-tank, argues that the offshore centers are supplemental, although that may soon change. In a report published in July called "Foreign High-Tech R&D in China", Walsh notes the rapid increase in R&D centers in China since the early 1990s (see chart, page 38). This, she says, was due to the opening up of the Chinese economy, and the opportunities that western companies saw in selling their products to the local market.

Although they came in droves, these R&D centers initially did basic work, and were only set up to develop guanxi. "They weren't really interested in the R&D itself, but in being in the China market," says Walsh. As their market interest grew, the motivation for R&D build-up changed. "Today these centers are more driven by strategic interests of the multinationals, and we see actual R&D, mostly in technology development, than basic, product research," says Walsh, adding that companies now send R&D activities offshore and "hope they do good work."

"[The moves are] experimental in many cases, so the jobs are supplemental. It's not like we're going to pick it up and move it over there. It may come to that at some point, but I don't gather that that's going on."

UTStarcom, a US-based telecom equipment company with about 1,400 engineers in China and India, seems to support that argument. "It's not really a question of migrating jobs from the US to China," says CFO Mike Sophie. The company has 400 engineers in the US, who divide development work with Chinese and Indian counterparts. Sophie says there are no plans to reduce the US headcount, but there are no plans to increase it, either. "We want to drive the growth of our engineering in China and India," he says.

It's these offshore gains that come at the expense of US engineers, Hira points out. "To say that Intel or somebody else is moving R&D offshore is not going to have some kind of adverse impact in the US is wishful thinking," he says. "If they're going to spend US$100 million over there, they're not going to spend US$100 million over here."

That may be. But as far as CFOs are concerned, it's all for the good of their P&L statements. Sophie says UTStarcom's R&D cost offshore is about 25 percent of what he would have spent in the US. This brings his R&D cost down to just 10 percent of sales. "If we were to assume that all those engineers were domiciled in the US, our R&D would be well over 15 percent of revenues."

Offshoring vs. Outsourcing

Similarly, E.piphany's Yeaman has no qualms about outsourcing R&D to India and China. "I can't tell you what might take the place of the development jobs which inevitably are going to be transferred offshore," he says, "but I can tell you that we need to do what's best for shareholders, and that is to have the most efficient development organization while maintaining the quality it takes to be an innovator in the industry." The inevitable difficulties involved with management of outsourcing relationships, such as long-distance staff management, have led some companies to use the "offshoring" model of outsourcing R&D, in which companies establish their own subsidiaries rather than farming out the work to third-party companies. Larger companies also prefer full ownership to ease the risk of infringement of intellectual property rights (IPR). In China, multinationals formerly did much R&D in joint ventures with Chinese firms or universities, says Walsh. Now they are abandoning this model in favor of wholly-owned enterprises, "to make sure anything they develop in the R&D centers are their own property."

In third-party outsourcing arrangements, US companies ultimately have little power over IPR protection. While Yeaman says iNova's IPR protection measures are strict, the exposure to risk is enough for E.piphany to explore the possibility of full ownership. The company is now analyzing whether to continue the fully-outsourced set-up, establish its own presence in India, or a mixture of both, "which would entail working with an outsourcer to build an operation where the intent would be for us to take it over down the line," says Yeaman.

The CFO is studying the cost and operational implications of each option, and expects to have a final decision by year's end. All options could work in India, where the IT market is mature and which has more established outsource providers. However, China also has a time zone advantage: the 15 hour difference between California and China, versus 12 hours between California and India, adds to the amount of time that US and offshore engineers can collaborate. Whatever E.piphany finally decides, Yeaman is confident the cost advantage will be substantial. Year-to-date, E.piphany's R&D costs have accounted for 35 percent of revenues, versus over 40 percent last year. "Ultimately, we expect to spend somewhere in the neighborhood of 15 percent on R&D," he says.

Given such promise, it's easy to predict that offshoring of R&D could only grow. Iyengar of Gartner says the next wave of outsourcing could be for big pharma companies in the US and Europe to choose India as an offshore location for downstream drug discovery efforts. Last June, AstraZeneca, the British pharmaceuticals company, announced it is increasing its US$10 million investment so far in India by another US$30 million, for the development of new treatments for tuberculosis. "This is a very expensive process, and heavily dependent on high-quality PhD 's, which are in abundance in India," Iyengar says.

To Yeaman, it all makes economic sense. "If you're going to have the most cost-efficient structure, you need today to have an offshore presence."