On October 30 Cisco chairman John Chambers will be in Bangalore to unveil the San Jose-based company’s $50-million campus that sprawls across 14 acres. The integrated high-tech facility will be the new home for 3,000 Indian workers across R&D, IT, sales and customer support teams.

Compare this scenario with media reports over the summer that some Silicon Valley companies were starting to pull jobs back from Bangalore to the U.S. The Wall Street Journal wrote on July 4 that firms such as Riya of San Mateo, Kana Software of Menlo Park and Teneros of Mountain Lakes have wound up their Indian operations and are moving engineers to the U.S., largely because of frustration over rising wages for Indian engineers and difficulties in retaining them.

Cisco and Riya present contrasting faces of the offshore outsourcing business in India today. While large companies like Cisco, IBM and Accenture are expanding their operations, smaller Silicon Valley startups are finding it increasingly difficult to sustain their operations.

Outsourcing jobs to India has become increasingly difficult and expensive in recent times. Since January, the Indian rupee gained more than 11% against the U.S. dollar, eroding the cost advantage of Indian offshoring firms. In addition, these firms face wage inflation, high workforce attrition, paucity of talent and increased operational costs. Profits are down and the stock prices of Indian IT companies are falling; for the first nine months of this year while the Sensex rose by 32.47%, the BSE IT index fell by 13.08%. According to P.V. Kannan, CEO of 24/7 Customer, a 6,000-employee outsourcing services firm headquartered in Los Gatos, Calif., many business process outsourcing (BPO) companies have seen about half their profit margins evaporate as a result of rising costs. He says BPO firms typically earn net margins of 14% to 15%, and every 10% decline in the dollar’s value eats up 6% to 7% of those margins.

Do the decisions of these Silicon Valley companies represent the start of a trend in which jobs that moved to India will now return to the U.S.? Or are they exceptions to the norm that will fail to stem the tide of service jobs moving to India and other low-cost countries from the U.S. and Europe? In an effort to answer these questions, The Economic Times, India’s largest business daily, and India Knowledge at Wharton interviewed executives in Silicon Valley and other high-tech centers in the U.S., venture capitalists, consulting firms and Wharton faculty. Their answer: Despite the difficulties, India still offers IT and engineering talent at a relative cost advantage to U.S. firms, and so the country will retain its appeal as an offshoring destination. That trend is unlikely to end anytime soon.

Captive Costs

According to Indian IT executives, it is primarily the captive units of U.S. companies that have been hit hardest by currency appreciation and wage inflation, rather than companies that provide third-party outsourced services to clients. S. Gopalakrishnan, CEO of Infosys, cautions against “generalizing” from the incidence of some firms pulling back their teams from India. He says western companies that set up captive units in India tend to bring in high costs to the captive unit. “They actually pay a little more [than prevailing wages] and their recruitment practices are more costly than at Indian companies,” he says.

In addition to recruitment practices, captive units also need a certain minimum scale to make their model work. “The problem with the captive units’ model is that the fixed costs are very high, so it is not feasible for small companies that have requirements for only 30 to 50 people,” says Sumir Chadha, managing director of the Indian operations of venture capital firm Sequoia Capital in Menlo Park, Calif. He says the captive offshoring model doesn’t work if a company’s requirement in India is less than 80 people.

Ravi Aron, a senior fellow at Wharton’s Mack Center for Technological Innovation and an expert on outsourcing industry trends, says that the wage inflation Riya and Teneros faced is the result of a talent shortage and that it varies across various levels of staffing. Project managers are in very short supply, but the problem is less acute in the case of lower-level jobs such as project leaders, systems analysts and programmers. “Project managers have the trifecta of business skills, client-facing skills and management skills,” he explains. “India has a shortage of managers who combine those three skill sets.”

If some Silicon Valley companies find it difficult to sustain their Indian operations, that is part of their normal evolution as with “any idea that works and grows rapidly,” says Gururaj (Desh) Deshpande, an investor in technology startups that have facilities and employees in India. He is also chairman of Sycamore Networks, a networking and telecommunications products and services company in Chelmsford, Mass., with 2007 revenues of $156 million.

The reason, says Desphande, is that some companies that try outsourcing to cut costs “fall into the trap of not quite knowing how to do it, or because they don’t have a long-term commitment or the right talent.” He says the companies best positioned to sustain their outsourced operations in India are those that have large teams or those with specialized products or services that can command premium pricing. Kannan of 24/7 believes outsourcing services providers that “don’t have the conviction and ponder over every issue” are walking the line of a self-fulfilling prophecy. “If you don’t know how to make it work, don’t blame the model,” he says of the offshoring units that pulled back their India teams.

Pari Natarajan, CEO of Zinnov Consulting, a market research firm, also discourages clients who want to set up small teams of 20 to 30 people in India; he believes a captive unit makes sense only if it has at least 150 people. Zinnov says 160 of the 440 captive R&D centers in India are small operations with between 50 and 100 people each. “Most companies overlook the soft costs associated with managing the remote teams and calculate the savings solely based on the indirect cost saving,” says Natarajan. A Zinnov report on the “Top 10 Myths around Offshoring” says the biggest myth is that companies can save 70% to 80% of their costs by offshoring.

Outsourcing for Outsourcers

Chadha advises promoters of the smaller captive units to source their requirements from the larger third party service providers. Sequoia has invested in GlobalLogic, a provider of product development support based near Washington, D.C., which has taken over a few captive units in India. The firm has 1,500 employees in India and another 500 in Ukraine.

“We have started a line of business taking over a number of those captives,” says Peter Harrison, CEO of GlobalLogic. “You have heard of the BOT (build, operate and transfer) model; we call it TOB — transfer, operate and build,” he says. In such deals, GlobalLogic absorbs the captive unit’s employees on its own payroll and takes over its projects.

Harrison says in two cases involving a total of 120 employees, his firm has cut costs by 10% to 20%, improved performance by 20% to 50% and cut attrition from 50% annually to less than 20%. “We could probably take five or 10 more of similar size this year,” he says. He reckons that about 40% of the 400 to 500 captive units in India are experiencing wage inflation and struggling to cope with that. “The business model for small captive units is changing to one of partnership with firms like us,” he adds.

Captive units also don’t have bargaining power with their employees because they are small, says Harrison. “People hold you hostage; losing one person can really be critical.” But he also believes that concerns about rampant wage inflation in India are exaggerated. “Most people don’t understand the difference between the increase in salaries and wage inflation. Wage inflation refers to how much your average salary has changed, assuming the average experience of your employees stays constant.”

At Infosys, Gopalakrishnan says his model accommodates annual wage increases of 13% to 15%, adding that the “net impact on overall cost to U.S. clients is only 2%.” When contracts come up for renewal, his clients are willing to increase rates by that level. “Inflation [in the U.S.] is at an annual rate of 3% to 4%, so it is not something that the client would dispute,” he adds.

Apart from the problems of captive units, India’s IT software and IT-enabled services industry appears to be in fine shape. Indian exports of software and services grew 33% to $31.4 billion in the latest financial year to March 2007, according to the annual survey of the National Association of Software and Services Companies, or Nasscom, released in July.

Nasscom forecasts that the country’s IT software and IT-enabled services industry, including the domestic market, will continue growth in the current year at 24% and 27%, respectively. India’s share in the global offshore business process outsourcing (BPO) business has grown from 39% of $2.3 billion in 2001 to 47% of $13.4 billion in 2006, according to Noshir Kaka, the Mumbai-based director and global practice leader at consulting firm McKinsey’s outsourcing and offshoring practice.

The BPO industry employs some 1.6 million people. Three-quarters of them (1.2 million) work directly or indirectly for foreign clients; that number grew 34% in the past year, and Nasscom says that is in large part because India brings “28% of the suitable talent across all offshore locations” worldwide.

Currency Movements

Even as those numbers appear promising, investors like Sequoia are worried about the impact of a stronger rupee on the fortunes of the companies in their portfolios. Chadha describes it as “the biggest whammy for offshore companies.” Besides depressing their rupee earnings, he says the stronger rupee reduces a company’s valuation by 20% to 30%. The rupee appreciated 8% against the U. S. dollar between 2004 and 2006, versus 7% for the Filipino peso and 3% for the Chinese yuan, according to the McKinsey survey.

Sequoia has invested more than $100 million in nine Indian companies in the offshoring services sector. Chadha says he now wants to fund “high value businesses in the offshore space where the bill rates are high,” such as legal outsourcing firm Pangea3 in Mumbai that he says commands between $35 and $45 an hour.

Shiva Ramani, co-founder and CEO of CSS, a provider of remote IT infrastructure and enterprise technology support based in San Jose, Calif., notes that the Indian outsourcing services industry is experiencing robust demand, adding that his firm is on track to achieve $100 million in revenue this year, which would represent a 60% to 70% increase over last year. CSS specializes in servicing the financial services and telecommunications industries, and has 4,250 of its 5,000 employees in Chennai. The rest are spread across offices in Silicon Valley and Singapore.

Despite the stronger rupee and rising wages, Ramani adds, Indian outsourcers continue to have a labor cost advantage. “The wage arbitrage may have changed from 1:3 in the late 1990s to 1:2 or so now,” he says, referring to Indian wage levels versus those in the U.S. Still, India does have a relative cost advantage, he explains.

R. Ravishankar, the New York City-based vice chairman of i-flex Solutions, a provider of IT products and services to the financial services industry, sees the situation differently. He says i-flex has from its inception in 1991 avoided using India’s wage arbitrage and exchange rate differential as the basis of its business plan. “We knew that whether it is the currency movement or labor arbitrage, it is not going to last forever,” he says.

The strategy i-flex adopted was to invest in building products and upgrading the skills of its employees, Ravishankar notes. He claims the firm’s FlexCube and Reveleus banking software products are top sellers in their industry segment. “We established quality as a major differentiator, and not lower cost,” he says. “When your brand gets leadership and visibility, it gives you pricing power.” The company had revenues of $472 million for the financial year ending March 2007. Some three-quarters of its 10,000 employees are based in India.

Changing Pricing Models

Infosys is working on a non-linear model — one where growth in revenue and margins doesn’t depend solely on its head count. Gopalakrishnan says he is trying out alternative pricing models, such as those based on risk-reward equations, “because we want to share in the upside with the client.” Similarly, Infosys is also pitching value-based models or transaction-based pricing where it gets paid for the volume of work achieved and not for the number of people assigned to a project.

The pricing power of Indian service providers has moved in cycles, says Gopalakrishnan. It was at its peak during the Internet boom of 2001, and then it declined during the next four years before picking up again in 2005. “If you look at the last five quarters, you will find that we have been able to increase revenue per employee quarter upon quarter in the last five quarters,” he says.

Pure-play BPO services firms like 24/7 that don’t have the higher-margin software services find other ways to tackle a stronger rupee. “One way is to get paid in rupees instead of dollars,” says Kannan, adding that his multinational clients with an Indian presence don’t mind that. His firm has also invested in long-term hedges to dodge future dollar declines; he says that limits the impact on net margins to 2% to 3%.

Management consulting and outsourcing services firm Accenture is also moving away from pricing its services on a per-transaction basis to one that is “outcome-based,” says Pankaj Vaish, managing director of its BPO delivery center network in Bangalore. He cites the efforts to inject technology into various processes and standardize them to “achieve higher volumes without proportionately increasing head count.”

According to Desphande, an emphasis on specialized talent has worked well for Tejas Networks India, a Bangalore-based maker of optical networking products where he is the lead investor and chairman. He claims that Tejas’s 500-strong team has “five times the talent of any group in the world” in its specialty. Two months ago when Tejas went on a campus recruitment drive for 72 positions, 60 of those it hired were graduates of the Indian Institutes of Technology.

Another longer-term solution Aron points to is for companies to specialize rather than trying to do everything from documentation, training and testing to higher value assignments. He says that strategy will bring about “an industrial ecosystem instead of vertical behemoths.” Companies that specialize will also find themselves less impacted by pressures on margins, he notes.

Chadha believes investing in products is a sound strategy for IT companies because the margins can be between 60% and 80%, insulating them from the rupee appreciation. However, he says, they face problems in their ability to find talent. “There are not too many engineers in India who can understand product creation for the U.S. market, which is why that model hasn’t taken off in a big way.” According to Aron, only one-fourth of India’s engineering talent pool has the ability to work for western clients, directly or indirectly. Further, he says, “only a tenth of Indian engineers have the ability to work directly for a multinational company like Motorola, Intel or Microsoft.” The primary reason is their lack of familiarity with the global business environment.

Growing Demand

Every industry spurs the demand for engineers in India, says Asim Handa, the New Delhi-based country director in India of FutureStep, a division of executive search firm Korn/Ferry. The shortage of talent is pronounced, he says. He estimates that just about a fifth of the engineers graduating each year — about 80,000 — “are really employable,” and that they get absorbed quickly. “Just Wipro, Infosys, IBM and TCS will hire more than 80,000 engineers in any given year,” he notes.

“There is a supply side solution to this,” says Aron. “Greatly increase the pool of engineers through training and through colleges. This solution is being ignored.” If the Indian government ramps up its educational infrastructure and doubles or triples the number of engineers it puts out, he predicts that “the rupee issue will go away and will become a non-issue.”

India could potentially play “a pivotal role in the coming global war for talent,” says Saurabh Tripathi, principal and director at the Boston Consulting Group in Mumbai. “It is high time we stop calling this industry offshoring,” he says. “It is about companies creating a strategy in the context of globalization and how they decide what [operations] should go to India or China or elsewhere. That is the thinking that is now evolving.”

What’s Next?

In times to come, Aron says, India will lose market share in call center services to Vietnam, Cambodia, the Philippines, the Caribbean, South Africa and the French-speaking markets of Mauritius, Tunisia and Morocco. He also sees countries like Slovakia, Poland and Estonia emerging as stronger near-shore alternatives for companies in northwestern Europe.

The large Indian IT companies recognize that trend and have begun setting up operations in those markets. TCS has facilities in Latin America and is also eying Morocco. Infosys recently set up shop in Mexico, and Wipro has a presence in China.

GlobalLogic’s Harrison is convinced that it doesn’t makes sense for companies to worry about rising wage levels in India or spread their outsourcing bets across several markets. “We see companies now go to China and Latin America because they’re worried that in two or three years India will become too expensive,” he says. “They’re completely wrong; they don’t understand. They don’t realize that IT engineers account for less than a tenth of a tenth of the population of India. We’re talking about a tiny, tiny fraction of the country’s total workforce.”

Infosys has also placed some of its bets on China, but that strategy has its wrinkles. Gopalakrishnan says wages in China tend to be actually higher than in India, but Infosys wanted to go there to both tap the Chinese market and create an alternative to its Indian operations in the long term. “We must have some options if the ability to recruit in India at some point” is compromised,” he says.

Gopalakrishnan has found that his clients in general did not share Infosys’s confidence in China. “India continues to be the number one location from the security perspective, and it has service providers that are able to manage large relationships,” he says. “We try to push China to our clients, with Chinese employees, with the Infosys name and with Infosys systems and processes. But it is still very slow to take off with our clients.”

Deshpande says that companies have little reason to press the panic button on India. Concerns about the future of India as an outsourcing destination remind him, he says, of the doomsayers who periodically predict the death of Silicon Valley. “Every few years you hear the same story when things start going wrong,” he says. “People grumble about traffic jams, the cost of living, the difficulty in hiring people, attrition, and so on. But to counterbalance those factors, Silicon Valley has a critical mass that is just amazing. It just keeps growing, right?” Deshpande believes that outsourcing in India “will see its share of failures — like Silicon Valley — because there will be a lot of experiments. Still, the toughest will survive.”