An opportunity for Indian IT firms

24 September 2007
By Sudhakar Ram

There has been much discussion about the impact of the rising rupee on the profitability and competitiveness of exports in general, and IT companies in particular.

There has been a demand for RBI intervention to keep the rupee down. This demand does not take into account the enormous opportunity that the rising rupee could present to export-oriented industries. In the medium-to long term, with global market mechanisms in operation, a rising rupee should lead to decreased costs and hence, a marginal impact on our global competitiveness.

The rising rupee, however, does throw up short-term challenges and opportunities. It will force the IT industry to look beyond labour cost arbitrage to create value for its customers - what can be called the Third Wave approach. It will refocus the industry on driving new efficiencies and improving productivity.

When we look at globalisation, industries in emerging economies typically go through three waves of evolution. The electronics industry, first in Japan, then in SE Asia and now in China, is a good examples.

In the first wave, companies in EMs typically act as component suppliers to developed countries that manufacture the complete product. In the second wave, the local industry gains enough expertise to provide cost-effective contract manufacturing services - of either the entire product or major sub-assemblies. The third wave is when a set of firms start marketing these products under their own brand - initially within their own countries, and then abroad.

We can trace the evolution of the software services industry in India using a very similar paradigm. As shown in the table below, the Indian software industry has gone through two waves already - as a component supplier and as a contract manufacturer.

Wave 1 started in the ’70s and ’80s and peaked in the mid- ’90s; it established that the Indian software professional was competent and the industry got results largely through staff augmentation.
Wave 2 established India as a destination for low-cost, high-quality programming services.

The catalyst was the Y2K bug and Indian companies’ success in delivering these projects in a cost-effective manner.

Many Fortune 1000 companies discovered that moving their application maintenance and ongoing development activities to India was viable. The second wave of Indian IT started in the mid to late ’90s, and is at its mainstream phase today. Like all mainstream markets, this is characterised by the emergence of a few leaders, namely the Tier-1 IT companies, who demonstrate high rates of growth and profitability and increasing market share.

Wave 3, which is emerging, will be characterised by Indian companies moving up to high-value services that are strategic to the customer and hence command premium, value-based pricing. As we have seen, the industry is already facing a severe shortage of talent. There are indications to suggest that the linear relationship between growth and head count will not be sustainable much longer. The future is in creating strong brands out of India whether in services, products or solutions - that command the respect global customers.

The third wave is not just about better margins. It’s also about true global scale. It’s about the industry achieving new heights - growing from the $20 billion currently to over $100 billion in the next decade. It’s about moving up in value from an ‘order taker’ to a true strategic partner. In many ways, the appreciation of the rupee has shaken up people and possibly accelerated the third wave of Indian IT.

Another opportunity that the rising rupee gives us, as an industry, is the necessary impetus to take a fresh look at cost structures, productivity and financial metrics. At the entry level, the IT industry has created a fair amount of pressure for the other industries in terms of salary levels. This has cascaded up to all levels. The rupee pressure will force all of us to reassess salary levels and maintain them at realistic levels. We are already seeing signs of this in the salary increases granted this year.

In terms of productivity, a large proportion of work carried out from India tends to be on a time and material (T&M) basis. In general, there are few incentives in T&M contracts to raise productivity. With rising costs and shrinking margins, there is a possibility of at least some of these contracts being renegotiated as fixed-price contracts, around work packages. This gives an incentive to the service providers to improve productivity and margins.

As regards financial metrics, the IT industry has so far focused on returns on sales as the basic metric. Given the shortage of talent and the high proportion of salaries in total costs, the industry has already started measuring return on talent through metrics like EBIDTA per employee, PAT per employee, etc. This will help us generate the best value for the talent we have, rather than selling them by the hour!

While the rising rupee does create issues for all of us in the short term, meeting the challenge and generating value-based strategies will benefit industry.