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Software: Staring at margin gloom

Aug 19, 2002

The Indian software industry has grown rapidly due to its ability to offer services at a much lower price (sometimes as low as one fourth) as compared to their western counterparts thanks to the to availability of cheaper manpower. Leveraging on the cost arbitrage, the companies today have operating margins in the range of 30% plus. For some like Infosys, the margins are as high as 40%. However, going forward it seems that that the margins for the Indian software industry are likely to head south. We look at some of the reasons for this. The strongest drag on the margins comes from competition, and the competition is no longer local. Initially, as the Indian software industry faced the heat of downturn in the US economy, a few players began to undercut. This triggered a price war within the industry. This made life even more difficult for foreign competition. Consequently, western software industries decided to counter the cost leadership of the Indian software industry.

Many top rung IT services providers have now started to explore the possibility of getting the work done in India and have started offshore development centres. Thus, they are now able to offer pricing that is competitive to the Indian companies. The list of global IT services majors’ offering offshore development include IBM and Cognizant. It’s a question of time before the trickle of global IT majors becomes a flow. And that means the competition is likely to intensify.

The first wave
Company No of employees in India
IBM 3,100
Cognizant 2,712
Oracle 2,000
Hewlett-Packard 1,489

While some have landed in India, others have chosen the third party route to counter competition. In 2001, Satyam and CSC entered into an agreement. According to the agreement CSC would outsource work to Satyam and therefore, be able to provide competitive rates.

Not only will the Indian IT industry’s cost leadership be threatened, but it will also have to face intense competition for talent. Already staff costs for Indian software companies are as high as 40% of revenues. Increased competition from global IT services majors will be a problem for top rung IT companies that were till date the best names to work with. This will no longer be the case.

Employee costs as
% of revenues
FY01 FY02
Wipro 13.8% 14.7%
Satyam 39.9% 45.6%
Infosys 37.8% 42.9%

In FY02, Infosys saw operating margins decline. This was due to a 44% growth in employee cost during the fiscal on account of floor pay being increased by the US government for the H1-B visa holders. As competition becomes tougher, governments’ abroad are likely to resort to protectionist measures to aid domestic industry against foreign players. However, the company cushioned the impact by adding 2.4% to the operating margins. The improvement was achieved due to aggressive cost cutting. But there is a limit to which companies can cut costs.

Thus, the Indian software industry at one end faces foreign competition offering competitive prices adapting to the model of offshore development. On the other hand, the same competition will try to attract quality talent and thus, competition for talent will intensify. It seems unlikely that Indian software industry will be able to hold margins. Therefore, gradual erosion in margins from the software business is in the offing.

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