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Software exports: Understanding the model - Views on News from Equitymaster
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Software exports: Understanding the model
Dec 27, 2007

The Indian technology sector has grown leaps and bounds since the dot-com bust and the factor that has contributed to this growth has been export of software services. Now, in line with the stock markets, the rupee is also gaining new highs everyday and the exports have been hit hard. Most of the software stocks have faced tough times on the bourses. But, do all software stocks face the risk of currency appreciation to the same extent? This question can be answered only if we dig deeper into the type of export service the company is providing, which is the purpose of this article. Software exports can be divided into three categories based on where software is developed and how the development is managed and organised.

The first category is projects based on pure professional services, where service provider provides the clients with software professionals with particular skills asked for by the latter. These skills could vary from mainframe related software with expertise in UNIX operating systems or to WinNT platforms developed by Microsoft coupled with a programming skill say Java. The key point to be noted here is that the entire project is executed at the client’s site. Thus, the billings are also higher and the costs are also higher resulting in lower margins. The client himself manages the project, controls the deliverables and ensures that the project deadline is met. Software is developed according to client process. This service is called as staff augmentation services or body shopping services. Since the earnings in dollars and the costs are also in dollars the companies involved in providing these services though have lower margins but are not hit by appreciation. 8 to 10 years back all large companies of today were providing the body shopping services but today they have scaled up to the second category but even then there are many companies who are proving these services even today. An example of a company following this model is Prithvi Information Solutions.

The second category is project exports. The main areas in which project exports differ from body shopping exercises are that in project exports, the service provider supplies a team of programmers and software developers rather than a group of individuals. In some cases, the client may have some say in the size and composition of the team. Project management is also done by the service provider and not the client. Unlike body shopping, where the work is done at the client’s site (onsite), in project exports, the software development activities are split between the client’s site (onsite) and the service provider site (offshore).

How this happens? In the initial part of the project, the service provider sends a few software developers to the client’s site for requirement analysis or training in a particular system. These professionals then bring back the specifications for the software back to India and have a larger team develop the software offshore. If the project is large, a couple of professionals remain at the customer’s site acting as liaisons between the project leaders offshore and the client. Sometimes these onsite professionals are needed for emergency operations and for reassuring the client that the project is proceeding according to schedule. To execute such projects, a firm needs not only skilled professionals, but also a software development process and methodology, and an ability to manage software development. Unlike in onsite projects, Indian firms provide technical and managerial expertise as well. Now since the project is spilt between onsite and offshore the impact of currency appreciation is there but only to the extent of the offshore work. Most of the Tier – 1 companies are in this category. Now readers who are regularly reading newspapers would know that these companies are setting up centres in Latin America and other low cost countries. Why? We believe that over a period of time the margins in this sector will come down but perhaps by opening centres in other low costs countries these companies are protecting themselves from the currency risk.

The third type of software exports is that of an Offshore Development Center (ODC). An ODC is an entity formed especially for the US and European firms that wish to take advantage of the skilled talent pool and lower wages in India. An ODC involves an umbrella contract with a long-term agreement on prices for time and materials (man-hour basis). In this method of outsourcing, a large fraction of the project is executed offshore and the Indian firm is responsible for adherence to schedules for delivery. From time to time, the client sends projects to the center. For each project, negotiations are largely limited to the resources and time that will be required. Many of the established Indian software firms will have more than one development center. Here since most of the work is done offshore the impact is even bigger. The worst hit in these categories are the pure play BPO players whore margins have come down drastically over the last four quarters

The distinction between offshore and onsite work is important because billing rates differ considerably between the two. The bulk of the difference is accounted for by the higher cost of living in the US, as well as greater overheads and communication costs. Offshore work is more profitable for the vendor but not under the current scenario.

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