The Outsourcing Industry in China: Factors Behind Its Fast Growth and The Key Challenge of Employee Retention

The idea of China as a low cost manufacturing location coupled with huge consumer base is well known globally. However, China as an outsourcing destination is an interesting proposition. China does not come immediately to the minds of many corporate decision makers, looking to outsource IT related services.

An industry pioneer since 1995, VanceInfo Technologies Inc. (NYSE: VIT) is an IT consulting and solution provider and one of the leading offshore software development companies in China. VanceInfo was the first China software development outsourcer listed on the New York Stock Exchange. IDC ranks VanceInfo as number one among China-based offshore software development service providers for the North American and European markets. VanceInfos offers expertise across a wide range of industries in the Financial Services, Technology, Telecommunications, Travel and Transportation, Manufacturing and Retail & Distribution sectors. It delivers IT consulting, solution, and outsourcing services that include enterprise solutions, application development & maintenance, quality assurance & testing, globalization & localization, R&D/software product development, infrastructure outsourcing, and BPO/call centers. Its clients include many Fortune 500 & 1000 companies such as 3M, ABB, Cathay Pacific, Citibank, HP, Huawei, IBM, Lenovo and Microsoft (Vanceinfo, 2012).

The total global offshore IT Services Industry was nearly $50B in 2007, and is estimated to have grown to $58B in 2008 China. India offshore providers continue to take the lions share of this business through companies such as Tata Consultancy, Wipro and Infosys that generate a total of USD 20billion in annual revenues between them alone China. Leaving a relatively small amount of $2.4B (4%) in 2008 to China (Mao and Xing, 2011). According to IDC (Mao and

Xing, 2011), however, the growth rate over the next four years will favor China with China based providers expected to outpace the overall market in the foreseeable future.

This paper will analyze the factors behind the fast growth of the Outsourcing industry in China through an external environmental analysis followed by addressing the key challenge of the industry identified by VanceInfo which is employee retention.

Success Factors: Environmental (PESTLE) Analysis

Political: One of the major drivers for the outsourcing industry comes from the Chinese government which in its effort to increase country wide income levels is taking steps to move away from a manufacturing based economy to a service based economy. There is a major focus and emphasis by the Chinese government to make outsourcing as one of its major industries. In recent years, the Chinese government has introduced a number of stimuli to boost this industry. For instance, in 2006, it introduced the 1000-100-10 project, with the objectives of: a. Developing a base of 10 internationally competitive cities for service outsourcing b. Encourage 100 well-known transnational corporations to transfer their outsourcing business to China. c. Cultivate 1000 large and medium-sized service outsourcing enterprises with international qualifications. And in January 2009, it increased the number of cities to 20 destinations in China, including Beijing, Shanghai, and Guangzhou (Ministry of Commerce, 2006). This is similar to what India did with its cities Bangalore, Pune and Hyderabad. The support of the Chinese government through policies and incentives for the outsourcing industry is crucial to its success. This will result in significant investments in outsourcing, and eventually bringing China on par with India

Economical: The Chinese economy, after having grown in the range of 10-11% range in the last 5 years has somewhat cooled to 6%-8%. While this is a significant slowdown from recent growth, it still far outpaces growth forecast for the rest of the world (both developed and developing economies). As a complement to the multinational corporations China & Asia Pacific expansion plans, local China-based vendors are often selected to assist with their regional software system rollouts. Furthermore, in China strong and long-term relationships (Guanxi) are important to business success, therefore partnering with a China-based provider to tap into the relationship ecosystem for software product development, customization, and delivery, has made more sense than going with overseas based outsourcing vendor such as in India. Social: Chinas strengths in outsourcing are its vast talent pool of skilled technicians and engineers. China has 600,000 engineering graduates compared to 400,000 in India and 70,000 in the U.S. This is further coupled with the fact that China produced 50,000 PhD graduates in 2007 of who 3,000 had computer science specialities (Gereffi et. al, 2006). Another source of high quality skills is the large number of Chinese returning home from the U.S, Canada and the U.K with degrees form top schools. Vanceinfo has significantly tapped into this resource for its Top Management positions. While China has a massive pool of engineers at the entry level, however it will take more time and experience before there are enough senior managers. Retaining these high performing employees will also present a problem and will be discussed later in the paper on overcoming the challenges to be successful. MNCs are increasingly recruiting Chinese individuals returning from universities and jobs in the US and other developed countries. According to a McKinsey report (Farrell and Grant, 2005), in 2003 there were 120,000 Chinese students studying abroad. These candidates exhibit greater business skills and work experience than local Chinese employees. They can speak fluent foreign languages, understand foreign cultures and are able to have effective communication with both their domestic and foreign

counterparts. More importantly, their hiring cost is significantly below the cost of hiring or assigning expatriates from the MNCs home countries.

Wages: Along with the fast rising wages in India, which is undermining the countrys cost advantage, China also compares favorably in terms of wage levels, although average billing rates vary widely from Shanghai and Beijing on the high end, to Wuxi and Chengdu at lower end. China is generally acknowledged to offer a 30 percent to 50 percent discount over Indias prevailing rates. The National Association of Software and Service Companies (NASSCOM), the industry association for the IT-BPO sector in India, recently estimated that a newlygraduated Chinese engineer might receive USD250-300permonth compared to average rates in India of USD750-1000 (Oppenheimer Equity Research, 2008). It is important to note however that for higher-level IT jobs, the wage gap between China and India is already more negligible due to annual wage increases of 15 percent in Chinas software industry (China Statistical Review, 2009).

Language: Chinese officials and outsourcing companies have fully recognized the need for good English language skills to win business from western customers and compete with rival locations in India and Philippines. The Chinese government has made English instruction a strategic priority at universities and even in primary schools, where English as a foreign language is now mandatory. Currently, most of the technology-related work done in China involves very few voice components due to a lack of spoken English skills suitable for a worldwide customer. Nevertheless, this situation is fast changing as more efforts are being put into improving spoken English amongst technology and outsourcing workers. The issue of language is also being addressed. According to Mellissa Ning of Vanceinfo, Chinese engineers in general are not as proficient in English as Indian engineers but compared to Chinese university graduates of a previous decade, the English level has improved considerably.

Furthermore, English language is not so much of a barrier when it comes to offshore work as only the client facing staff would require such language skills and for that companies like Vanceinfo can hire from the overseas market. For those doing programming in China, however, speaking English is not such a high priority or barrier. Language skills have also presented an opportunity to Chinas outsourcing market as it is boosted by the approximately 2 million Chinese who speak Japanese or Korean, a particular key consideration in northeastern hubs such as Dalian (Benni and Peng, 2008). The Asian market has been under-served, as India has traditionally focused in the American and European market; whereas, China can work for both the American and European markets, as well as the Asian markets in Japan, Korea and the large domestic market in China.

Technological: Probably no country in the world has invested much in infrastructure in recent years as China has, enhancing the credibility of Chinas outsourcing proposition. In addition to financing modern ports, highways and airport, the government has authorized major capital expenditures to secure steady power supply and modernized telecommunications network with high-speed broadband connections in key strategic locations and major cities. Chart 1, below clearly shows Chinas significant advantage over India in terms of infrastructure quality. Furthermore, new software parks have sprung up in Shanghai, Beijing, Hangzhou and many other cities. These state of the art facilities have played a major role in supporting the flourishing of this nascent business in China. One of the earliest software industrial parks to open was Shanghai Pudong software Park in 1992. Today it houses more than 250 companies including several major outsourcing vendors. Shanghai alone has at least seven software centers.

Chart 1: Percentile Ranking of Infrastructure Asset of selected countries out of 133 countries

Geographic Diversification: Large coporations in the US are looking to de-risk their offshore supplier bases by sending work to alternate offshore locations such as China. According to Sid

Pai, Managing Director at the Indian arm of TPI, one of the largest global outsourcing consultancies, it is typical for CIOs at large corporates in the US to adopt an i2+1 approach,
where they want two delivery locations in India and one other offshore location, which is increasingly either China or a Latin American location (Joseph, 2011). For instance, GE Capital has taken a strategic approach of outsourcing in multiple locations to reduce the risk of relying on a single country for its outsourcing activities. Between 2006-2009, it has reduced the volume of work going to India while increasing Chinas share from less than 5 percent previously to approximately 20 percent of its offshoring. While Latin America receives another 20 percent of GE Capitals outsourcing contracts with the remaining 10 percent divided up among other markets around the world (KPMG International, 2009).

Outsourcing Challenges in China: Retention

Nevertheless, China is not without its challenges in its pursuit of dominating the global outsourcing industry. According to Phillip Chow, the Head of Financial Business Group at Vanceinfo, the biggest challenge that the company faces is the retention of employees. This is not only true for existing players in the industry but also to new entrants planning to enter the Chinese market. The false premise that many multinational companies have is that a country with a population as large as Chinas would not have a labour shortage. This may be true for the unskilled labour market but not for the skilled labour market such as outsourcing where employers are looking for individuals with specific skills in software programming. Acquiring talented employees and retaining them is becoming one of their greatest challenges in China. Chart 2 below from Mercer (2011) clearly shows that in the first 9 months of 2010 the average turnover rate was 15.1 percent with second tier cities hitting the 20 percent mark.

Chart 2 : Voluntary Turnover Rate in year 2010 Further, Chinas steady growth has generated many opportunities for employees to hop from job to job and enjoy substantial pay increases. Huge salaries and quick promotion opportunities are

not aiding employee retention. In China, according to Mercer (2011), salary increases for the software industry grew at a faster rate than other industries, about 10.5 percent in 2011 as shown in Chart 3, this not sufficient to keep up with the fact that when talent is lured away from other Chinese companies, employees typically get a 40 percent salary increase. Attracting and retaining staff under such an environment becomes even tougher for companies in China.

Chart 3: Average Industry Salary Increase for year 2011 In the IT outsourcing industry the reasons for the higher turnover rate can mostly be found in the characteristics of the industry itself. According to Phillip Chow, the fact that most China-based outsourcing companies still provide project-based work and low-end services such as coding and testing and have no proprietary core technology will often prevent engineering talent from accepting such an offer; they are concerned about devaluing themselves in the market and about the stability of their job once the project is completed. Current employees who have expanded their skill-set to a certain extent will often feel stuck if they have little opportunity to work on technically challenging projects that add to their experience and provide an exciting and motivating work environment. Thus leading them to consider alternative employment outside the current company.

Based on the factors identified above for the high turnover rate, the management at outsourcing firms can adopt specific strategies for retention which include competitive compensation, focus on training and development and promote career advancement opportunities.

Competitive market compensation: Compensation is likely the key to recruiting and retaining qualified labour worldwide and especially in China. Companies must ensure that they are offering a competitive wage to their employees. Furthermore, in China, compensation standards can vary significantly based on location for example salaries in the largest cities (Beijing, Shanghai and Guangzhou) can be twice as high as in second tier cities like Dalian or Chengdu (Mercer, 2011). Top local Chinese managers on the other hand can earn salaries similar to Western levels. Training and development programs : Training programs can reduce turnover as young Chinese professionals are attracted to the training opportunities in new skill development such as foreign language, business writing (both English and Chinese), public speaking and presentation skills, and job specific training (Management, sales, etc.). A major advantage for outsourcing companies with offshore locations in terms of retention is the ability to offer overseas training programs to employees. The prospect of overseas training can be an incentive for employees to stay at a company. Career Advancement: Career advancement is crucial to retention in China. In the past, with guaranteed lifetime employment, job performance was not important for promotion. Today, the most talented individuals in China are very demanding in terms of career advancement. The younger generation in Chinas private sector is not willing to wait for promotions based on years of experience. They expect to be rewarded immediately for their accomplishments. Career management can be an effective tool for adding value to employees and at the same time reducing turnover and increasing their employees engagement. Particularly in China, the

development of a career infrastructure can help organizations build internal functional excellence in areas where it is difficult to hire or keep experienced staff such as marketing, sales, engineering, and research and development. Companies wishing to retain their highpotential employees need to create an environment that allows those people to grow. This is especially true for fresh graduates, who make up the biggest part of the resources for the outsourcing industry at this point, who need to feel they have a career path with the company.

Job Title: A surprisingly simple, yet effective way to reward performance in China is through job titles. It is noted that Chinese are generally very sensitive to their titles. The title of director, for example, seems much more impressive than manager. For multinational companies, employees can be assigned a standard title in English and a more importantsounding title in Chinese. This allows for adherence to the companys global HR policy while allowing the employee to feel accomplished among his or her peers (Fernandez and Inderwood, 2006).

Accept turnover and develop the right strategy to minimize its effects: Given the fierce competition for talent in China, companies should not place a high expectation on retention. Both the government and China-based outsourcing providers understand that, given the competition for talent and rapid growth in the outsourcing industry, turnover is here to stay. It is a question finding the right strategy to control and minimize its effects. Survey results show that employees with one to two years of experience are the most unstable group, and comprise around 44 percent of the whole turnover population (Eltschinger, 2007). Creating training or internship programs at local universities and colleges will not only allow students to learn about the company but also creating a steady flow of fresh graduates as employees.

Summary China still has some years before it can be considered as powerhouse in the global outsourcing industry. However, with the political, economic, social and technological factors nurturing the industry positively there is little doubt that China will dominate the market. It is important for firms in the market currently and firms planning to enter the market acknowledge that the strength of the outsourcing industry lies in its talent pool and success in the Chinese market will heavily depend on retention strategies and ensuring a steady supply of fresh/junior programmers.