March 2006 – Offshoring trend in human capital management

The practice of moving various company services to cheaper labour markets will grow dramatically in the next few years as available skills improve in developing countries, a new report says today.

But the role of human resources professionals in influencing labour sourcing decisions is questioned in a section of the report that raises concerns for the future of HR at the highest level of companies.

The report, Key Trends in Human Capital, compiled by Saratoga, the human capital business owned by PricewaterhouseCoopers, is the second annual overview of labour market data among 15,000 employers across Europe and the US.

One of the most striking changes in labour sourcing, it says, is in the rationale for “offshoring” – the practice of shifting work from the home country to centres where wages and overheads are much lower.

Much of the early phases of offshoring involved low-skilled services such as call centres. But the report says that there has been a significant shift in the sophistication of work that companies are prepared to move abroad.

“It is becoming progressively evident that it is far more than low-skilled services and manufacturing that are being ‘exported’. India’s growth in particular has been fuelled by an astonishingly rapid development of skills and know-how, notably in information technology and other professional services,” says the report.

Low costs, it says, remain a powerful draw, particularly in India where the cost of operations is some 37 per cent lower than China’s and 17 per cent lower than Malaysia’s.

An increasingly influential additional attraction, however, is the scale of skill improvement within some of the most popular offshore centres. The Philippines, for example, produces around 300,000 college graduates each year, all of them English speakers, while India has about 2m graduates a year, 80 per cent of whom speak English.

The report stresses that employee skills – what it calls “the human capital issue” – are at the heart of successful offshoring moves. “Decisions to outsource or offshore motivated purely by reducing costs are providing disappointing results,” it says, adding: “it is the relative cost of labour and skills availability that are overwhelmingly dominant factors.” As skill shortages grow in the UK due to demographic trends, they may begin to influence labour sourcing decisions.

The report acknowledges that management, quality of service and sometimes a lack of cultural understanding, have raised concerns in some existing arrangements, but it says the evidence of strong investment flows in to India, China, Brazil, the Philippines and central and eastern Europe suggests that companies have not been deterred by these problems.

Anecdotally, indeed, there are signs that consumers are beginning to accept overseas-based services. In two separate conversations last week, friends in the UK told me of their dealings with Indian sales staff at Dell, the computer company. In both cases they had developed a personal relationship with an individual sales assistant who they would call back at intervals to discuss their computing needs. Both seemed happy with their sales discussions. What would have seemed strange only a year or two ago, is now accepted as the norm.

Spending by UK and US-based companies on offshoring contracts worldwide, says the report, is forecast to rise from Euros 8bn in 2004 to Euros 48 bn in 2008, 40 per cent of which is likely to come from the banking and insurance industries.

In the same period the Organisation for Economic Co-operation and Development (OECD) has suggested that as many as a fifth of all jobs in the US, Australia, Canada and the European Union before enlargement could be jeopardised by decisions to move work overseas.

While it is sensible that employers take in to consideration future wage increases as developing labour markets mature, pay is not expected to rise anywhere near western rates in the short term.

Offshoring arrangements do, however, require a broad understanding among human resources professionals of the management and employee skills underpinning any decision to take the offshore option.

“The success or failure of these decisions has been shown to depend largely on addressing the associated human capital issues. As such HR executives have a pivotal role to play,” says the report.

Just how pivotal, however, is debatable since the report says there is “little evidence” of increasing HR influence in companies. If anything, the reverse is the case. The number of HR directors on the main boards of FTSE 100 companies, it notes, has fallen to six. More worrying still for the profession in Europe is a visible trend of declining influence in the US. In 2003, some 81 per cent of HR directors reported directly to the chief executive. In the latest survey the proportion of those reporting directly had fallen to 61 per cent.

While it is arguable that full board membership is less essential to HR directors than having a high profile within the top executive team, most would expect to report directly to the chief executive rather than finding themselves one stage removed.

The PWC report speculates that such moves may reflect the increasing importance of human capital for corporate leadership. “The strategic importance of human capital may mean that CEOs and other senior executives are taking more personal responsibility and control over human capital issues, obviating to some extent the requirement for HR executives to sit at or close to board level,” it says.

Such comments are a wake up call for HR professionals in the UK who must seek a clearer understanding of the metrics underpinning the principles of human capital if they are to establish the discipline as a recognised feature of corporate reporting.

The decision in the autumn by Gordon Brown, chancellor of the exchequer, to abandon requirements for Operating and Financial Reviews has led to a Government rethink on the reporting of significant intangibles such as the costs, development and contribution of employees.

An industry-wide alliance of HR, management, auditing and investment interests, the Human Capital Standards Group, meeting at the London headquarters of Investors In People, is working on a common set of metrics and approaches that might be applied across UK industry. Unlike the compliance-led OFRs, the standards group is seeking to establish a firm business case for a unified approach to human capital reporting that will allow “like for like” investor comparison of certain standard measures.

At the same time these standard measures might be used as a platform on which companies can tailor distinctive individual approaches to workforce development that can provide measurable improvements in organisational performance and productivity. The Department of Trade and Industry’s consultation on reporting requirements - taking submissions up to March 24 – would seem an ideal opportunity to create a more effective human capital reporting approach than had been proposed in the original OFR guidelines. If the HR profession succeeds in placing itself in the vanguard of that debate it will do much to deflect the kind of criticism implicit in the Saratoga research.

*Copies of the Saratoga report can be obtained by contacting: emma.j.woods@uk.pwc.com