Posted By: Judy Smith

Alan R. ElliottFri Nov 10, 7:00 PM ET

Apple Computer thought it was nibbling at the core of its cost problem.
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When Apple (NASDAQ:AAPL - News) said in March it would build a 3,000-employee customer support center in Bangalore, India, to cut operating costs, it was a major step. Apple has always based its industry-leading support centers in the U.S. and Canada. A move offshore would risk a nick in its polished reputation.

"It would have been a first for them, the first outside American borders for customer support," said Ingrid Ebeling, an analyst with JMP Securities.

The news three months later was less earthshaking: Apple withdrew. It nixed plans for an Indian support operation before a spade full of earth was turned.

Ebeling speculates the decision was driven by quality of services, not cost.

The iMac daddy's lurch toward India only deepened a running debate between those tracking the country's offshore and outsourcing industries. Are U.S. companies, on average, successfully cutting costs by sending projects or entire business units a half a world away? The answer is, for manufacturing companies, without a doubt yes. For services firms: a definite maybe.

What is certain, however, is that a growing number of U.S. businesses are opting to own, rather than contract out, their offshore IT and call center service operations. Called "captive" operations, they are essentially divisions of a company, including offices, payrolls and corporate culture, operated overseas.

Major movers in this direction include Dell (NASDAQ:DELL - News), Microsoft (NASDAQ:MSFT - News) and Cisco Systems (NASDAQ:CSCO - News). Dell aims this year to double its Indian payroll to 20,000 workers. Microsoft also is doubling and Cisco tripling India-based staff.

The trend runs counter to the contract outsourcing model that gained prominence during the Y2K reprogramming blitz before the turn of the century. That model handles projects, business processes and customer service operations using a contractor's own employees and facilities. Some of India's most prominent success stories went platinum in the Y2K era: Infosys Technologies (NASDAQ:INFY - News), Wipro (NYSE:WIT - News), Satyam Computer Services (NYSE:SAY - News)and privately owned Tata Consultancy Services.

Combined, those outsourcers represent a little less than half the subcontinent's $28 billion in outsourced services. Smaller companies, many of them U.S.-based, handle much of the rest. Results vary.

Some reports show as many as one in five outsourcing arrangements ends in failure. The primary reasons for third party stumbles? Lack of communication and lack of visibility and control, says Jack Plunkett, chief executive of Houston-based Plunkett Research.

"Compound that with everything from huge time zone problems (to) cultural differences," Plunkett said.

Captive offshore operations also face many of those challenges. In addition, they incur real estate and infrastructure costs, as well as management of human resource tasks.

That has led a long list of U.S. and European companies, including heavyweights such as GE (NYSE:GE - News) and Deutsche Bank (NYSE:DB - News), to sell pieces of their captive business process outsourcing operations in India. Analyst Stephanie Moore of Forrester Research sees the trend toward captive operations as simply misguided.

"People think with captives they are going to save a lot of money and get more security," Moore said. "In actuality, they end up spending more money and getting poor service."

Captive outsourcing isn't really outsourcing. In strict terms, it is offshoring -- running a company business unit remotely outside the U.S.

Common parlance has seized on the term "outsourcing" to describe any group of U.S. jobs relocated elsewhere, particularly to India or China. Although the term is widely used, consumers generally don't grasp how far their lives depend on the trend.

Accountants in India each year handle hundreds of thousands of individual U.S. tax returns. In the growing field of teleradiology, Indian technicians and physicians analyze X-rays and CT scans performed in the U.S. and convey their analysis back to U.S. hospitals.

Contract outsourcing took powerful hold in the late 1990s. Western companies needed programmers able to alter legacy computer systems to track date codes beyond the turn of the century.

Contract outsourcers began giving up ground to captive operations in 2003, when India's population of boutique-scale programming and services shops flourished. The problem, says Rohit Shukla, chief executive and founder of the Los Angeles-based venture capital researcher, Larta Institute, is that the focus was on providing bodies, not on business model operations, client base and follow- through.

"It was driving a lot of people insane with spotty service," Shukla said.

The basis of both contract and captive outsourcing is labor arbitrage. The aim: exploit differentials in wage expectations.

India's IT workers generally earn $4,000 to $6,000 a year, says Terence Guay, assistant professor of international business at Penn State's Smeal School of Business. A typical American software programmer probably starts at $80,000.

But wages are a moving target. The rise of outsourcing in countries like India and China also brings the expectation of higher wages. Generally, wages for IT service workers in India are rising about 10% a year, says the Everest Research Institute in Dallas.

Sooner or later those increases will begin to squeeze off the arbitrage advantages of outsourcing.

"When you have differentials of 20-to-1, it's great," Guay said. "At the 50% level it is going to become a lot less attractive."

How long before wages rise to that level? Within five years, by some estimates. Everest Institute senior analyst Anand Ramesh says IT worker wages in India, on average, won't hit 50% of U.S. wages for 18 to 20 years.

The pressure may begin to pinch contract outsourcers sooner than it will captive operators, who pay slightly higher wages and benefits but do not suffer the brutal turnover -- up to 65% annually -- that contract operators must deal with.

Wage pressure is also a faster growing problem among the more developed areas of India and China. Companies with captive operations in Bangalore, Mumbai and Delhi see rivals earning better arbitrage advantages in less discovered cities, Chennai, Jaipur and Chandigarh.

In the long run, Apple, which says it's considering various global opportunities, may have the right idea. Shukla said both captive and contract outsourcing in the future will focus less and less on India.

"Things will be far less driven by a specific move to India than they will by, let's consider the whole world our oyster and look at opportunities in (countries like) Estonia and Bulgaria and Poland," he said.

Copyright 2006 Investor's Business Daily, Inc.

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