Offshore Outsourcing Opportunities and Challenges for the Canadian Economy

Offshore Outsourcing: Opportunities and Challenges for the Canadian Economy January 2005 The Voice of Canadian Business Le porte-parole des entreprises canadiennes TM MD 1 Introduction The Canadian Chamber believes outsourcing is a valuable business practice that contributes to the competitiveness and economic growth of the Canadian economy. With a strong technological infrastructure, highly educated workforce, low telecommunications costs and a history of trading with the United States, Canada is in the ideal position to pick up even more outsourced business from the United States. This would mean more and better, higher value jobs for Canadians and increased trade in higher value services. However, it is not enough to sit back and hope our current advantages lead to such benefits Estimates suggest that as many as 220,000 positions could be added with an aggressive public policy that seeks to attract outsourcing dollars to Canada. To fully capture this economic growth Canadian governments need to pursue policies that facilitate international trade, that work to address the shortage of educated labour and that promote Canada as a positive business destination in which to do business. The Canadian Chamber recommends the government of Canada focus on the following strategic elements: Foster Trade – by continuing to maintain an open border with the United States, playing a leadership role internationally in trade negotiations, including a focus on facilitating movement of skilled personnel. Pursue Education – by devoting appropriate resources to educating to meet the needs of the future labour market, and supporting research and development through programs such as Scientific Research & Experimental Development credits, and through working with universities to increase the level of research commercialization. Promote Canada – as an excellent nearshore destination for U.S. firms, with an internationally competitive business climate. The Outsourcing Case: Good Economics or Labour Arbitrage? Outsourcing has long been a common business practice around the world. Outsourcing refers to contracting business functions outside the firm. Businesses, across industries, use outsourcing as a means to reduce costs, improve employee productivity, and to focus on core business functions. For example, manufacturers have long outsourced aspects of parts manufacturing to smaller firms, and in the public sector, institutions such as hospitals outsource laundry or meal services. While the practice of outsourcing may not be new, information, communication and technology (ICT) has increased the demand for, and facilitated outsourcing. ICT specifically enables services to be provided outside the country, or “offshore,” often in lower cost destinations such as China, perceived publicly to have lower labour standards and exploitative human rights and labor practices. As seen recently in the fierce debate about “offshoring” during the American election, the offshore movement of services 2 raises important public policy considerations, as white-collar service industry jobs, traditionally considered to be “safe” from movement offshore, become affected. Today, companies need to be competitive both domestically and globally. In Canada, where firms face a small domestic consumer market, looking beyond Canada for business opportunities has long been a norm, especially for firms in the technology sector. Businesses’ internal use of information and communications technology across the enterprise has further redesigned business processes, creating new outsourcing needs and patterns. Use of ICT itself has lead to the need for technical support, which seldom can be provided in-house, given its complexity and the high degree of expertise required to install, use and maintain information technology systems. Falling telecommunications costs have facilitated increased international activities for firms; not only can firms trade in goods, but services can now be provided from anywhere in the world, if the telecommunications infrastructure is available. Outsourcing or Offshoring? Key Terms The offshoring debate has spawned its own jargon just to describe contracting out: Outsourcing: Contracting out services to an outside firm Offshoring: Used to denote contracting services to a firm located outside the country. Nearshoring: Contracting out to neighboring or very close countries; is used in a more positive context. Inshoring: Essentially the same definition as outsourcing; used to emphasize the fact that the contracting activity does not occur ‘offshore.’ Outsourcing, whether at home, or offshore, is a permanent part of today’s economic landscape. Indeed the practice should be seen as a fundamental structural economic adjustment to an internationalized economy where international mobility of capital – including labour – is increasingly possible. Proponents of offshore outsourcing argue that outsourcing is just good economics. Service outsourcing increases the competitiveness of companies and raises worker productivity. The basic economic case suggests that moving outsourcing offshore lowers costs and boosts productivity. For the economy as a whole, the result is lower inflation and interest rates and higher economic activity. While certain jobs may migrate overseas, increased economic activity creates new, higher value higher paying jobs as skilled labour is now available to move to these positions, leading to a beneficial cycle of new job creation. A recent report by the information Technology Association of America1 forecast that outsourcing will create 317,000 net new jobs in the U.S. by 2008. In addition, spending for offshore outsourcing of computer software and services is expected to grow at a compound annual rate of almost 26%, increasing from approximately $10 billion in 2003 to $31 billion in 2008 and leading to total savings for firms from these activities of $20.9 billion. Critics of offshoring allege that whatever savings consumers might gain from a decrease in reimported goods is countered by long-term loss of income to domestic workers, who either lose their jobs due to outsourcing or lose potential income from investments not 3 made in the country in question. As international pressure for cheaper manufacturing intensifies, outsourcing is just a form of ‘labour arbitrage:2 a downward spiral of effective lowering of the average wage and living standard for workers in industrialized countries. A variety of reports have bolstered such claims and increased public alarm. A much quoted study by Forrester Research predicts that in the next 15 years, 3.3 million U.S. service-industry jobs, and $136 billion in wages will be moved abroad. This total includes an estimated 472,000 computer services jobs.3 Other studies, meanwhile, suggest the impact on the U.S. economy is grossly overstated. According to the International Institute for Economics, while significant in numerical terms, the job loss figures predicted by Forrester represent only 0.45 % of total U.S. jobs.4 In the context of recent U.S. labour statistics, such a change is not significant. A detailed look at U.S. job turnover from 1992 to 2003 reveals that 7-8 % of all private sector jobs in the U.S. are lost every quarter, including during boom years.5 Between 2000-2002, overall employment in the U.S. declined by 2.2 million (1.71%). Upon examining official labour data provided by the Bureau of Labour Statistics, employment in the industries identified as ‘at risk’ by the Forrester study6 had declined at a greater rate (1.97%) over this period, but the vast majority of this decrease was in the manufacturing sector (25.4%), which comprises only 10% of total employment, while service sectors and government experienced an increase in employment.7 By these estimations, outsourcing to date has continued to affect manufacturing, not white collar service industry positions. In addition, this data indicates only that the jobs have moved out of the IT manufacturing sector, and not which sector they moved to. Given the increase in both the government and service categories, this may suggest the movement of the lost functions laterally into other categories within the U.S. economy. In addition, building on these numbers, an alternative projection would suggest that most jobs projected to be lost are below the U.S. average wage8 - not the high value services jobs. Taking into consideration the imminent retirement of a large group of working ‘baby boomers’ and the low level of population growth in the U.S., it may be concluded that an alternative explanation would predict a lower impact on the U.S. jobs than its critics claim. The Canadian Nearshore Opportunity What can Canada learn from the American policy debate? From a public policy perspective, offshoring merits examination and policy response. Changing business models, lower communications costs, the proliferation and accessibility of low cost consumer technologies, such as personal computers, coupled with easier international trade, make offshore outsourcing of higher value IT jobs a coming reality we should prepare for. Offshoring also offers Canada significant opportunities. Canada’s proximity and trading relationship with the United States, combined with our relatively lower business costs, good technological infrastructure and highly educated workforce means that outsourcing can be a real opportunity for economic growth and high value job creation. While understanding the potential impacts of offshoring on Canadians, it is now up to 4 policymakers to seize this opportunity and enter the offshore outsourcing market more aggressively as a provider of services. IT Services in Canada: the Current Picture It is assumed anecdotally that Canadian companies in the service sector are significant outsourcing providers, and so by inference, any U.S. trade protectionist measures to limit outsourcing contracts will result in job losses for Canadians as firms pull outsourcing work back to their home states. In reality, Canadian statistics present a mixed picture, indicating that outsourcing work is more of a future opportunity than a current reality. Currently, Canadian companies employ approximately 550,000 information technology professionals in both manufacturing and services, which accounts for 3.5% of total Canadian employment. The highest level ICT employment was 3.9% of total Canadian employment in 2001.9 Taking into account the effects of the technology downturn, job losses in the sector should be expected. In addition, outsourcing related job losses are forecast to be at least 75,000 positions - if Canada does not aggressively position itself as an attractive outsourcing destination.10 Working aggressively to attract offshoring dollars could result in a net gain of approximately 220,000 jobs for Canada.11 The largest type of offshore outsourcing performed in Canada is the call, or “contact,” centre business. Contact centres are important contributors to provincial employment and key elements in economic development policies across Canada. Call centre strategies are in place in nearly all Canadian provinces, and constitute a continued area of focus for economic development activities for the provinces. Indeed, even Senator John Kerry used a call centre in Ontario for calling voters during his primary campaign.12 Contact centres have played an important role in bringing high value, white-collar services-based employment to communities across Canada, especially to rural or remote communities. Contact centres increasingly focus the majority of their work on higher value service activities, such as customer service or technical support, rather than telemarketing. Out of 5,921 call centres, 5,327, or 90%, were reported as in-bound operations.13 In Sault Ste. Marie, for example, U.S. outsourcing has reportedly created 2,500 jobs over the last three years, the vast majority providing customer service and technical support for a variety of clients, bringing the unemployment rate from 12.4 in 1998 to 7.2% today.14 But, across Canada, many call centres do not seem to be engaged in outsourcing activities. According to Site Selection Canada, when asked about whether they engaged in outsourcing or in-house operations, 310 centres across Canada, employing 79,150 people indicated they were engaged in outsourcing, and 5,625 (or, 263,485 employees) engaged in in-house operations.15 Indeed, overall across the IT sector, it is estimated that under 20,000 skilled IT workers are engaged in outsourcing projects.16 Trade and Internationalization of Business Activity As offshoring occurs between several jurisdictions, it maybe considered as a form of trade, and can likely be measured through trade in services statistics. In the Canadian 5 context, trade in services continues to be difficult to measure, as trade data does not allow clear measures of intra-company activity, and do not measure trade in components used to make a final product. This is significant as in many sectors, intermediate inputs are imported, whether from overseas manufacturers and suppliers, or intra-company. According to the 204 Trade Update,17 in 2003, Canada exported just over $ 56 billion, or which the vast majority were commercial services. Commercial services which include categories such as computers and communications, accounting, legal, insurance, and financial, accounted for $30.03 billion of exports and was the only services category in 2003 to record an increase. Similarly, trade in commercial services recorded the most imports, at 49.5% of total imports. Analysis by the C.D. Howe Institute indicates that what the Canadian trade balance does not show is increased outsourcing by Canadian firms; Canada remains an important destination for IT and business process global outsourcing, and our exports account for a substantial share of U.S. business service imports.18 The Cost Imperative Despite higher wages than India or China, Canada represents a relatively low cost outsourcing opportunity for American firms. In fact, looking at cost alone, Canada is tied with Mexico as the second best destination, behind India, for outsourcing. While labour costs in Canada are clearly higher, a highly educated population combined with high employee retention rates, cultural and linguistic similarity, a stable political environment, a business-friendly climate, and proximity to the United States are the factors that distinguish Canada as a desirable destination for nearshoring contracts.19 In a recent survey of 127 US information technology professionals, respondents rated cost as the third most important criteria, choosing availability of experienced professionals and access to specific technical skills as more important factors in their decision.20 Given that half of all offshoring deals do not produce the expected results, cost must be weighed against other factors that ensure successful completion of the project, and provide savings and value to the firm. Indeed, respondents indicated that companies considered factors such as high quality of English competency, and shared business culture important areas to consider. Telecommunications costs in Canada give firms a clear advantage. Over a variety of telecommunications services, Canadian firms across business size, in Toronto, and Calgary, paid less for services than their American counterparts in Atlanta, Chicago or Detroit.21 This means an inexpensive business environment that facilitates Canadian firms’ abilities to provide services to American clients. Various benchmarking studies continue to recognize that Canada has the right business environment for technology use and growth. For example, Canada follows only South Korea in the level and accessibility of broadband infrastructure.22 As well, Canadians are generally regarded as familiar with technology and as high users of information and 6 communications technology. In terms of connectivity – basic ability to access the internet including availability, price, reach and use – Canada comes second in the G-7.23 As a gateway market to the United States, and with a well-developed high technology industry, Canada can clearly compete with other destinations for outsourcing. Indeed, recognizing Canada’s unique business environment, large Indian IT firms have begun to open branch offices here. Both Tata and Cognizant opened facilities in Canada, cite Canada’s proximity and cultural similarity as important factors that make it worthwhile for US firms to do business here, and hence for the companies to open offices in Canada.24 Capturing the Benefits of Outsourcing: Recommendations for Canada Industrial policy has three elements: innovative polices, which work to promote growth in the economy; defensive policies, which attempt to protect firms, sectors, or regions affected by changing economic conditions; and adaptive policies, the goal of which is to ease the adjustment process by reallocating capital and human resources away from declining economic activity into new productive activities. While being mindful of its role in defensive policy, the Canadian Chamber believes that Canada must move to aggressively pursue innovative and adaptive strategies, to proactively capitalize on the economic opportunities of outsourcing. These strategies are: 1. Foster Trade • Canada needs to work to maintain an open border with the United States, as well as the other NAFTA partners to allow firms to successfully provide their services cross-border. • Canada should play a leadership role internationally in making the customs moratorium on electronic transmissions permanent, giving businesses certainty that any electronic transactions (such as of outsourced work product) will never be subject to duties. Facilitating the movement of skilled personnel (known as ‘Mode 4’) through GATS negotiations needs to be a key policy goal. Outsourcing, especially when it involves the provision of technical support, often requires frequent travel to different countries. Canada must also continue to pursue trade liberalization by participating in trade negotiations, taking a leading role where possible and ensuring commitments that we have made are met. • • 7 2. Pursue Education • For the cycle of job creation to work, Canada must ensure it commits appropriate resources to education to maintain and grow our base of highly educated citizens. In China, for example, it is estimated that 195,364 individuals graduated with an engineering degree in 1999 (44.3% of all graduates in China).25 In comparison, of the just under 3.7 million people aged 25 to 64 in Canada who had a university degree in 2001, approximately 9% or 333,000 had degrees in engineering (which includes technology-oriented studies).26 • This includes not only facilitating education for young people, but appropriately funding post-secondary educational institutions, committing to lifelong learning, to supporting research and development through programs such as Scientific Research & Experimental Development credits, and through working with universities to increase the level of research commercialization. 3. Promote Canada • Canada has many advantages as a nearshore destination for our U.S. colleagues, as well as being internationally competitive. However, even current trade and outreach initiatives do not do enough to focus on our excellent low cost telecommunications, highly educated population, and innovative firms. Information Technology Association of America and Global Insight, The Comprehensive Impact of Offshore IT Software and Services Outsourcing on the U.S. Economy and the IT Industry, March 2004. 2 Paul Craig Roberts, “The Hard Truth about Outsourcing” Business Week, March 22, 2004. 3 Forrester Research, 3.3 Million US Jobs to Go Offshore, Research Brief November 2002. 4 Jacob F. Kirkegaard, Outsourcing – Stains on the White Collar?” IIE, 2004. 5 Ibid. 6 These occupations fall into the following 9 areas tracked by the US Bureau of Labor Statistics: management occupations, business and financial operations occupations; computer and mathematical occupations; architecture and engineering occupations; life, physical and social science occupations; legal occupations; arts, design, entertainment, sports and media occupations; sales and related occupations; office and administrative support occupations. 7 Kirkegaard, IIE, 2004. 8 Ibid. 9 Statistics Canada, ICT Sector Employment 2002. Online at: http://strategis.ic.gc.ca/epic/internet/inicttic.nsf/en/h_it05840e.html. 10 PWC, Fine Balance 2004. 11 Ibid. 12 Robert Franciosi, “Outsourcing in just good economics for America” The Arizona Republic Online Edition, February 22, 2004. 13 Ibid. 14 Cathy Gulli, “Canada Calling” National Post Business May 2004. 15 Site Selection Canada, February 2004. 16 Robert Scott and David Ticoll, A Fine Balance: The Impact of Offshore IT Service on Canada’s IT Landscape, Price WaterhouseCoopers 2004. 17 See, Fifth Annual Report on Canada’s State of Trade: Trade Update – 2004 Department of Foreign Affairs and International Trade. 18 Danielle Goldfarb, How Canada Wins from Global Services Outsourcing C.D. Howe Institute Commentary, No. 206, November 2004. 19 AT Kearney, Where to Locate: Selecting a Country for Offshore Business Processing 2003. 1 8 20 IDC Global Outsourcing Trends Necessitate Considerations of Nearshore Sourcing in Canada IDC White Paper March 2004. 21 Iain Grant, Yankee Group, Competitive Advantage: Business Communications Costs in Canada Canadian Market Strategies REPORT Vol. 5, No. 10, August 2001. 22 Ipsos-Insight, The Face of the Web, January 2004. 23 Conference Board of Canada Cashing In on Connectedness April 2004. 24 Fawzia Sheikh, “Indian IT firms increase their Canadian presence” ITBusiness.ca December 17, 2004. 25 Office of Sen. Joseph I Lieberman Offshore Outsourcing and America’s Competitive Edge: Losing Out in the High Technology R&D and Service Sectors May 11, 2004. 26 Statistics Canada, Education indicators in Canada: Report of the Pan-Canadian Education Indicators Program 2003. 9