Services in Europe's Backyard
by Indrajit Basu
May 30, 2007

Even as many Western companies turn to India and China to seek IT and business services, a growing number is finding countries like the Czech Republic, Hungary, Poland, Russia, Ukraine and Belarus more suitable

When Deutsche Bank, the Germany-based global investment-banking powerhouse, needed to replace its legacy customer-relationship management system with a new one in March this year, it turned not to what would been an obvious choice to many, one of the global IT services giants like Capgemini or IBM, or an Indian outsourcing service provider. Instead, Deutsche Bank turned to a Russian boutique IT provider called Luxoft that has a total staff strength of about 2,300 professionals.

When Deutsche Bank, the Germany-based global investment-banking powerhouse, needed to replace its legacy customer-relationship management system with a new one in March this year, it turned not to what would been an obvious choice to many, one of the global IT services giants like Capgemini or IBM, or an Indian outsourcing service provider. Instead, Deutsche Bank turned to a Russian boutique IT provider called Luxoft that has a total staff strength of about 1,000 professionals.

"We talked about Canada , Ireland and low-cost locations in the U.K. But it really came down to India and Russia ," says Dan Marovitz, Managing Director, Deutsche Bank. "But every time we went over to India and we tried to get things going and do a little pilot, we found it difficult to get traction. We spent time knocking around India at all the big companies. It was hard to get them to focus on something that would be pretty cutting edge, but would start very small, and where the forward roadmap was very much a work in progress."

"In Russia ," adds Marovitz "we found people who think on their feet, which is what innovative projects like ours needed. And in Luxoft, we found experts ready to grill us with tough questions; just what one needs for complex projects."

Marovitz may be pardoned for being partial to Luxoft, and Russia as an outsourcing destination, because after all Deutsche Bank still continues to outsource a major part of its IT work to India , and the bank is not a Russia or Europe aficionado.

Bangalores in Europe 's Backyard

Even as most American companies turn to India — and also to China and the Philippines — to fill many of their IT and back-office outsourcing jobs, over the last few years a growing number of large as well as smaller outsourcing services seekers from Western Europe has found Bangalores in their own backyard; countries in the Central and Eastern European (CEE) region, particularly Czech Republic, Hungary, Poland, Russia, Ukraine and Belarus.

Although the IT services outsourcing market of this region is still tiny — about one percent of the nearly $386 billion global outsourcing market — imports of IT-based services from the CEE into the European Union (EU) is rising fast. Between 1992 and 2004 the region's IT imports to the EU rose by an average of 13% per year compared to imports from India, which increased only slightly faster during the same period at 14% per year. And, according to a recent Gartner report, the IT outsourcing services market in the region could expand by 30% by 2010, compared with 25% for the global market in the next four years

"UNLIKE THE GLOBAL AVERAGE ATTRITION OF ABOUT 25% IN THE OUTSOURCING INDUSTRY, THE CEE BOASTS AN AVERAGE PERSONNEL ATTRITION RATE OF ONLY ABOUT EIGHT PERCENT"
Nick Puntikov, Chairman, Programming Committee, Russoft

For that matter American companies, too, are cashing in, as global giants like IBM, Dell, Capgemini and Morgan Stanley, among others, have started seeking as well as providing outsourcing services to and from this region. "We have over 5,500 employees in our two offices in Brno (Czech Republic) and Budapest (Hungary), supporting 500 global clients," says Fernand Sanchez, VP, Global Delivery Operations, Europe, IBM, "Part of our $40 billion in global spend for supply chain procurement is sourced in Budapest and Sofia."

Expensive, Yet Attractive

Following the unification of Germany and the collapse of the Soviet Union , as this region's economy tries to quickly integrate with its more affluent Western neighbors, many of its countries are trying to become not only the extended workbenches of companies from high-cost countries, but also their backoffices.

"This trend started about three years back with the large Western European companies with large-scale transaction processing, tapping the outsourcing potential of the CEE," says Rebecca Scholl, an ex-Gartner outsourcing expert, who is now the VP of Business Development at U.S.-based IT and BPO service provider, Affiliated Computer Services (ACS). "But increasingly this concept is catching up with many other companies as well."

What is unusual about this trend is that even as cost in CEE countries is high and availability of human resources is still low compared to their Asian counterparts, something other than cost savings is driving companies to this region. "The main reason we went to Russia is that we needed high quality people for our work. We are not looking for hundreds of people; we need just tens of them but we want high-quality," says Robert D. Miningham, President and CEO of U.S.-based Miningham & Oellerich that too preferred Luxoft after dealing with an Indian company for a "pretty long time."

The biggest attraction of this region for the new breed of outsourcing seekers is proximity; and this refers to both physical distance and cultural closeness. The time difference, particularly with Western European, is almost non-existent, while the CEE countries have close geographical and cultural ties with the markets of Western Europe and the U.S. Typically, nearshoring locations score high marks because of their lower costs for communication between the purchaser and the provider of the nearshoring service.

Proximity has other advantages as well. First, personal contact that enables solutions of complex problems face to face. Next comes the benefit of a common language — even though official languages may differ, nearshoring locations often have people who are proficient in the language of their client. This is followed by cultural understanding. Nearshore service providers almost always offer a better knowledge and understanding of the cultural background of their clients than their counterparts in far-shore locations.

Studies reveal that CEE is particularly interesting for German companies since nearly 40% of schoolchildren in the new EU member states learn German. The proportion is particularly high in those countries bordering Germany and although this does not mean that German is spoken fluently, it does signify that at least there is a basic level of proficiency that can be built upon. Similarly, Romania is interesting for French companies as 85% of schoolchildren there learn French.

"There is great affinity between the CEE nations and the West [ern part of the world]," says Nick Puntikov, Chairman, Programming Committee, Russoft, the official lobby of the Russian IT outsourcing industry. Puntikov is also the President-Europe of Exigen Services, an IT service provider in the CEE that has a strong presence in the U.S. He adds that his U.S. clients too "have observed numerous times that the psychology, mindset and work ethic that CEE nations have is a very good fit with the U.S. and the EU culture."

Along with proximity many Western companies perceive the stable workforce and relatively big wage difference between Western Europe and the U.S. as other key determinants of the appeal of this region. "Unlike the global average attrition of about 25% in the outsourcing industry, the CEE boasts an average personnel attrition rate of only about eight percent," says Puntikov. "This is a strong incentive for clients to put work there, because it means time and money saved on the hiring and training of new staff to replace the team members lost to attrition," he adds.

As for cost effectiveness, although the labor and other costs are much higher in the CEE nations than the world's most favorite outsourcing destinations, India and China , they are still much lower than Western Europe and the U.S. In the new EU member states the average labor costs for non public services are around one-fifth of those in Germany ; in Romania and Bulgaria labor costs are less than 10% of those in Germany, according to a Deutsche Bank research.

Where and What in CEE

While the general perception is that Russia is good for IT outsourcing and Central Europe is ideal for back office, many offer diverse views. Scholl of ACS, for instance, says that Central Europe is only suitable for back-office work in German and English and for no other language. Overall, for language-related back-office work Spain is a much better option, according to her. But Puntikov of Russoft says, "Learning international accounting is not more difficult than software programming. So it is just a matter of time that Russia emerges as a BPO destination, too." However, Bulgaria, Czech Republic, Hungary, Poland, Romania and Slovakia could be considered as "key countries" for both IT and BPO services, according to the IT and business process advisors, EquaTerra.

Nevertheless, it is a fact that many large U.S. and EU clients outsource R&D and complex IT to Russia than the rest of the region. This is because for long Russia has had a reputation for skills in science and math and its powerful system of higher education — a legacy of the Soviet era — produces many graduates every year that specialize in computer science, math and engineering. AMR Research estimates that half of Russian students major in engineering or science and math (20% more than in China, and at least twice the amount of India, Japan, or the U.S.). As a result of this high-degree of education, the Russian workforce also possesses a great amount of creativity, which is vital for quality problem solving. The nature of the education itself is also very problem-solving focused, which in turn produces a project-oriented culture and workforce, as opposed to a staff augmentation approach that characterizes other regions.

Challenges

Still, outsourcing to the CEE is not an easy decision. For one, "pressure of overheated labor market and rising cost  margins in the CEE requires service providers to reevaluate their outsourcing model carefully," say Julia Simonova, Marketing Director, Luxoft. The costs in recent years have risen considerably: Between 1996 and 2004 labor costs in the new EU member states rose by an average of 7.7% each year, according to the Deutsche Bank research. In Romania they have climbed 8.1%, in Slovakia by 9.7% and in Lithuania by no less than 15% per year. By contrast, wage growth in Western Europe was modest: 2.1% in Germany and 3.4% in the EU.

"To remain competitive, even as Lev Saks, CEO-U.S.A., Luxoft, says that most providers, who wish to stay competitive, "are moving bulk of their delivery organization to regional offices, keeping only the front offices in high-cost major cities or location", Peter Schumacher, of the Germany-based outsourcing consultancy firm Value-Leadership says that "cost in the CEE is more likely to increase rapidly than otherwise."

Then there are several regulations to be taken into consideration when outsourcing in the European markets. "In particular, employee transfer rules regulated by the European Acquired Rights Directive (ARD), as well as data-privacy regulations, need to be integrated to the sourcing process," says Scholl. The ARD provides protection to employees in the context of the transfer of a discrete function to an external party, but in some countries employees complain that they would prefer to have the right to choose.

Fragmentation and size of the providers is the other constraining factor. For instance, the Russian IT-service sector has hundreds of providers, most of which are fewer than 100 people in size and only a few years old. This creates a scenario of unknown firms with questionable stability and viability from the user perspective. It also means that many offshore projects are simply too large for these firms to undertake. Consolidation for firms also proves challenging from a business perspective, particularly across borders (e.g., a U.S.-based Russian firm buying a domestic Russian provider) due to restrictions on foreign ownership and taxation disincentives.

The final challenge is scaling up. While the talent pool in the CEE is deep and talented, the unsavory truth is, it is also very young and inexperienced. Though the pool of skilled labor is quite large in most offshoring locations, formal qualifications often provide very little indication of whether that pool is also suitable for employment by a service provider with international clients. "Not all universities satisfy the standards that are usually met in Western Europe or the U.S. ," says the Deutshce Bank report, according to which just 10% of graduate engineers, mathematicians, statisticians and physicists in Russia are suitable candidates, in terms of their training, for the jobs required by a Western outsourcing seeker.

These issues give enough reason to some to argue that while the CEE is at best a cost cluster, India is a value cluster. "For some companies this is a big difference. Also the CEE is a localized proposition while India is a global platform from which many markets can be served," says Schumacher. However, the key areas to consider are what to outsource or what services to access and from which region, according to EquaTerra. After all, while there are similarities across the region as a whole, customers must address each country individually when assessing its appeal and viability as an outsourcing destination.

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