Pulling the Plug on Outsourcing
Before you move part of your business to Bangalore, know this: It may not be worth it.
By Richard McGill Murphy

(FORTUNE Small Business) – When Silicon Valley Entrepreneur Ajit Deora was starting enKoo, his latest tech venture, he had to deal with one very important question: where to develop the product? The last three times he had faced that issue, the solution seemed obvious. Although Deora, 48, lives in Northern California, he offshored much of the engineering work for his startups to his native India for all the usual reasons: cheap land, cheap office space, and most important, an abundance of skilled engineers who spoke excellent English and worked for a pittance compared with their U.S. counterparts.

But when the time came to develop his new product, a software–hardware package that lets users access their computers from anywhere in the world via the Internet, Deora realized that Bangalore wasn't quite the bargain it used to be. So he rented office space in Fremont, Calif., hired three engineers, and set to work, spending $500,000 over 14 months to develop a working prototype. He estimates that in Bangalore he would have spent as much as $1.5 million. "India has changed a lot in the last ten to 15 years," says Deora. "You can't be a small–time operator there anymore."

Huh? Everyone knows that big U.S. firms now outsource their tech needs to India and other low–cost, high–brainpower destinations. And the same has been true of small U.S. tech companies. Last year 55% of U.S. software companies with annual revenues of $10 million or less sent some part of their development work overseas, according to a new survey by the Sand Hill Group, a tech investment and consulting firm based in San Francisco. India is by far the most popular destination, the choice of 69% of all U.S. software companies that offshored work in 2004. Another 14% chose Russia, followed by China and Canada at 9% and 8%, respectively.

Yet office rents in Bangalore now rival those in many midsized American cities, according to Ton Heijmen, senior advisor on offshoring at the Conference Board in New York City. And the Indian labor market is less of a bargain nowadays. Multinational tech companies such as Dell, Intel, and Microsoft have built big development centers in India during the past few years, sparking a talent war that has driven Indian tech salaries from around 10% of U.S. wages in 2000 to perhaps 20% today. "It's like Silicon Valley in 1999," says Mark Heesen, president of the National Venture Capital Association in Arlington, Va. "People are constantly hopping from company to company for more money or stock options."

An 80% discount on engineering talent might still sound like a great deal—and emerging offshore tech destinations such as Vietnam and Ghana are cheaper still—but much of that advantage disappears once you factor in high offshore attrition rates and lower productivity. Deora estimates that he would have had to hire nine engineers in Bangalore to do the same volume of work that three engineers can do in Fremont. What's more, to ensure quality control, he would have had to either send an experienced U.S. manager to live in India (at an estimated annual cost of $250,000) or travel back and forth constantly, juggling development duties there with fundraising and marketing responsibilities back in the U.S. (At presstime the cheapest roundtrip flight to India from Silicon Valley cost around $2,200.)

There's more than just money at stake in this decision. "If you save money but don't deliver the product, you're missing the mark," says Gerhard Eschelbeck, CTO of Qualys, a Redwood Shores, Calif., company that sells network security products. Worried that far–flung engineers wouldn't understand his needs, Eschelbeck decided to develop Qualys's code in California, where he could keep a closer eye on his staff.

Even in a wired world, physical and cultural distance can impede business communication. Perpetual Entertainment, an online–game developer and operator based in San Francisco, ran into problems when it commissioned a Romanian art house to design 3–D lions for its new multiplayer game, the Roman–themed Gods and Heroes. The Romanians drew realistic lions that players felt were too beautiful to kill, says CEO Joe Keene, 45. Perpetual Entertainment asked for wilder, more threatening lions. Since then, Keene has learned to invest more time and resources to explain visual concepts upfront. That's important anywhere, but it's especially challenging with contractors in countries where the first language is not English. Even after he factors in those costs, however, Perpetual Entertainment still saves 65% by offshoring its character design.

"The people who love outsourcing the most are the people who don't have to deal with it," says one Wall Street IT manager with extensive experience developing software in India, who asked to remain anonymous. Those people include venture capitalists, who have reacted to a post–bubble tech economy by asking startups to do more with less money. As a result, startups are under enormous pressure to cut costs. "Capital–efficient investing is key," says Boston–based venture capitalist Whitney Bower.

Yet offshoring still makes more sense for larger companies than it does for startups. Big companies can take advantage of economies of scale and are better equipped to handle the daunting challenges of managing a global IT supply chain. That's why, now that his company is growing, Deora is taking a second look at sending some of his maintenance and quality–assurance work to India. Had that been his original strategy, he might not have survived to tell the tale.