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Analysis of Software Services Industry Essay

Q1 – Which industry is being analyzed?

The industry that will be a part of my analysis is the software services & consulting industry. I would simplify and constrict it further to consulting services based on a global development model – provide r procure services from anywhere in the world to any part of the world. I have been associated with this industry or business model for over a decade. As a business consultant I provide my services to my client & manage their IT operations, including large programs that align with their strategic needs. Software services industry started gaining a lot of attention since the mid-80s. The reason was personal computing capabilities that democratized the digitized world from large companies to households. Since then advances in networking & technologies have catapulted the world we live in into different dimensions. Since the 90s, as the Eastern Europe & Asian countries opened post-communism, with decrease in network cost & high availability, software services made a paradigm shift.

Q2 – Barriers to Entry
Economies of scale

The software industry is highly competitive. First we will analyze the economies to scale. Usually with all industries the overhead costs are spread with the scale of operations. However, the fixed cost in the software outsourcing industry is low. The only real fixed costs are those of buildings where industry workers sit and perform their work and sales. In comparison with the revenues, the required assets to perform the work being very low, software industry faces very low advantage related to economy of scale. Everything else, management costs, cost of administration, cost of equipment like computers etc are somewhat proportional to the number of resources employed.

However, an entrant into this industry may need to pay higher salary to their employees being new in the industry, since the risk involved in joining a new company from the perspective of a potential employee, is higher compared to established names and large companies whose operations may be diversified geographically or across industries. Similarly, larger companies are able to market the services to potential customers while the cost of the sales team gets proportionately divided across delivery units. Thus a larger company is able to enjoy economies of scale over smaller, new entrants.

Distribution Channels

Distribution is a critical function in the software industry. Ability to market potential products or services for a particular company depends on the ability of the sales team to grow a relationship with customers. For some companies the relationship is managed by delivery teams who can interact more closely with the customer’s management group. Usually the customers have their operations unit as well as a separate vendor management unit.

Usually the larger companies have their sales teams interact with the vendor management group, while the relationship with operations and domain capability groups are maintained by the core delivery group who are more oriented towards the day to day operations of the clients. Essentially, distribution channels towards the customer is maintained both by delivery as well as vendor management units. And building up the relationship with clients is usually a time-taking process and does include costs when a new customer is approached by the sales team with the capabilities of the service or product providers in the software industry.

Capital Requirements

The capital requirement in the industry is usually low. Small companies can operate by just renting small buildings or some even from home offices. Networking facilities can also be hired with low cost in this age. As such with low capital requirements, the industry offers as ease of entrance.

Switching Costs

Switching suppliers is not easy in this industry. The primary purpose of every service provider is to build a repository of knowledge sufficient enough to service the operations of the client. And since it takes time and effort to build up this repository, either through people or through documents, it is usually difficult to switch suppliers – in terms of time, cost as well as the risks involved in impacting operations in case of an unsuccessful event in managing operations. The bigger factor of switching is the comfort factor of the customers in this industry in dealing with switching of providers. As a result, this is probably the most important aspect in barriers of entry.

Cost disadvantages independent of scale

For a potential entrant, there are multiple barriers independent of scale. One is the need to get resources with certifications and a high level of skill. The industry builds competency and certifications usually form a precious measure of it. For eg., customers usually demand a PMP certified project manager or legal-certifications needed for resources supporting compliance related operations or CPAs supporting accounting operations. Also there are certain cost and continuity advantages related to services being sourced offshore (like India & China) as opposed to on-shore or near-shore services. Usually the ability to service clients from Offshore is so strong, it is unusual to open operations without an Offshore unit being able to service clients, just from sheer cost & continuity of service operations perspective. The industry operations are primarily driven by the labor cost arbitrage paradigm.

In short, we see a number of barriers of entries in this industry, usually from distribution channels, switching costs and other costs independent of scale rather than prohibitive capital requirements in some other industries.

Q3-Substitutes

The primary form of substitute comes from the individual contracting as well as permanent staff categories of the clients, being managed by the client’s organization as in-house. Before software or consulting outsourcing services industry was present, all the work used to be performed in-house or with individual contractors being managed by the client’s IT division. On the other hand the mode of operations of Indian software services companies are SoW based; most companies operate in a turn-key mode rather than substituting for permanent employees and contractors. This has enabled client to concentrate on their core processes and business while keeping a lean management structure to enable their IT operations. This has cost savings associated with the expertise that they gain from companies whose primary focus is IT operations.

Although the industry has moved away from in-house IT operations, but still this remains as the primary alternative for clients against the outsourced software services providing industry operating under a GDM model. Another possible substitute can be in-sourcing. In in-sourcing a company has a special contractual relationship either with a specific unit of itself or another group which specializes in managing or performing a specific function within itself. An example is that of UPS which repairs Toshiba computers on behalf of Toshiba.

The work is done at the UPS hub, by UPS employees acting on behalf of Toshiba. Such in-sourcing capabilities can be performed onshore or near-shore by companies themselves or specific companies working on behalf of another. Although not in vogue as much like outsourcing, specific knowledge &capabilities of certain companies or groups of companies knowing & performing on behalf of another organization or another unit of the same company can form a powerful substitute in the future.

Q4 – Pressure of Suppliers

The primary supplier in this industry is labor force. Other than labor there are network service providers. The labor market demands in this industry are skill specific. Certain skills demand higher rates since the demands are high. Usually there is a demand-supply mismatch currently in the industry favoring the suppliers. The work in demand much outstrips the skills in supply. As such the suppliers currently have an upper hand over the companies that operate in this industry. As such rates of attrition and volatility of personnel changes are pretty high. As a direct result of such attrition, the cost to source appropriate skills is also high.

One of the primary reasons why the industry has seen a boom of offshoring is to reduce the cost of procuring skills on-site or near-shore facilities. Both India & China, with their high number of available educated skilled resources at a comparative lower costs and less benefits is able to provide a better cost alternative to the industry. As days have passed, more and more operations are being sourced at Offshore, now including development, testing, BPOs, KPOs and in some cases architecture consulting too. Increasing costs and heavy demand of appropriate skills has made the industry highly competitive from the supplier side. However, on the other hand, the industry does not have formalized unions (primarily due to demand mismatch) and continues to be attractive in that front.

Q5 – Pressure of Customers

The presence of large number of customers in the industry has somewhat enabled the customers to put pressure on the service providers. Through competitive bidding, customers are pitted against one another to force pressure. Specially in a multi-vendor scenario, especially with reduction in client’s IT investment, suppliers try to encroach each other’s area of operations leading to greater pressure being exerted by the client’s with relation to cost or quality or sometimes even commanding additional work or some items to be done for free. With the increase in software services outsourcing and freely available resources in the market with specialized knowledge or skill on specific functions of the IT industry, the knowledge-gap between software providers have dwindled.

With the customer in recent years cutting back on their IT investment has meant greater pressure to the software providers. In some cases customers even have asked for long term commitment through competitive fixed price bidding for multi-year operations projects without defining scope of the work appropriately. This has caused imperfect and sometimes incorrect pricing situations. With availability of a large number of providers with GDM capabilities have enabled customers exert their will over the service providers. In that respect, both from supplier and customer side, the margins of the service providers have reduced considerably as well as the growth of the industry has diminished also.

Q6 – Rivalry in the industry

All the factors stated above – lower barrier of entry due to low capital requirements, pressure from customers with reduction in IT expenditure and investment, pressure from suppliers due to higher cost of skilled resources & attrition and the availability of a viable alternative from in-house resources result in a very high level of intense competition. Earlier the outsourcing companies like IBM, PWC, Deloitte used to operate in onshore or near-shore locations only.

But with the increase of India, China & Brazil being powerful & intense alternate destinations, the outsourcing industry has taken a powerful dimension of off-shoring resulting in lowering revenues, decreasing profit margins or in some cases being eliminated from competition. The US based companies also face greater pricing pressure from Indian locals since they already have established in USA and Indian workers prefer joining named Indian companies like Infosys, Wipro, TCS who provide them with better opportunities.

The current industry does not have any market leaders as the top companies are equally competitive with mostly similar operating model utilizing aggressively the labor cost arbitrage phenomenon between societies in a globalized environment. Even the services that these companies produce are similar with very few differentiating factors (like cost or brand image). With reduced IT expenditure due to great recession companies more often than not poach other’s established customers or employees.

Also the growth that was established a decade or so ago with enhanced software services offshoring enabled the companies take a very aggressive growth strategy; but with a rapid reduction of growth as well as margins, the competition has become enhanced between various industry players with higher level of competency to address potential barriers of entry. Overall the industry has been dynamic with priorities shifting across geographies and the access to competition & customers are getting easier while access to resources is getting stiffer.


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