EBE Assignment

7/30/2019 EBE Assignment

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Economic Vulnerabilities and its costs:-

Organization has been growing at a rate of 30% over the last 5 years and much of this growth has beenfueled by strong demand for outsourcing services as well as Organizations investment into its infrastructureand human resources.

The major component for the cost of revenue for its applications outsourcing services is salary for skilledsoftware professionals, followed by the hardware environments to support software development,maintenance, and software licenses. The software cost includes proprietary software, tools and packagedsoftware. Additionally, the skilled software professionals require investment for both Organization-specificand client technology-specific knowledge training.

As these employees become highly skilled at the specific technology it becomes costly to replace them andthe cost becomes a quasi fixed cost. This is due to the fact that the portfolio of legacy systems software isusually the dominant portion of its installed base of software, and requires specific knowledge of its usageand implementation.

Furthermore the labor market regulation imposes severance costs for cutting the labor force and asOrganization has already invested in the enhancement of skill, knowledge and overall quality it becomesdifficult to layoff skilled workers and loses the opportunity to amortize their investment. Hence when theeconomic environment sours which is outside Organization control it reinforces the Quasi Fixity due to itsinvestment in resources which results in type-1 vulnerability for Organization. As a result of these externalevents, it cannot layoff the experienced workers and lose the opportunity to amortize their investmentwhereby adding costs to its operations and squeezing its bottom line. There was ample evidence of thisduring 2003 and again seen in 2010.

Secondly, lot of the software purchased is specific to the clients requirements and cannot be easilyrepurposed due to the depreciation of software assets and can be considered sunk costs.

Average Cost Curve

0

5

10

15

20

25

30

35

40

45

50

Volume of

Production

Volume of Production

AverageC

Qout


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As a result of this the SRATC curve for Organization represents a moderately steep U curve. Thisrepresents a Type 1 Vulnerability wherein the intensification of the competitive pressure leads to decreasingmarket share and prize pressures which can squeeze the operating margins and makes it vulnerable toexternal shocks.

Approximately 79% of the billable workforce is based out in India and due to the growing shortage of highlyskilled professionals with lot of competition, the wage costs have been rising significantly. As Organizationssuccess depends on its ability to attract, retain and effectively utilize highly-skilled professionals, theshortage has caused salaries to rise which has raised the Short run average cost rise. As a result of thisthere has been an increased margin pressure.

SRATC Curves adjusted forWage Inflation

0

5

10

15

20

25

30

35

40

45

50

0 2 4 6 8 10 12 14 16

Average Cost with Wage inflation Average Cost

The conclusion of this is that Organization has significant exposure to Type1 and Type 2 vulnerabilities tothe nature of its cost structure as shown in table below.

%

%

Internal Costs as % of Total costs 0.18

Fixed Costs as % of Internal Costs 0.78( High Type 1)

External(hiring) costs as % of total costs 0.35( Med Type 2)

Organizations Market Exposure

Organizations Competitors:-

Organizations gets 92% of its revenues from the Fortune 500 companies where they work with the I.Torganization across the Enterprise to provide outsourcing services. As a result of this, they come acrossstrong competition from large as well as Mid-sized Outsourcing providers.


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Organization is ranked at 16th among the Indian Outsourcing providers by NASSCOM in terms of revenuebut has outperformed some of its peers with operating margins of 28% which is one of the highest forOutsourcing providers where the average Operating margin is around 15%.

Even though there are many IT service providers who cater to the Fortune 500 companies, Organization hasbeen able to differentiate itself through high value application management services using its Global DeliveryModel and customized frameworks and processes to meet the clients needs.

This has been a source of Organizations market power due to its differentiated product which means that itfaces a downward sloping demand curve and is moderately inelastic. The cross price elasticity of demandbetween the services offered by its competitors is positive, but Organizations services are described asclose but imperfect substitutes. The services offered by them perform the same basic functions but havesubtle differences in how, where and what is offered to distinguish them from each other.

As can be seen from the above figures, the overall industry profitability is around 14% which is asupernormal profits (greater than 8%) and Organization is one of the leaders in its peer group in both theoverall operating margin as well as the net profit per employee figures.

This demonstrates that even though the Supernormal profits have attracted new entrants into its marketwho try to reduce the cost to their service, Organization has managed to maintain its margins through itsApplication Outsourcing services which require a very good understanding of the client applications. The

extensive knowledge transition and high switching costs required to onboard a new provider for the clientreduces the threat of new entrants into its key markets and ensure it does not descend into Strategic Hell.

Price Elasticity :-

Organization believes in a Customer for Life philosophy which emphasizes flexibility, responsiveness,cost-consciousness and a tradition of excellence. It is focused on the organic growth within its existingclients which account for almost 80% of its overall revenues wherein it is able to expand the range ofservices due to its understanding of customers applications and business.


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Number of Resources supplied

WageRate($/H

r)

Demand

D1Demand

D2Supply Curve

S

30

1000

720 810

shift

Figure: - Organizations Price Elasticity

Most of the services provided by Organization require deep understanding of the clients businessapplication and knowledge transition to provide application outsourcing services which it is able to dothrough its mature processes. As a result it is able to create differentiation through service excellence andable to exercise market power and some degree of control. This market power derived throughdifferentiation extends not only to pricing but also to its price elasticity.

Due to this knowledge transition requirement, the threat of substitution is reduced in the short term due tothe high switching costs involved in providing the outsourcing services. As a result of this, when the demandfor the application outsourcing service rises due to the increased cost pressure at client location the demandcurve shifts to the right.

However, Organizations demand is relatively inelastic in the short term due to training and knowledgetransfer requirements for its resources which can be seen from the diagram above.

GDP Development :-

Organization generates 92% of its revenues in the North American markets while 76% of its operations staffis based in India. However this has not insulated Organization or any of its India based ApplicationOutsourcing competitors from the effects of fluctuatations in the GDP Growth.


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GDP Growth %

-6

-4

-2

0

2

4

6

8

10

12

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Canada

UK

USA

India

The current global economic slowdown has made it a roller coaster ride for the Application Outsourcingcompanies. Organization being dependent on the IT spends in the North American economy has also beenexperiencing the tremors of the global economic crisis.

IT spending as a percentage of revenue normally varies from 3.5% to 6% in most industries to whichOrganization provides IT services and as the demand for IT services is a derived demand, any fluctuationsin the GDP or consumer demand has an effect on IT services.

A declining or slower GDP growth in the U.S. impacted the businesses growth outlook and IT budgets forthe major clients serviced by Organization. As a result there was a marginal decline in the revenue growth of

the Outsourcing companies as their clients began to defer the expenditure on new IT deployments due tothe economic conditions. This impact was higher for discretionary outsourcing expenditures rather than forcritical, ongoing Application Development and Maintenance (ADM) services.

As Organization is focused on providing ADM services as well as discretionary outsourcing services, therewas a moderate impact on its revenue growth as can be seen in the figure above.

Macro-economic Exposure:-

Exchange Rates,Interest Rates & Inflation :-

Exchange Rate and GDP :-

Organizations sales are primarily sourced in the United States and its subsidiary in the United Kingdomand are mostly denominated in U.S. dollars or UK pounds, respectively. Its India based subsidiaries incurmost of their expenses in the local currency. As majority of its business comes from North America itbecomes very susceptible to the macroeconomic changes in North America. As of December 31, 2010,


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approximately 79% of the Organizations billable workforce was in India, while 93% of its revenues weregenerated in North America.

The table below lists the revenues from different geographies.

GDP and Syntel Revenue Growth

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Syntel Canada U.S

Revenue Share by Geography

North Am erica

Asia-Pacific

Europe

Their exchange rate risk primarily arises from their foreign exchange revenue, Interest rate, rise in inflationand foreign currency debt.

The exchange rate between the rupee and dollar had fluctuated significantly in recent years and maycontinue to fluctuate in the future as shown in the figure below.


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The depreciation of rupee during 2008 2009 was the outcome of surging demand for dollar due to high

demand for Oil. As Oil is traded in dollars, the demand for oil increases the demand for dollar. Oil prices

during that period hit a new record of $135 per barrel in May 2008. As most of Indias crude oil requirements

are met from imports, rising prices of crude oil meant that domestic oil companies needed more dollars to

fund their purchases. This triggered a surge in demand for dollar leading to a weakening of rupee.

Operating Margin

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

2005.5 2006 2006.5 2007 2007.5 2008 2008.5 2009 2009.5 2010 2010.5

As a result the appreciation in the dollar to rupee conversion reduced their costs for salaries in India andincreased their margins. As can be seen from the above graph, the weakening of the US dollar in 2007depressed the earning, but as the dollar began to strengthen in 2008 and 2009, the margins began toincrease again. It is anticipated that for every 1% movement in the Indian rupee to US dollar rate, there is an

impact of around 40 basis points to Organizations margins.

A 1.52% decrease in operating margin for application outsourcing in 2008 & 2009 was attributable primarilyto an increase in the exchange rate for the Indian Rupee (INR) against the US dollar.

Wage Inflation:-


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The Majority of the Organizations contracts are multi-year fixed price contracts where the client has locked-

in the rates for the next 3 to 5 years for providing the Application Outsourcing services. This places an

emphasis on planning the outlays over years and attempt to deliver on budget to maintain their margins.

The explosive growth of software development firms in the last decade had led to an increase in the wages

paid to software developers, which on average has increased by 10% annually (in 2010). As the industry in

which Organization operates is a very human capital-intensive industry and the projected 30% annualgrowth rates are approximately comparable to the growth rates in demand for workers, this has created a

shortage of engineering graduates.

As a result, the wages for employees has been rising at over 10% year over year as the competition fortalent increases from competitors and other industries. An 8.2% increase in its cost of revenues in 2010 was

attributed primarily to the increase in headcount and salaries.

This has further created margin pressures for Organization and puts emphasis on Productivityimprovements to control the cost increase due to the Wage inflation. This wage increase in part has beenbuoyed by the high inflation rate in India which has been averaging around 8 % in the last 5 years.

Interest Rate and inflation rate :-

One of the key factors which affect the GDP and exchange rate is the interest rate and the inflation rate. Afall in the interest rates usually increases the business confidence and the level of economic activity for thebusiness.

However this did not seem to occur during the 2009 and 2010. Even though the US interest rates were at anall time low level of 0.25%, the US GDP continued to falter despite the increased money supply. Theabnormality was due to the impact of the credit crisis and implosion of the US housing market. Thisimpacted the domestic demand which drives the business for Organizations client.


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The US inflation has also been very low during this period which helps to boost the economic growth but this has

also had limited effect due to the ongoing credit crisis.

Protection:-

Production Possibility Frontier and Entry barriers :-


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While we dealt with the short run macroeconomic exposures faced by Organization, we will shift the focus inthis section to understand the long run strategies adopted by Organization to address its vulnerabilities. Inthe long run period the quasi fixed inputs such as labor become fully variable and can be changed andconfigured. The investment in human capital and infrastructure which was constrained in the short termenables it to produce it more in the long term.

Organization has been able to make significant investments in the development of new facilities to increasethe seating capacity. Organization has used its Global Delivery Model to implement a knowledgemanagement program and increase the productivity of its resources. This learning effect has helped it toincrease the efficiency of its operations and lower the cost of its services which has been a competitiveadvantage for it.

A v e r a g e C o s t p e r E m

0

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1 0 0 0 0

1 5 0 0 0

2 0 0 0 0

2 5 0 0 0

3 0 0 0 0

3 5 0 0 0

4 0 0 0 0

4 5 0 0 0

5 0 0 0 0

2 0 0 1 2 0 0 2 2 0 0 3 2 0 0 4 2 0 0 5 2 0 0 6 2 0 0 7 2 0 0 8 2 0 0 9 2 0 1 0 2 0 1 1

Keeping in mind the quality of the labor available and the forecasted demand, Organization has started anindustry-academia programme aimed at enhancing the quality of education in the IT arena. Organizationhas partnered aggressively with education institutions to implement curriculums in accordance with thefuture requirements of the IT industry. It has also created special programs to develop the skills andspecialization required for its future needs and alleviates the labor shortage in the long term. This not onlycreates a human capital for it but also increases the barriers to entry due to its influence on the supply ofskilled employees and provides Organization a mechanism to neutralize the effects of wage inflation and itstype-2 vulnerability.


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Brand Development and Positioning

Organizations services are best described as close but imperfect substitutes as the services it caters to areapplication management services which can be replicated easily, however Organization differentiates itselfthrough the way these services are delivered. The key to its superior performance is not pursuing the samestrategy as its competitors but exploiting the differences which exists between them through customized

frameworks for its clients.

Price Discrimination:-


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Price discrimination is very important in Application Outsourcing as it often leads to significant marketpower.

Organization has been able to differentiate itself by leveraging different pricing models to acquire new

customers as well as lock-in existing customer through price discrimination.

It leverages a Fixed Price model for the initial entry wherein it commits to free transition to replace

existing provides and commits a risk/reward with its customer for working towards a common goal of

bringing predictability and efficiency in its new engagements.

It has uses an outcome based Managed Services model for its existing customers which shifts the

focus on outcomes versus the effort capacity of labor thereby allowing it the flexibility of leveraging its

frameworks. It is able to share the cost benefits of this flexibility with the clients and as a result able to

effectively use Cloud Computing to affordably deploy, flexibly manage a broad range of services. This

provides variabilization of cost and scope of the IT resources and reduces its type 1 vulnerability.

Hedging:-

Organization has been using the foreign exchange forward contracts to mitigate the risks of changes in

its cash flows denominated in certain currencies.

Strategic Positioning and Competitive advantage :-

Even though Organization is a provider of Application Outsourcing service, it is able to differentiate itselfthrough its domain specific offerings and training. Its strategy of focusing on key clients (75% revenue fromtop ten customers) allows it to create customer specific frameworks and focus on organic growth to drive itsbusiness.

Similar to perfect competition, it has many firms which have free exit and entry, but unlike perfectcompetition it is not competing solely on price but has differentiated services which produce supernormalprofits. This Monopolistic competition model retains all the characteristics of a perfectly competitive model


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but the product differentiation creates a market imperfection giving it a quasi monopoly power, which is afirm specific imperfection and creates competitive advantage.

Even though cost reduction is the key factor driving Organizations growth, it has built competitive advantageby focusing on delivery excellence, innovation, flexible pricing models and effective knowledge managementfor its key clients and sustains its margins.

The challenge is though to sustain its differential advantage with new entrants being attracted by thesupernormal profits. The new entrants increase competition for resources as well as the market, butOrganization has been able to create imperfections by locking-in business through long term contracts andfocusing on innovations for clients.

Conclusion:-Even though the IT Outsourcing landscape has seen growth-related challenges in the short term withincreased competition, Organization has been able to sustain its growth and profit margins by focusing onkey clients by leveraging strategic areas of differentiation and does not descent into Strategic Hell. It hasmanaged its bottom line through measures to address its macroeconomic exposures and utilize its

profitability levers for moving beyond cost reduction to co-creation of technology solutions and buildsustainable advantage.

As the US environment still looks weak, Organization would have to focus on expanding its geographicalboundaries to Asia-Pacific and Europe to create new opportunities. These areas, if tapped intelligently,would enable Organization to ease the blow of this financial crisis and help them tide through the toughtimes.

Bibliography

1. Managing Global Financial and Foreign Exchange Rate Risk by Ghassem

A Homafair

2. WWW.IMF.ORG

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