What Is Meant By Offshore?

In simple words, offshore can be any country outside the home country, similar to the word foreign. Before the promulgation of the phenomenon offshore outsourcing, the common usage of offshore in the business context was for offshore tax havens, often on small islands, offshore, such as the Cayman Islands off the coast of the US.

Today, the word offshore has taken a new meaning. It is understood by many of its business users to mean the shifting of tasks to low-cost nations, rather than to any destination outside the country.

Low-cost nations are those that fall into the economic grouping of “developing nations” or “emerging nations.” Thus a British software firm does not usually refer to its US software research center as an “offshore site.”

Offshore has spawned many derivative terms, the most important of which is the opposite: onshore. In this usage “onshore services” are those that are provided by foreign firms locally (onsite) often using lower-wage foreign employees. For example, the US special work visa, the H1-B, has been used to import labor in order to staff these “onshore” services.


Stories about offshore often mention follow-the-sun Opens in new window, also know as round-the-clock. Along with low costs, follow-the-sun is another allure of offshoring. It is often mentioned by those who seek to make offshoring sound unique and appealing.

Follow-the-sun Opens in new window, as the name hints at, exploits time zone differences to speed up project work. For example, a team in America can hand off its work at the end of its day to team members in India or China, who can then continue the work while the US team members sleep.

The Offshore Stage Model: progression and diffusion

We now turn to look at companies that are offshoring in order to understand the progression and diffusion of this phenomenon. The Offshore Stage Model, first described in an article by Carmel and Agarwal, helps us to tell this story.

Companies tend to move through four offshoring stages depicted below, in Figure 1.1.

Stage I

Companies that do not offshore are in Stage 1, known as, Offshore Bystander, in which they metaphorically watch the others. In fact, as we later discuss, most companies, whether large or small, are still in Stage 1.

Stage II

Stage 2, known as the Experimental, is a transition stage in which companies test the offshoring waters for a year or more. For large corporations this stage’s expenditures could be as large as 10-20 million USD per year.

offshore stage model
Figure 1.1 The Offshore Stage Model.
Credit: Erran Carmel, Paul Tjia, Offshoring Information Technology: Sourcing and Outsourcing to a Global Workforce

Experimental is a wise approach for organizational learning and risk reduction because of the many difficulties in offshoring. Savvy managers experiment to the point where they see measurable, positive results, and only then do they grow to the next stage. Some call this the “Start-Small” strategy and, according to one study, 63% of companies are using this approach.

Stage III

In Stage 3, called the Cost Strategy, companies begin to experience significant and consistent cost savings in their IT work. By this stage, firms have corrected some early missteps and have expanded their offshore activity as measured by number of projects, staff, or budget. There have been hundreds of firms, if not thousands, large and small, which claim cost savings in their software related activities driven by the low wages in offshore nations. Various studies have tried to determine just how much offshoring saves. The composite of studies indicate that the cost savings ranges from 15% to 40% for companies offshoring at least a year .

Stage IV

Experienced companies move to Stage IV, the highest stage, where they truly leverage offshoring. In this stage companies move beyond mere cost savings derived from wage differentials and benefit from other strategic advantages. Here, offshoring is used to drive innovation, speed, flexibility, and new revenues.

The Offshore Stage Model is also useful to measure offshoring diffusion. Since its inception in 2002, it has been used to estimate the ratio of large companies at each stage of the offshore progression, as shown in Table 1.1.

Table 1.1

Stages Percent of 1000 largest US firms in this stage (2003-2004) Percent of all software work which is offshored for a typical firm in this stage (%)
Meta Group (%) Forrester (%)
Stage I 55 55–60 0
Stage II 33 25–30 5
Stage III 8 5–10 10–30
Stage IV 4 <5 40–50
Source: Estimates by Meta Group and Forrester

The rough estimates in this table, made by two American research companies, indicate that only 10% of the largest US corporations were active in offshoring in 2003—2004 (i.e. they were in either Stage III or IV). Furthermore, about half of the largest American firms do not offshore at all. In spite of the enormous attention to offshoring in the US in the early 2000s, offshoring was still rather limited.

The stages can also be used to anticipate offshore diffusion for large firms. If, assuming conservatively, only 20 firms a year move out of Stage 1 and into Stage 2, and the annual advance from stage to stage is just 10% of the firms in that category, then by 2010, nearly one-third of US “Fortune 1000” firms will be active offshore users in Stage III and IV.

Driving Factors of Offshoring

Offshoring IT work is an important milestone in the history of global economics. But why has this happened now?

Offshoring is emerging from a set of six driving factors that have unintentionally converged at this particular time, as depicted in Figure 1.1, to enable the shifting of work to its lowest-cost provider regardless of the provider’s physical location.

  1. Globalization of trade in services

The first of these factors is well known: the globalization of trade and, more recently, the globalization of trade in services, which is now approaching 2 trillion USD annually. Borders began opening in the 1980s as market-based solutions gained broad acceptance. The collapse of the Soviet bloc spurred this process even more.

  1. Business friendly climate

Nations that were once hostile to business, or at best indifferent, are now competing with one another to attract foreign investment and spur their software sectors, creating a business-friendly climate. Nations are offering tax incentives and are easing government regulations. They are building technology parks to make it easy to set up and run business operations. India and the Philippines are dotted with such technology parks. To date, China has established 15 software parks and 53 technology parks.

  1. Growth of offshore labor pool

Interesting, the number of engineers pouring out of universities and technical schools in India, China, and other nations has surged. China, alone, graduates four times as many engineers as the US every year.

While the quality of these programs was once inferior to those in industrialized nations, the gap has narrowed. The elite of the offshore labor pool — the talent that is now being directed at higher-end software activities (e.g. research and development [R&D]) — was always there. But, not long ago, this talent would emigrate to the industrialized nations or find other jobs. Today, global technology firms tap these talented engineers and scientists wherever they may be.

  1. Drop in telecom costs

In the course of just a decade communication costs have decreased to almost zero for nearly unlimited usage. This has brought about a remarkable outcome — that it is almost as easy to work with someone across the ocean as across town (though not equally the same). Between the late 1990s and the early 2000s the benchmark international calling rates have fallen by 80-90%; that is, for those who still use standard rates.

Many software workers use voice over IP at zero marginal cost. Equally important for software, the bandwidth has expanded by orders of magnitudes, from almost zero n the late 1990s, reaching 4 gigabits per second to India alone in 2004 (with up to 9 terabits per second of system capacity). It was only in 1994 that one of the pioneering project managers offshoring to India had his team copy the weekly software “build” onto tape ever Friday just in time for the FedEx pick-up that would fly the tape across the ocean.

  1. Software commoditization

Software commoditization is not as well understood by those outside the software industry. It is the standardization of software development practices and tools. For the first time, in software’s 50-year history, some software tasks are sufficiently routinized and automated that they have been commoditized. These tasks are nearly undifferentiated by producer, like a barrel of oil or a bushel of wheat. Once some tasks are commoditized they can be produced by the lowest-cost, most-productive bidder. As one manager commented to us “these are the skills that you can shop for on the Internet.”

  1. Wage differentials

Finally, and make no mistake about it, the dominant force in offshoring is the wage differential between low– and high–wage nations. The wage differentials lead to lower costs. Some managers will utter other politically acceptable reasons for offshoring that seem less offensive than simply slashing costs, but these are often secondary considerations voiced for appearances. The cost pressures have made offshoring a strategic necessity for some firms.

Not only are corporate executives stressing cost savings, but American venture capital firms, in an effort to reduce their own capital investments in young firms, have pushed technology startups to perform their R&D offshore from the outset. Until the 1990s, technology firms looked largely at labor pools in high– and middle–wage nations: the G7 nations, Switzerland, Israel, Brazil, and several others. This has permanently changed.

There are other secondary forces that helped spur offshoring, such as the emergence of sophisticated IT firms offshore, especially in India; and the advantages, in isolated cases, of working around the clock. Additionally, market access has been a factor for large technology companies. Large global firms need to, or are forced to, invest in operations in important nations. China is the premier example of this. No important technology firm can sell to China today without having some R&D or manufacturing operations in-country. For example, in 2003 China mandated its own cryptographic standard for wireless local area networks (LANs). Foreign firms who wanted to access this market were forced to collaborate in software R&D with local companies.

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