Offshore R&D Takes Off

Research and Development isn't core anymore. MoreÂ
and more US companies are outsourcing R&D projects to offshore
service providers as they look to cut costs and take advantage of available
expertise in Asian countries such as India and China.

The potential benefits of an offshore R&D outsourcing
strategy are compelling: companies can save money because of lower labor costs
and gain an early foothold in some of the fastest-growing overseas markets by
having an R&D presence in those countries. But offshoring R&D also comes
with challenges and risks, such as overcoming language and cultural barriers;
security and regulatory issues; protection of intellectual capital; and the high
turnover rates of employees in foreign countries.

However, these and other concerns are not stopping
increasing numbers of US companies from shifting at least some of their R&D
efforts offshore. Some of the work is  conducted
in captive (company-owned) centers, but more of it is sent to third-party
service providers. Some of the work results in functionality embedded in cell
phones or laptops, but quite  often
the work involves commercial software.

A practice that began with General Electric hiring
engineers in India more than a decade ago is becoming pervasive in the IT
industry, with technology-sector heavyweights such as Microsoft, IBM, Cisco,
Intel, AMD, Motorola and Texas Instruments moving some product development to
India or China. US companies in industries such as electronics, pharmaceuticals,
automotive manufacturing, and biotechnology are outsourcing more R&D work to
service providers in China, India, and other countries.

“Currently larger amounts are flowing into
China in the area of new product development and manufacturing research,” says
R Balachandra, professor, College of Business Administration, Northeastern
University, Boston, Mass. “The flow to India is in the area of pharmaceuticals
and in high-level R&D, which is expected to increase significantly in the
future.”

“Essentially, the main driver is growing demand for
innovation that US companies face on a global scale,” says Navi Radjou, VP,
Forrester Research “Unfortunately, US firms lack in-house capabilities to
effectively meet that growing demand.”

The transformation in R&D strategy is reflective of
changing corporate views of risk and reward. R&D is both a business
expense-and a risk-that doesn't always pay off. In contrast, the concept
of transferring R&D risk to a third party that guarantees results begins to
persuade corporate strategists. It's becoming too expensive for corporations
to adopt a 'not invented here' attitude.

But, of course, there's a trade-off. It's harder to
manage what you don't control in-house.

Heating Up

Consulting firm Frost & Sullivan has estimated that the IT R&D
outsourcing market in India alone will increase from $1.3 bn in 2003 to $9 bn by
2010, at a compounded annual growth rate of 32%. The R&D outsourcing market
for telecom in India is expected to increase from less than $1 bn in 2003 to
$4.1 bn in 2010, at a CAGR of 29%.

Ernst & Young's 2005-2006 Global Transfer Pricing
Survey released in November 2005, which polled 348 multinational companies and
128 subsidiary companies in 22 countries, found that about 10% had created
either new or relocated R&D operations in the past two years. Of these, 27%
said India was the leading destination for relocation, while 17% identified
China as the leading destination.

The  offshore
R&D outsourcing market has attracted both large service providers and
smaller niche players that focus on specific industries. Among the companies
offering services are Wipro, MindTree, HCL Technologies, Sasken Communication
Technologies, Satyam Computer Services, Ness Technologies, and Office Tiger.

Wipro, with more than 12,000 engineers in Bangalore, is the
world's largest independent R&D services provider. Its R&D services
business has grown an average 36% over the last three years, according to Sachin
Mulay, strategic marketing manager-embedded and product engineering group, Wipro.

The company provides services such as product strategy and
architecture, product design and development, product verification and testing,
and product lifecycle management to companies in sectors including IT, consumer
electronics, automotive electronics, medical devices, and telecom.

Wipro is providing R&D expertise in some of the hottest
technology areas for US companies. For example, the Wipro RFID Centre of
Excellence offers a portfolio of radio frequency identification enablement and
deployment services for retail, consumer goods, and distribution companies. The
RFID center provides consulting, data integration,  application development, and deployment and data analytics.
Mulay says Wipro has created an 'Innovation Council' that funds and supports
the development of intellectual property in areas such as wireless local-area
networks, Linux, and hands-free telephony technology.

Another R&D service provider, MindTree Consulting, is
seeing 70%—90% annual growth in its business as demand for outsourcing
increases, contends S Janakiraman, president and CEO-R&D Services, MindTree.

The company leverages its expertise to offer custom
product-development services including end-to-end new product development,
creation of subsystems or modules of an existing product that need additional
features, re-engineering of existing products, licensing of intellectual
property on an upcoming technology and sustenance engineering of existing
products to fix bugs and produce new releases.

Over the last 15 years companies, including computer
hardware manufacturers, communications and networking system vendors and
software application developers, have used offshore R&D services, says
Janakiraman.

More recently companies in consumer appliances, storage
systems, semiconductors, medical equipment, and automotive/avionics engineering
have outsourced R&D to India.

Driving Offshore R&D

There are a number of key drivers  and potential benefits of R&D offshoring,Â
according to experts. Forrester talks about newly emerging 'innovation
networks' that will allow US companies to match global demand for innovation
with a worldwide supply of talent and ideas, including those available in India
and China.

“Innovation Networks will let firms fluidly weaveÂ
internally and externally available invention and innovation services to
optimize the profitability of their products, services and business models,”
says a Forrester report released in 2004. These networks “will deconstruct
vertically integrated invention-to-innovation cycles in software, finance and
industries-and reinvent the formula for success in
regional, national, and global markets.”

US companies are also facing competitive pressures to
introduce new products at an ever faster pace, and that puts more pressure on
the R&D team, which might not have the resources to meet the growing demand.

One of the main benefits of offshore R&D outsourcing is
the presence of a large pool of lower-cost talent in other countries. Through
outsourcing, companies can get access to R&D, engineering and scientific
expertise that might not be available at an affordable cost-or at all-in the
US.

“Currently the wages of a science or engineering graduate
in China or India about 20% or less of US wages,” says Balachandra.
“But these wages are slowly inching upwards.”

JMD Manufacturing, a manufacturer and distributor of
production-line machinery such as label dispensers, conveyor line markers, ink
cartridges and related supplies, has saved 30%— 40% in labor and material
costs by offshoring R&D, according to Sushil Bhatia, president and CEO, JMD
Manufacturing.

JMD Manufacturing has been using offshore service
providers, mostly in India, for R&D since the mid-1990s, says Bhatia. “For
the last 10 years the Indian government has been pushing into new product
development,  R&D and exports,
so this fits into the goals of the Indian government, and meets our goals of not
having to spend too much money on  developing
products,” says Bhatia. “India seemed like a natural place for us to start
developing products.”

He declines to identify the service providers JMD is
working with, but says the relationships have been successful, and the company
has developed 12 to 15 of its new products as a result of R&D efforts in
India. One of the areas JMD is focusing on with new development efforts in India
is RFID used in combination with nanotechnology, particularly as a technology to
prevent the counterfeiting of products.

Another company that has benefited from offshoring R&D
is Micromuse, a San Francisco-based developer of IT infrastructure-management
software. Micromuse outsourced its R&D operations-mainly testing and
quality assurance of products initially-to Ness Technologies in India in
November 2004.

Ness is helping Micromuse build an R&D lab in Bangalore
called Extended Development Centre (EDC). Ness manages the lab,Â
and Micromuse has the option of taking over the facility at some point in
the future. Micromuse started with test functions initially because it was “a
low risk strategy and would give us good exposure to the offshore model,” says
Richard Callaby, VP-engineering services, Micromuse. “This allows us to
incrementally increase our use of offshore as our confidence grows.”

The outsourcing strategy gives Micromuse more flexibility
in terms of future product development and testing resources, Callaby says.
“The offshore test team is now an intrinsic part of our delivery capability,
providing coverage for 75% of our product portfolio with the remainder due to
complete early this year,” he says. “These teams fully complement our
global-test functions within Micromuse and work cooperatively asÂ
one team to ensure our delivery goals and objectives are met.”

The greater flexibility has resulted in costs reductions,
although Callaby did not specify how much the company is saving. Other gains
include removing bottlenecks for product releases through more efficient testing
and increasing the depth and breadth of the tests and quality assurance
processes.

Micromuse plans to offshore some of its non-core
development functions to Ness over the next several months, says Callaby.

Another driver of offshore R&D is the desire to break
into new markets in Asia, where populations and demand for new products are
growing faster than in the US. “Traditionally, the focus was to make things
overseas to sell back here. But there's a sense that consumer is
taking place overseas,” says Keith Rabin, president of KWR International, New
York, a research and consulting firm specializing in business and technology
development.

Population growth in these overseas markets will likely
accelerate over time, fueling even more demand for goods and services, says
Rabin.  He cites as examples the
rapid rate of adoption of products such as cell phones in Indonesia and high
broadband communication penetration rates in Korea.

As a result of the rising demand, US companies will shift
some R&D, manufacturing and product testing to Asia to be closer to those
markets, and therefore serve them better. “We've got a maturing market here
. Companies have to adopt a more global model with the growth driver
being overseas markets,” says Rabin.  A
big part of that strategy will be conducting R&D in these foreign markets,
he says, and it will often be with help from service providers.

Much of the manufacturing of goods already takes place
overseas, and it makes sense to have R&D and manufacturing in physical
proximity, Rabin adds. “It helps to have the R&D people close to the
actual factories so they can make modifications,” without the time-consuming
and costly effort of sending products back and forth from the US to the overseas
plants, he says.

Risky Business

But companies considering offshoring any R&D work need to consider the
potential hurdles. As with any business processes handled in foreign countries,
there will likely be language and cultural barriers to overcome.

Another concern is having adequate protection of
intellectual property (IP)-a major component of R&D efforts. Companies
need to determine how they will safeguard IP and make ownership rights clear in
contracts with outsourcing providers and other partners. There are also security
implications with sharing research data and trade secrets electronically.

“The big challenge is the IP issue-will the IP of the
US firm be safe?” Balachandra says. “India has better IP protection than
China. From a strategic perspective, there is another challenge. Will the US
firm lose its ability to innovate if most of its R&D is done offshore? Does
this mean that the US firm should send out only those activities that are not
strategically important? These are serious issues that need to be looked at.”

Labor issues are another concern. While countries such as
India have large numbers of highly skilled engineers and other knowledge workers
who are eager to work on the latest technologies and products, the attrition
rate tends to be higher in other countries than in the US, says Paul Schmidt, a
partner who heads the global service delivery practice at TPI, The Woodlands,
TX.

Companies that outsource work overseas can expect to see a
relatively high rate of turnover among workers on a given R&D project. That
could create some risks in terms of shared trade secrets and intellectual
property. One constant concern for corporate customers is the prospect of a
competitor hiring its supplier's most talented R&D engineers. Employment
contracts are not exactly ironclad.

Companies considering offshoring R&D must also put
processes in place to ensure that product development cycle times are fast
enough, says Schmidt. That includes making sure hand offs from one entity to the
next are done in a smooth and timely manner. Incentives are often a part of
agreements, too.

JMD Manufacturing sometimes encounters delays in getting
responses from the people involved in development projects in India, Bhatia
says, largely because the Indian service providers are becoming increasingly
busy working for different clients. “We have to keep them focused,” he says.
JMD has implemented technologies such as instant messaging, video conferencing
and voice over IP telephony to help improve communications between its US office
and the service providers offshore, as well as keep costs down.

Another potential problem with offshoring R&D is the
political backlash and negative publicity that might result. “R&D
doesn't really employ many people, so on the one hand it probably doesn't
get noticed so much, as far as eliminating jobs in the US,” says Rabin. “But
on the other hand, in many cases people feel that the US. is supposed to retain
R&D for competitive reasons.”

The cost of R&D outsourcing might be another hurdle for
some. While pricing models are essentially the same for R&D outsourcing as
with other types of service engagements, the cost of R&D services tends to
be higher.

“Margins are higher for R&D services because there is
a different set of resources that command higher prices,”Â
says TPI's Schmidt. The people who work on R&D projects generally
have more specific skills and background such as wireless communications, Java
development, or industry-specific knowledge.

Janakiraman of MindTree says the company offers a variety
of pricing models including charging clients on a fixed-price or time and
material basis. “There are few product developments done on a risk-reward
model that has an element of IP co-ownership, and priced with clear
objectives of timeline, performance, bonus, and penalties,” he says.

Because the R&D services work is more specialized,
Janakiraman says, they are normally priced 15%—25% higher than application
development, depending on the complexity of the work and scarcity of skills.

But the higher fees apparently aren't keeping businesses
from shifting much of their R&D work to offshore providers. “Companies are
developing full-blown products out of India,” says Vamsee Tirukkala,
co-founder and EVP, Zinnov LLC, a Bangalore-based firm that helps clients with
offshoring activities.

“Some startup and mid-sized companies have their entire
engineering teams in India,” Vamsee says. “Companies are leveraging vendors
for doing specialized tasks or non-critical/monotonous activities. Some are
building centers of excellence for vertical domains in their India centers.”

Despite the apparent management challenges offshore R&D
is a compelling business proposition that an increasing number of corporate
customers will find impossible to resist in the remainder of the decade. Not
every project will succeed. Cautionary tales will abound, but paying close
attention to best practices in governance may make all the difference between
success and failure.

Bob Violino

Republished with permission from Global Services

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