I have briefly blogged about it earlier, and this point continues to interest me. Profit margins of Outsourced Product Development (OPD) companies has continued to lag behind that of the more generic Outsourced Software Development (OSD) counterparts. The top brands in OPD space have been well behind their better known top Indian companies in the OSD space.
I believe that this is a warning sign for OPD companies and they need to evolve their offerings or risk losing their identity with the more generic software OSD vendors
Before I go further, as per commonly used terminology, Offshore Product Development (OPD) refers to transferring design, development, testing and other related services of the product development life cycle to a third-party service provider. Some companies make a part of a product, some do re-engineering, while a few develop an entire product. Offshore Software Development (OSD), on the other hand, is customized application development or services for a company’s own usage and is usually non-distributive in nature—this could be customized application development, application migration, software functionality testing, packaged software implementation, etc.
Common industry understanding is that OPD needs teams that are more skilled (and are paid higher) than those that work on vanilla OSD. In terms of development, OPD is considered more difficult. Usually, in the case of OPD, your customer is the open market so the product has to be flexible enough to be used across user-base. In case of OSD, you know your users well and can interact with them, this makes the job a lot easier for the developers involved.
At first indication, it would seem natural that companies with a niche (and more complex) offering would have a higher price & higher margin business than that of a plain vanilla offering. The flip side would be niche players would probably have a smaller size as they are not attacking the entire market. However, while the latter part (about smaller size) appears to be true, when it comes to profitability it appears to me that most OPD companies have lesser profitability compared to their OSD counterparts.
Lower OPD profitability: Possible reasons
What could the reasons be? I think this could mean one of the following:
1) The actual work being performed does not command higher value, in the eyes of the customers
This could be the case in case there are projects in which a large part of the product specifications are being provided by the client. In such cases, the clients may genuinely feel that the value add of the OPD is not much higher as compared to the other OSD vendors. While the client may still be willing to give business to OPD vendors due to other reasons e.g., the development tools & automation processes that products need, but may not be willing to pay much higher in terms of billing rates. Should this be the case, then the way out for OPD vendors would be to move up the value chain and be able to get work that can actually justify higher billing rates and higher margins. However, this is exactly what OSD companies have also been working on, so that question is if the OPD companies would be able to grow fast enough to maintain their separate identity.
2) The value addition is not significant enough, and is being offset by higher employee costs
The other reason could be that there is some value addition and higher costs being charged by OPD players, but it is not significant enough and is offset by higher employee costs. I don’t have the data to make a conclusion on this, but from a pure financial perspective it probably means that the industry needs to reduce costs.
3) The OPD players have not learnt to manage the operating costs as effectively as the established larger players:
As per this hypothesis, OPD companies are actually doing higher end work, and are getting higher billing, but their operating costs are too high. This could be because of lack of scale, ineffective business practices (e.g., administrative costs, building lease costs, sales & marketing, etc.). For example, most of the larger OSD companies operate out of their own campuses and their operating costs are spread over a larger base.
Many possible reasons, One likely outcome
Irrespective of which is true, should the trend continue, these businesses runs an imminent risk that investors would soon push the OPD businesses to match the operational practices (and hence, the profitability) of the OSD players. This would allow the investors to achieve higher valuation of the business, at a low risk, as the OSD model is a relatively proven model in terms of margins and scale.
The investor push can be along one of the 2 paths
a) Dilute the OPD offerings and move to OSD model: This could also include a possible sell out to existing OSD players, who can then use their operating practices to bring down the costs to achieve higher profit margins. The expectation would be that “cloning” the OSD practices would allow OPD companies to earn at least a similar (if not higher) valuation than what they would get by being alone.
b) Create new product offerings to support higher margins: As I see it, this requires some out-of-the-box thinking. I have put some of my thoughts into this. The last section of this blog captures my thoughts on how OPD companies can create new offerings to boost sales and margins.
OPD: New approach, New offerings
It is probably fair to say that currently, the OPD industry is a slightly modified version of OSD. Except for size - where the largest OPD player is a fraction of the size as compared to the large OSD players.
Otherwise, both have the same (engineering-centric) roots. Both have largely similar sales differentiators – revolving around development processes
Culturally too, most product teams at OPD companies comprise essentially of engineers, who have little idea about the business of the product they develop e.g., in which geographies their product gets sold in, the profile of the customer who buys them, pricing options, nearest competitor offerings & their strengths and weaknesses, the maintenance and support costs, etc.
This is not how a product company should be. Walk into any “true” product organization, and you will notice that irrespective of job functions e.g., engineering, QA, support, even finance and accounts would know about enough about their products. Further, this difference is highlighted in each interaction with the OPD organization, which validates the customer’s impression that they are dealing with a bunch of techies. Once you are positioned at that level, that moment is not far away when you end-up negotiating on the per hour billing rates of your resources. You are now in the commodity business. You have already lost the chance to position yourself as an OPD. You are now competing with OSD players, without the benefit of their size, scale, business practices, etc.
The question that OPD companies are probably not asking themselves hard enough: What is it that we do as an OPD player, than non-OPD software development companies don’t or can’t do? As of now, the answer probably is very little. And this is one of the risks for most OPD companies who do not change their positioning carry.
OSD companies are also entering the OPD domain. They don’t seem to be encountering too much of an entry barrier, and are already providing competition to established OPD companies.
OPD differentiators: Shift focus from client’s top-line to bottom-line
So, how can OPD companies differentiate themselves? Is there life as a separate OPD companies, or is OPD going to merge with OSD?
For starters, I think that the biggest change that Indian OPD companies – who want to break out of the mold – need to do is to stop pitching their engineering skills. For most Indian companies, this is now almost taken for granted.
Instead, the mantra now needs to be on improve the bottom-line (profits) as opposed to the top-line / costs.
How to do this? Lets consider a few scenarios to see how this may be possible:
a) You see a product company doing well in US markets. Do you think you can strike a deal to profitably sell this in APAC on a revenue sharing arrangement? The company would be more than willing to invest in you. In course of time, this will also reaffirm that you understand the domain. You can package your engineering services at that stage.
b) Are you willing to sign-up as a re-seller for the product company in the areas where you have local offices? Many product companies do not have an office in APAC, but are looking to enter the market. Benefits:
- Your team gets trained by the product company
- Your organization is now ideally positioned to hold the Product Manager role for the development team. This person not only provides inputs to the development team, but also engages with the client on product requirements, feature requests, roadmap etc.
- You contribute to the new release. You can start contributing to the testing of the product d. In due time, you start taking ownership of the engineering deliverables
c) Can you provide product implementation / consulting services for new sales? Again, product companies should love to talk to you, as this helps them sell better. It provides you with a natural entry door into these organizations. They know that you are an OPD company, and the fact that you also help them generate revenue, means that your interests are naturally aligned in terms of understanding their business as they do.
d) Can you provide sales support with a revenue sharing model? Again, another way to start discussions. OPD companies should move forward with a complete services offerings. In terms of costs, I don’t think this adds to much, as a lot of roles are either common or shared across products. I am noticing that large OSD companies e.g., Wipro have a lot of reseller relationships with their software vendors, and I think that it is a good strategy to start building relationships with the product companies too.
Ideally the product team should be able to perform the following roles: -
- Product Sales – the OPD company should be the local reseller of the product across geographies
- Product Customer support
- Product Marketing & Branding – the OPD company should be able to provide product branding / marketing support
- Product Documentation
- Product Management
- Product Engineering
- Product Implementation
Once OPD companies start interacting with their partners on a more holistic, 360-degree, engagement model, their relationship will naturally extend to the next level of depth. This will help them improve not only the value of the relationship, but also the quality of service that they would be able to deliver
