Toos Daruvala
American Banker

McLEAN, Va. – Decades ago western companies began to manufacture physical goods in offshore locations such as Taiwan. Despite the cost of transporting the goods, it was cheaper to make them there than to keep the factory onshore.

But anyone suggesting back then that service centers could be housed abroad would have been laughed at. How could agents who interact directly with customers work halfway around the world, where monitoring the agents would be impossible and every call would be international?

With the advent of reliable and cheap global communications and the emergence of skilled labor forces in many developing countries, remote offshore services have become both feasible and real. Many banks and others in the financial industry have already moved IT operations abroad, and some have started "business process offshoring" efforts in which whole processing tasks are exported.

Early successes encouraged others to promptly follow suit, and by 2008 worldwide offshoring expenditures are expected to reach $346 billion.

Operating offshore is particularly attractive to financial institutions because their operations depend primarily on data, which is expensive to process here but easy to move. And since their savings can amount to more than 10% of noninterest expense, moving as quickly as possible to an offshoring model seems the obvious choice, right?

Well, yes – and no.

Offshoring has its strengths but is not a panacea. Institutions should ask themselves some questions: Which processes could actually be offshored – and what is the magnitude of the opportunity? Are these processes stable? Is the company ready for the disruption? Can important risks be identified and managed?

Whether you are exploring a pilot program or ramping up an established offshoring portfolio, it is critical that you work deliberately through these questions.

You want to offshore a number of processes. Can they be performed with just a PC and a phone, without your being physically close to other pieces of the value chain? Are they standardized? Are specialized skills required? Is there a sufficient scale? Will regulatory constraints allow offshoring? If the answer to all is yes, then the process is a candidate.

Take the mortgage business. Here much of the opportunity is in the data-intensive servicing functions. Insurance tax and escrow processing, early collections calling, and much of the customer service call-center function can be offshored along with at least a part of loan-service setup, post-closing documentation, manual payoff processing, account balancing, statementing, and refinancing. Many are considering offshoring select origination functions, including application processing, direct sales, credit scoring and approval, and verification of title. Overall savings could be 10% to 15% of noninterest costs.

A similar analysis of any company's corporate center would show that about a quarter of those positions are offshorable as well. So the savings can be enormous even if some operations are kept onshore for redundancy.

But remember: Offshoring is no antidote for underperformance. Indeed, what troubles performance onshore is exactly what will compromise – and be magnified by – offshoring. Thus, a second filter – is the company ready? Are the processes stable and completely under control? Are they well defined? When something goes wrong, does everyone know what to do? If the answers are yes, then it's time to think about location.

The criteria for an offshore location are the caliber and cost of labor; language skills; telecom bandwidth, cost and reliability; political stability and the enforceability of contracts; the general maturity of the business environment; and senior management's comfort operating in different locations.

If you need English speakers, two standouts are India and the Philippines. India is cheaper and has more English-speaking graduates, but the Philippines excels in the call-center space due to its close cultural connection to the United States. China offers low labor costs but a less mature offshoring environment and weaker English-language skills. Ireland, South Africa, and New Zealand have skilled workers in a mature business environment, as well as greater cultural similarities with the United States, but at somewhat higher cost. Finally, the Caribbean and Mexico offer moderate skill levels in the same time zone as the United States.

After what and where comes how: Do you set up a captive – a 100%- or majority-owned subsidiary – or outsource? Captives offer better long-run savings but require scale, a bigger up-front investment and closer management, and expose you most to local risks. Outsourcing is viable below scale and leaves you less exposed, but the vendor takes some of the potential savings. Then there is time – setting up a vendor-partnership can be done within six months, where a captive will take most of a year.

Then there are emerging hybrid alternatives: joint ventures where risk and return are shared; build-operate-transfer agreements in which the outsourcing firm builds a subsidiary for the parent, operates it for a while, and turns it over; and outsourcing agreements with a buyout option.

Companies often mix and match. For some functions you may lack the experience to set up your own operation. For others you may not want the risk. Many companies with offshoring experience use both captive and outsource arrangements.

Transitions are difficult. Technical problems crop up. Natural disasters, political intervention, and cultural differences can all compromise the effort. What can be done to mitigate these risks? It's a challenge, but with the right commitment from management focus it can be done.

Transition stress can be minimized by investing senior management time (in most cases by augmenting the existing management team); by offshoring well less than 100% of any activity, at least to start; and by maintaining some backup capacity onshore. Technological redundancy in hardware and telecom lines can cover for technical failures, and backup capacity in a second operation elsewhere can ensure against political risk.

Culture differences can be managed through exchange programs and by training the initial work force at domestic facilities. Most important is ensuring that all processes – from the work itself to process changes, all onshore-offshore interactions, and problem-solving – are clearly and fully documented.

The pressures are lighter when outsourcing rather than operating a captive, but they are still substantial. Companies must manage vendors closely for quality and cost -- the newness of the field has led to wide variability in terms, and some vendors have negotiated to give themselves very attractive margins.

The time difference, and some vendors' lack of experience, can be managed by putting small management teams on the ground.

Mr. Daruvala is a director at the New York consulting firm, McKinsey & Co.
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