Offshore Outsourcing: Pay Attention to Exchange Rates

There are many matters to consider when setting up an offshore outsourcing deal-scope, location, roles and responsibilities, service levels, governance plans and price, just to name a few.

The effect of foreign exchange rates on the transaction tends to fall pretty far down the priority list at the negotiating table, if the outsourcing customer considers the issue at all.

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But ignoring the currency exchange considerations associated with offshore outsourcing transactions can be a multi-million dollar mistake, say analysts. Unanticipated swings in currency valuation can increase a company's exposure to financial risk and drastically minimize savings.

[ For more stories on the impact of currency fluctuations on offshore outsourcing deals, see The Rupee's Rise, the Dollar's Demise and You: Managing Currency Risk in Offshore Outsourcing and The Weak Dollar: What, Me Worry? ]

"Many clients do not spend adequate time building a financial hypothesis of what [problems] currency fluctuations could cause in the short and long term," explains Sandeep Karoor, managing director of offshore outsourcing consultancy neoIT. "At best, loose terms and conditions get agreed upon."

Most U.S. companies think in terms of U.S. dollars. That's understandable; everything from budgets to their day-to-day business is doled out in greenbacks. And during the golden age of offshore outsourcing, the savings reaped from labor arbitrage alone were significant enough that any additional money left on the table from a lack of currency arbitrage was pocket change by comparison.

But that scenario is changing. "Today, with many companies entering into second- and third-generation offshore deals, the low-hanging fruit is already gone," explains David Rutchik, a partner with outsourcing consultancy Pace Harmon. "Companies need to look at currency implications as a way to drive down costs."

How Offshore Outsourcing Providers Profit from Falling Exchange Rates

Typically, an outsourcing buyer pays in its own currency to the offshore vendor-in the case of an American customer, the almighty dollar. Meanwhile, the provider pays for its offshore resources in its local currency. As the value of that local (offshore) currency drops, the providers' costs go down and the customer ends up paying more in dollars for the services provided than the services actually cost in the foreign currency.

For example, during 2008, the Indian rupee fell 23.3 percent against the U.S. dollar. A company with a $10 million IT services contract that would normally cost the offshore provider $8 million to provide (pocketing a 20 percent profit margin) would have actually cost the vendor less than $6 million, landing the provider a windfall of an extra $2 million.

"We have seen these margins translate into literally millions of dollars annually," Rutchik explains.

That's no mere pocket change in today's economic climate.

Offshore outsourcing providers-and multinational vendors with offshore subsidiaries-understand the impact that the complexity and unpredictability of currency markets can have on their business. Smart vendors have hedging strategies in place to deal with currency fluctuations that may prove unfavorable to them.

"In most contracts that have language around currency fluctuations, the terms tend to be service provider friendly, not client-friendly," explains neoIT's Karoor.