Saturday, March 20, 2004

The supply-side argument for offshore software development

Is demand in the U.S. for new software about to explode? Perhaps so, if the law of supply and demand still holds.

The law of supply and demand states that, in a perfect market economy, a commodity has three economic variables: supply, demand, and price. Normally, the law is explained in terms of price as the result of supply and demand. For example, if supply is constant and demand increases, price will rise. Or, if demand is constant and supply increases, price will fall.

However, the law can also be stated in terms of demand as the result of supply and price. Consider two scenarios:
  1. Supply remains constant and sellers drop the price. In this scenario, demand should increase. This is the strategy of retailers who mark down excess inventory to increase sales.

  2. Demand remains constant and sellers increase the supply. In this scenario, prices should drop to the point where demand increases to consume the increased supply. This is the so-called supply-side argument for increasing the supply in order to stimulate the overall market for a commodity.
But what happens when prices drop and at the same time supply increases? In this scenario, demand should greatly increase. I would call this the "super supply-side scenario."

Now, I ask, isn't this exactly what we should be seeing with the trend toward offshore software development services, where both factors are at work?
  • Lower cost. It is generally accepted that labor rates for offshore software development are less costly than equivalent services in the U.S. (There are all kinds of risks that should be considered to determine total cost, which I have discussed elsewhere, but let's ignore them for now and just stipulate that costs offshore are lower).

  • Increased supply. As I wrote in December, offshore locales such as India and China are cranking out thousands of software engineering graduates every year, flooding the labor market with additional supply. So for the foreseeable future, there should be no shortage of software developers at the lower rates.
The law of supply and demand would indicate that the combination of lower prices and increased supply should greatly stimulate demand for software development. So if I am correct, there should be over the next few years an explosion in demand for software development in the U.S.

Sources of demand
Where will the increased demand for software development come from? Anyone who has been involved with corporate information systems knows that the backlog of new system requests and enhancement requests is measured not in months but in years. Users often give up asking for new systems because the ones they've already asked for have not been delivered. I have seen cases where system requests get so old that that the original requestor is no longer with the company. Of, if he is still around he has forgotten what it was he was asking for. At some point, users stop asking. I call this the "hidden backlog" of software development requests. The hidden backlog is sometimes manifested when a company does one successful new software development project. Suddenly users realize that they can ask for stuff and stuff gets delivered. So they begin to ask for more. Demand for software development is not like demand for baby diapers--a relatively static number based on the number of babies born each year. Dropping the price for software development can often stimulate new or hidden demand.

Demand for new commercial software packages, such as ERP or CRM, is also highly dependent on price. These systems are expensive, and many companies that could benefit from them continue to nurse along legacy systems because the price to acquire, implement, and maintain new systems is simply too high. If upfront software license fees and on-going maintenance costs were lower, there would certainly be a greater demand for new packaged systems. This argues for software vendors making better use of offshore services to drive the price point for their applications lower, thus increasing demand. In fact, this is already happening. Not only major vendors, such as SAP and Oracle, are moving development offshore. Even smaller vendors are getting into the act, such as MAPICS, which is outsourcing most of its software development to India, and Ross, which was actually purchased outright by Chinadotcom, an offshore software development organization. As vendors get better at managing offshore development, the price of packaged software should drop. In a market economy, it has to.

Outlook for U.S. jobs
Some will argue that, yes, there will be an increase in demand for software, but all the jobs will be offshore. My reply is that for every U.S. software acquisition, there are many activities that must take place on-shore. For example, it is likely that initial requirements definition will be done directly with the U.S. customer. It is hard to imagine how user training and acceptance testing could be moved offshore. It is also probable that significant pieces of the functional design would need to be done in the U.S., in close collaboration with users. In all likelihood, it will be mainly technical specifications, programming, and unit/system testing that is done offshore. Even then, there will need to be a project management layer in the U.S. to coordinate activities on-shore and offshore.

Similarly, if prices for commercial software packages were to fall due to offshore software development, I have no doubt that there would be an increase U.S. sales, with increased demand for on-shore U.S. based implementation-related services such as system integration, training, and project management.

Therefore, I am hopeful that the trend toward offshore software development will increase demand for software development and package acquisition by U.S. buyers, resulting in many new jobs for IT professionals. Unfortunately, they won't be the same jobs that have moved offshore. The key for software professionals, then, is to recognize the economic realities and prepare for the types of IT jobs in the U.S. that will prosper in the coming years.

I'm interested in feedback on this point: are we seeing a general pick up in demand for software development? If so, where are the best opportunities for U.S. IT professionals?

Links to related posts:
Risks of offshore outsourcing
Productivity risks in offshore outsourcing
Outsourcing: the next bubble?
Internal IBM memos reveal plans to move thousands of jobs offshore
Offshore outsourcing driving down US IT salaries
Offshore labor drove firm to brink
Companies mum on savings from IT offshore outsourcing
Impact of offshore services on IT job prospects in the US
Ross Systems gets "Shanghai'ed"
MAPICS outsourcing most software development to India

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