14 Aug 12 Cost analysis of new entrants to the ESO market

Engineering services outsourcing (ESO) traditionally refers to outsourcing of service functions which deal with the core engineering processes. The verticals included in the engineering services range from automotive, oil and gas, telecommunication, aerospace and defense, and construction. The degree to which the services can be outsourced varies from vertical to vertical. Services like detailed designing, analysis and validation, and digital manufacturing engineering are easily outsourcable, whereas high-value services, such as process design is not. According to the ValueNotes report titled “Offshoring of Automotive Design & Engineering services to India”, data (CAD) services account for about 75% of the total engineering services that is outsourced to India.

The global spend on outsourcing of design and engineering services was about USD 11 billion in 2006 (ValueNotes Database Pvt Ltd., 2006). These figures were estimated to witness a double digit growth in the following years. The ESO market in India alone is expected to grow to USD 50 billion by 2020. According to the World BPO/ITP forum’s report titled “Emerging trends in Engineering BPO services”, the compound annual growth rate (CAGR) registered by the ESO market in the country between 2006 and 2009 was 33% whereas the expected CAGR until 2020 is 30%.

Reducing costs, skill shortage, easy availability of offshore talent, and standardization of data and process have resulted in an increased demand of outsourcing of engineering services. With tremendous growth potential in the sector, many firms have started to venture into this field. A company which plans to enter the ESO market has to accurately estimate the start-up costs and the challenges that exist in employing skilled labor in order to avoid failure or losses. There are two costs the business plan needs to identify: direct costs such as rent and license fees, and indirect costs, for instance, training. The exhibit below represents a brief overview of the estimated cost structure to be incurred by a start-up ESO firm with 2 seats for CAE, 4 seats for AutoCAD, 3 seats for CAD and 3-4 permanent engineers. However, since the costs largely depend on which vertical one is planning to enter and the engagement model, this estimate would vary.

Exhibit 1: Estimated start-up cost for an ESO firm
eso_exh1-14aug.png

Since undertaking such a massive investment is risky, in its infancy the company can operate its delivery center in two shifts with one seat for each of the services. This will enable the company to maximize the utilization of its delivery center. Once the company is well established, with contracts from diverse clients, then they start to expand internally through accruals. An adequate return on investment necessitates the acquisition and retention of a client before providing the initial capital needed to setup the ESO firm.

Apart from the massive costs involved there are some other barriers which a start-up ESO firm may come across, such as talent availability. Engineers with practical knowledge in the right domain are difficult to find. Furthermore, annually increasing labor costs has resulted in decreasing profit margins for the firms which have been offering outsourcing services.

In order to avoid failure and major challenges that a company might come across in the nascent stage, a newly established ESO firm should start by offering low-value CAD services which might attract clients to try out services of a startup. Once a successful relationship has been established with the client, larger volumes work can be outsourced and the firm might be able to leverage their existing relationship to sell higher-value services. Thus, despite the significant challenges, there is potential for an ESO firm to establish itself in the growing market.

ValueNotes Research
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