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Sunday, October 15, 2006

Trends In Business / Technology Development

Some key observations about the future of innovation and technology in American business practically leap out of headlines from the week of October 8, 2006. First, the news, then the observations.

Fall Housecleaning in Corporate America -- A handful of companies, including CNET, McAffee, Apple Computer and United Healthcare, are frantically considering the removal of CEOs, CFOs, or board members or looking for replacements for those that have recently resigned or have been terminated due to back-dated options. The companies are facing pressure to confirm the impact to current and past financial statements to avoid potential penalties under SOX requirements. (#1, #2)

IBM Cuts 400 Jobs On A Core, Profitable Product -- The news story from Information Week pretty much says it all: IBM is quietly laying off about 400 U.S.-based engineers who have been working on the development of components for one of the technology giant's most important hardware products, according to sources familiar with the company's plans. The memo doesn't specify whether the work performed at the affected facilities will be moved elsewhere. However, IBM has publicly stated its intention to invest $6 billion over the next three years developing its high-tech workforce in India. Engineers and programmers in India are paid less than half of what their U.S. counterparts earn. IBM officials weren't immediately available for comment. (#3)

IBM Relocates Procurement Department to China -- Though claiming none of its domestic 2500 employees would be affected, IBM decided to relocate its headquarters to Schenzen, China where a growing number of component manufacturers have located as China encourages firms to move further inland. (#4)

Indian IT Outsourcing Firm InfoSys Announces 52% Net Profit Growth -- InfoSys added 10,795 jobs to support work for an additional 42 American firms. InfoSys now has a total of 66,150 employees. (#5)

Google Purchases YouTube -- A company founded by two men with only $6 million in cash becomes the most popular web site for video sharing in 21 months. The company has yet to turn a profit and has yet to prove it has a viable business model that can placate the potential copyright issues involving much of its content but is acquired for $1.65 billion in Google stock. (#6)

Bookends of the Outsourcing Trend

The stories about IBM and InfoSys make interesting bookends. Free market theorists would argue IBM and countless other American firms outsourcing domestic technology jobs to India, China and other low-wage countries are simply following the law of supply and demand. These other countries are producing workers of equal quality who work for wages substantially lower than their American counterparts. If IBM didn't take advantage of cheaper labor, its competitors would, eventually jeopardizing all of IBM's jobs. That's the theory, anyway.

What about the reality? High-bandwith internet connectivity obviously enables calls to be delivered anywhere on the planet for functions like tech support and allows emails, data and images to be shared in real time for collaboration and round-the-clock development. However, the quality of the business information and goals provided by the domestic firm to the outsourcer and the quality of the services coming back are not as clear. Firms like Dell Computer which depend upon call center functions have already determined that foreigners who speak impeccable English (possibly better English than some Americans) may still not understand customers and provide acceptable service. If English to English idiomatic language barriers exist when trying to talk a customer through the process of running a diagnostic on a server or shipping a defective part back for replacement, can you image the barriers in trying to communicate complex business processes that are being automated in an expensive ERP application or a customer self-care web site?

Anyone working in Information Technology or Engineering roles has no need to imagine such communication gaps. They already deal with them every day in corporate America and those gaps are likely fueling much of the outsourcing. Hardware and software in the 1980s developed rapidly but mainly by improvements in memory and sheer speed. Someone who DID technical work in 1983 would still recognize all of the paradigms and challenges involved if they were MANAGING technical work ten years later. The adoption of Internet based models for developing and running systems changed design paradigms from 1994 to about 1998. Once the first round of lessons were learned about the difficulty of developing and running web software at scale, an entire new generation of frameworks were developed (J2EE, ASP/.Net / AJAX) and have become commonplace. However, that means most mid-level managers and executives in Information Technology are now two technical generations removed from technical solutions they understand and with which they have hands-on familiarity.

Managers operating in this generational gap are prone to making mistakes in two areas. First, they often fail to understand how the flexibility of the technology allows systems to change much more rapidly than in the past. This is a double-edged sword. On one hand, the systems can adapt to changes much more quickly. On the other hand, they HAVE to change much more frequently because all the systems they integrate with are changing rapidly as well. To keep ahead of this curve, developers need to be close to the users and customers of the system to more quickly understand areas needing improvement without waiting for lengthy, obtuse documentation to be written. Outsourcing development to workers outside the company (whether domestic or off-shore) breaks this direct link between the user community and developers.

The other problem posed by the generation gap is the fixation on the cost of the development work versus the cost of inefficient "requirements" analysis that drives the development work. For every dollar saved by finding cheaper labor to do the final low-level technical work, it is likely in many scenarios that a matching dollar is being spent on convoluted requirements gathering, "use case analysis", and negotiations for contract terms and change requests. Highly profitable for outsourcers like InfoSys in India. Not so productive for the firms outsourcing the work.

Long Term Concerns With Outsourcing

For outsourcing to be effective, a firm must be able to describe in tremendous, mind-numbing detail EXACTLY what it wants the outsourcer to accomplish. The detail is required not only for contractual clarity to ensure avenues of recourse are available if the outsourcing firm fails to deliver but to ensure the requirements are clearly understood. Outsourcing relies on treating every layer of a project as a completely independent, isolated, well-defined black box so that any "resource" can be found to read the requirements for the contents of that box and produce it without knowing ANYTHING about ANYTHING else in the product being developed.

This approach would be similar to a buyer contracting to build a $1,000,000 custom home using a contractor who plans on subcontracting the assembly of the house down to the 2x4 and nail. Every detail of the house design must be specified down to the nail because the guy nailing the 2x4s in the wall between the kitchen and dining room will be different than the guy nailing the sheathing on the roof. It's technically possible to build a house this way but there is a tradeoff between the cost of a more traditional approach versus the cost of preparing specifications down to this level of detail.

The same problem applies to virtually all work performed by outsourcers (domestic or off-shore). The problem can actually grow more complicated as outsourcing takes root because the more technical resources you lay off within the firm, the fewer permanent employees you have to write the requirements documents that are detailed enough to state your needs so you don't pay for work that doesn't solve the problem because the requirements weren't correct. If you hire contractors to write your business requirements to hand to outsourced workers, you will pay a premium for the contract labor over regular full-time employee wages and all of the expertise about your core business will lie outside your firm where it can (and will) be sold by the same consultants to your competitors in your industry. In effect, you'll pay a premium to share any intellectual property you have with your entire industry. I wonder how astute board members might react when THAT outcome of outsourcing is explained.

A Case Study in Business Development

The YouTube portal simplified video sharing on the web by:

* providing simple video file upload tools for users
* mediating between different video formats / codecs
* providing a tagging scheme to categorize and search for content
* providing a message board function for users to provide comments on videos
* providing the actual hosting storage for the content for free

So exactly what was it about YouTube that made it an attractive acquisition at $1.65 billion? Google is already the master at search engine content, Google already hosts one of the biggest blog engines (www.blogspot.com) that provides content hosting and discussion board-like functions. Google already hosts and searches video and image content. There's no single component of the YouTube portal that can be protected by patent or trade secrets. Can a URL really be worth the $1.53 billion premium over YouTube's actual start-up cost?

YouTube's founders appeared on Charlie Rose a few weeks before the sale and explained how the company was founded and grew. The two founders attended a neighborhood party with friends and heard people who had bought new digital camcorders complain about how difficult it was to share videos with friends and family due to differing video formats, etc. The company was founded around February 2005 with about $6 million in venture capital. By the time the portal was live and on the public's radar, the company had still only spent about $12 million.

Google attracts some of the sharpest talent in software development and web site operations on the planet. By agreeing to hand over $1.65 billion in stock, is Google's management already telegraphing to the world they don't think their engineering staff could replicate the YouTube experience for less than $1.65 billion when YouTube only spent $12 million? Google has only been public for two years but it appears its management has already reverted to using the strategies of a much more sclerotic "old economy" company.

Google shareholders would be well advised to look back at Cisco Systems' track record in the 1990s of spending its stock to grow its product line by acquisition. Cisco certainly remained profitable but took a HUGE correction in its stock price after the weight of a long serious of expensive acquisitions hit the bottom line. Like Google's purchase of YouTube, Cisco used its stock as currency in most of its transactions which preserved cash but still diluted shares of existing stockholders considerably. If the acquisition really doesn't produce the value promised or distracts the combined firm, the deal can spell problems for shareholders.

In addition to the dangers of dilution to existing shareholders, business development by acquisition poses other risks as well. A firm focusing on external acquisitions instead of internal development assumes it will always be successful in acquiring a firm that creates a technology it needs or a technology that threatens its business. Bid too low and the target could stay independent or take a better offer. Bid too high and you'll get the target but dilute shareholder value. You might also bid too high and convince the target they really have something of value and convince them to stay independent and use their product to hurt your business.

Why Not Outsource Management, Marketing and Finance?

If one truly believes in a global market for talent and low wages, why should the market only apply to technology jobs? One thing that distinguishes technical work from other areas is that results can typically be directly measured and quantified and boiled down to a bottom line spreadsheet analysis. The new iPod either plays songs or it doesn't. The new call center in India either reduces average call time to 360 seconds from 390 seconds and call cost from $6.50 to $3.00 or it doesn't. Yields at the new plant either reached 3000 chips per wafer or they didn't.

The output of a CEO or CFO or CMO and their staffs is, of course, much harder to quantify (smirk). According to business school, they make decisions based upon highly complicated interactions between changing customer preferences, changing macroeconomic conditions, a changing regulatory environment, changing interest rates, etc. Of course, none of these caveats apply when the firm's stock does well --- when things are going great every executive claims to be "totally accountable" and wants to be measured by nothing except the stock price. Especially when flooded with millions of dollars in back-dated options guaranteed to be "in the money" unless the CEO tanks the company.

Anyone working in most of the Fortune 500 companies in America knows how corporate decisions really get made. Someone has an idea, someone makes an assumption about the revenue or "units" that idea will produce and a bogus attempt to formulate a business case to "quantify" the numbers previously assumed is made. The process is much like the process used in a freshman chemistry lab to produce data that proves PV = nRT when your real lab data didn't add up. The only difference is that in modern business, no one really "knows" the end formula being proven, they just think they do. After pencil whipping the business case, word comes down from the mountain to the minions and the project is approved. The minions then spend an inordinate amount of time using poorly defined strategies to meet what are often unachievable goals.

The process normally ends with maybe one of ten attempts producing something of value. Of course, the executives and bean counters are watching all the dollars spent on the projects and many of the hard, quantifiable dollars involve the actual technical work. When the project is late because of poor business requirements or it fails because of poor market research, the executives home in on the poor returns and begin trying to find cheaper ways to do the technical work.

Given the success rate of most product development efforts, exactly what is preventing the management, marketing and finance work supporting it from being outsourced as well? The typical 5 to 10 percent success rate in product development typically isn't due to absolute technical failures. Products typically don't fail because they didn't "work" as designed, they fail because no one wanted the product the firm's executives decided to make. Given that track record, how could off-shore, outsourced executives in these fields do any worse? With fewer lavishly compensated executives, maybe the firm could focus on customers more effectively using in-house talent rather than saving enough money through off-shoring to cover the costs of back-dated options and earnings restatements and defense attorneys.


#1) http://www.chicagotribune.com/business/chi-0610130199oct13,0,2814322.story?coll=chi-business-hed

#2) http://www.forbes.com/business/healthcare/feeds/ap/2006/10/15/ap3092145.html

#3) http://www.informationweek.com/showArticle.jhtml?articleID=193105453

#4) http://msnbc.msn.com/id/15238129/

#5) http://www.forbes.com/home/feeds/afx/2006/10/11/afx3081724.html

#6) http://www.taipeitimes.com/News/worldbiz/archives/2006/10/11/2003331337