The sustainability of labor arbitrage in offshore locations depends on a multitude of factors such as the wage differential that exists between the source and destination countries, exchange-rate movement, wage inflation in the source countries and, most importantly, wage inflation in the destination countries. Wage inflation rates tend to be higher in offshore locations than in source countries, and this can pose a significant threat to the savings from offshoring. Other factors soften the impact to a certain extent, but a high rate of wage increase in offshore locations often overshadows all the other factors, and is a potential threat to labor arbitrage and the offshoring industry in general. Labor arbitrage has been decreasing between the U.K. and India for Application Development and Maintenance (ADM) services (See Chart 1).

The strong impact of offshore wage inflation, coupled with the high reported numbers (15%–20%), encouraged the Everest Research Institute to undertake a detailed analysis of this phenomenon. We found that the reported wage inflation numbers tend to be exaggerated, if not entirely inaccurate. There are two key reasons for this: First, market reports often tend to quote the highest wage inflation numbers across all the levels in an organization, instead of reporting the weighted average inflation numbers that organizations are experiencing and second, wage inflation is often being estimated for individuals, instead of being estimated for roles or skill levels. This is an inaccurate representation of wage inflation as it includes the component of inflation associated with the individual’s growth in the organizational hierarchy, besides the basic inflation associated with the role or level.

Very recently, we heard an interesting statement from the CFO of one of India’s leading IT-services suppliers, who pointed out that the 14%–15% wage increase that they were indicating for the coming year was really the inflation associated with the change over from March to April, when the financial year in India changes and the individuals in the organization effectively become an year senior. At this point, the organizational pyramid fundamentally changes, leaving a big vacuum at the entry-level. During the course of the year, as new employees get added and the organization pyramid gets restored to normal, the inflation number drops significantly.

On a Year-on-Year (YoY) basis, from March of this year to the next, when the organization structure is comparable, the expected wage inflation is only five to eight percent. It’s worthwhile to note that organizational pyramids are quite stable for mature IT firms and largely for the industry also now, and are hardly expected to change over time — thus reinforcing the need to measure inflation for a given pyramid rather than for individuals.