India must retain its cost competitive position

India is fast losing its low-cost position. In Mumbai, executive compensation levels for the financial sector are higher than in London, rental costs are above those in New York and electricity is dearer than in Tokyo. Indian companies will need to evolve from their low-cost position. As Azim Premji, chairman of Wipro, mentioned, in the crucial IT sector, cost arbitrage is one entry point but the continued growth of the sector will have to be based on quality.

Increasingly, Indian companies will have to do more with their intellectual resources. The software sector will have to aspire to be the poet, not just the scribe. Indian exports of its own software or licensing of its own intellectual property (IP), amounted to only about $450 million in the year ending March 31, 2007. This is a tiny fraction of India’s IT service exports. India’s IT sector must go beyond “renting out IQ and start creating IP” if it is to compete in the face of ever rising costs.

The challenge for Indian companies is to develop innovative products. The premium for innovation and branding in products is best demonstrated in a cost analysis of Apple’s 30 GB iPod with video, which has a wholesale price of $224. It is manufactured in China and consists of 424 parts, of which three hundred cost one cent or less. The most expensive component is the display module, worth about $20, which is made in Japan by Toshiba-Matsushita. China assembles and tests all of the parts, but this accounts for just $3.70. Apple claims the largest share of the price—about $80 in gross profit.

Closer to home, consider Infosys, perhaps India’s best-known firm. Microsoft and Infosys commenced commercial operations about five years apart in 1975 and 1981. Yet Microsoft’s fiscal year 2008 revenues were $60 billion, with profits of $22 billion, whereas Infosys barely managed to top $4 billion in revenues and $1 billion in profits. While Microsoft has incessantly focused on developing innovative products, Infosys has focused on services. It is not as if Microsoft’s programmers are from another planet; on the contrary, a significant percentage of them are of Indian origin. The reality, harsh as it may seem, is that even iconic Indian firms like Infosys have still not completely overcome the mental block. The challenge is to move from “outsourced and made in India” to “imagined and owned in India.”

The problem for Indian companies in developing innovative products is that it requires a heavy capital outlay up front, which may never be recouped if the product fails to find enough customers. In contrast, service revenues are labor intensive and more predictable. Even i-flex Solutions, India’s biggest software-product success, survived its early years by running a profitable services business on the side.

In Indian companies, imitation still crowds out invention. For example, the much-vaunted pharma sector in India is populated by generics companies such as Cipla, Dr. Reddy’s, Nicholas Piramal and Ranbaxy, all of which are relatively global. While they have small drug-discovery arms, few of them are willing to take the deep risks that new drug research entails.

Most, like Nicholas Piramal and Ranbaxy, have spun off the new drug-discovery units because of the longer time horizon and higher risks. Invention may be a wonderful thing, but Indian companies still prefer that it be done on someone else’s balance sheet. So, though India is one of the world’s largest producers of drugs, it copies almost all of the compounds. Similarly, Indians and Indian companies may write most of the world’s software, but they rarely own the result.