Trading, manufacturing, services and Indian IT

Traditional ideas of services imply work done without generation of physical goods; many experts define “service” as intangible economic goods. Traditional ideas of trading imply purchasing of goods from a supplier, performing little or no value addition on the item, and then selling it to a buyer, hopefully at a profit. And traditional ideas of manufacturing imply applying a process of transformation on physical raw materials using labour and/or machinery to create something substantially different from the raw materials.

These ideas do not work with software, and specially with the Indian IT industry.

What are services?
Services are easy to understand at an intuitive level. When people perform actions to help others, they are offering service. If an office-full of people perform actions which help customers, and charge fees for such actions, then this is a case of providing services as a business. Lots of such offices in lots of companies together build the service industry. There is no creation or supply of physical goods here.

This intuitive understanding of services has been the basis for labelling the software industry as a service industry. Lots of people in lots of offices busily working away on their terminals, but no physical goods are produced. Therefore, this must be services, right?

So obvious, yet so hard to pin down, as we shall see. The question which is not asked here is: how is the business structured? What does the business owner see when he operates his business? What is his view of his business? If these questions are asked, a different answer may emerge.

What does trading mean?
Everyone knows what trading is. A chap finds out where some physical goods are available cheaply. He buys those goods, brings them to a market and sells them at a profit. He does not modify the goods in any significant way. What he is doing is called trading.

Once again, this needs to be examined more closely — nothing is as it seems.

One of the key characteristics of trading as an activity is the low involvement of the trader with the goods traded. By definition, he does not work on modifying his goods. He doesn’t care how they are made, unless it affects his profits. At most, he checks them for quality and specifications — is this really Surti Kolam rice or some other rice? Can the term “trading” therefore be applied to intangible economic goods if they are bought and re-sold? If you purchase services and re-sell them without modifying them in any way, can I call you a trader?

This is where the shades of grey start. The overwhelming majority of revenue earned by the Indian IT industry over the last three decades is by applying the following steps:

  • aligning programmers to offer services (by recruitment or contracts)
  • finding customers who need programming services
  • offering the programming services of the programmers to the customers, without modifying the (intangible) goods in any way

To me, this appears to be a trading activity. In my eyes, the individual programmer is offering services, therefore he may claim to be in the service industry. But the company which offers programming services is, in my view, trading in programming services. They purchase these services from the market, and sell them to customers.

Some economists will say that this is not strictly correct. They will point out that programming services are not being purchased here — employees are being employed here. The final output (the software source code) is not being purchased — it is being created by the employees. But the reality is not always so simple. Many software companies in India enter into contracts with their thousands of programmers — they are not employed, technically speaking. These contracts pay a fixed monthly fee for services delivered. The choice of employ-or-take-on-contract is a matter of convenience for the company — it is not an approach or cultural decision. This is truly “purchase of (intangible) goods”. Therefore, this business is trading.

In my view, the bulk of the Indian IT industry are modelled after trading businesses.

Sometimes a software services company engages in what is called a fixed-scope project with a client. Here, they (the vendor) captures specifications, then instructs and manages their programming team to create the software as per those specs, then apply their own process maturity to perform QA. In these cases, they are behaving like services businesses and not trading businesses. But fixed-scope software projects even today account for a minority of the Indian IT industry’s revenues.

What is manufacturing?
Worldwide, no one associates the term “manufacturing” with the software industry. I think this is a terrible error.

Let us re-examine manufacture of physical goods. Such businesses have the following characteristics:

  • a factory: a place where men and machines work
  • capital: required to invest in assets, product development and marketing before the revenues start creeping in
  • labour: workers, often skilled, who operate specialised machinery, and are instructed and managed by senior employees
  • product specifications: detailed information describing the items to be created, and quality checks to ensure that the output matches spec

A software product business has a factory (an office full of all sorts of computers), labour (smart programmers) and product specifications. They make products.

The similarities continue. Most manufacturers, be they Oracle database software makers or office chairs makers, need to invest in plant and machinery, marketing and sales. Both need a gestation period before they start making profits. And therefore, both are in risky businesses where they may struggle for years before making it big.

Yet the world keeps labelling anything to do with software as “services” and anything to do with making of pencils or office chairs as “manufacturing”.

This has had a crippling negative impact on Indian software product companies — no one understands them correctly, and therefore no one funds them. The organised banking sector can understand that manufacturers need large loans for long periods of time before they can make money out of their products. Therefore, banks lend money to manufacturers. But software product manufacturers don’t get a penny, because As Everyone Knows, software is services, and services are expected to turn a profit in their third month of operations. After all, they don’t really manufacture anything — they just get paid month on month for their services, right? As Everyone Knows, services are just a way of getting paid for labour.

This complete incomprehension on the part of the Indian banking system to understand software products has been a very expensive weakness for the software products industry.

Software and the Indian businessman
The Indian business universe was dominated by trading. The Indian business communities are basically the trading communities — they have been very enterprising in spotting arbitrage opportunities, setting up trading businesses, often including difficult long-distance logistics. Like traders everywhere, the Indian business community too focuses on quick returns and short-term profits. They are not institution builders. This mentality of trading pervades everything they engage in, to a deeper extent than we suspect.

Post-Industrial Revolution, when businesses became larger and more complex, and they realised that there was more money to be made by setting up factories, they applied their trading mentality to understand how to turn a profit from factories. The India in those days, perhaps fifty years ago, did not have a strong community of scientists and engineers. Manufacturing involved importing know-how from technically advanced manufacturers overseas, and setting up factories in India to avoid import duty and tap the Indian market. Therefore, in the 1950s to 1980s, most manufacturing businesses started with a joint venture or a technology transfer agreement between an overseas major and an Indian businessman. The trader therefore graduated from buying and selling of goods to buying the manufacturing know-how and bringing it to India. Traditionally, a manufacturer is deeply involved in the process of fine-tuning both the quality and cost-effectiveness of their manufacturing process. This fine-tuning requires management involvement, a culture of exploration and constant refining. The Indian manufacturer did not need any of that. He built a culture of manufacture by import of know-how. His involvement with the goods manufactured was as low as a trader’s involvement with goods he bought and sold.

This was not manufacturing — this was trading by proxy.

Then in the nineties, the world of software began to unfold before his eyes. How does a trader make money out of software? By trading, of course. This time, the raw material was talented, hard-working young programmers. By the nineties, engineering colleges were churning out thousands of young engineers who could learn programming easily and would be willing to work anywhere in the world for a small fraction of American salaries. The Indian businessman saw a new arbitrage opportunity: wage arbitrage. He began setting up businesses which would recruit young engineers by the hundreds, often without even a proper employment contract, and ship them overseas to the US, Canada, the UK, and Western Europe. Thirty years ago, he paid the young engineer INR 3,000 a month as salary and another USD 2,000 as on-site allowance to cover the young chap’s living expenses in a dingy apartment in New Jersey shared with three other young engineers. And he billed the American customer USD 5,000 a month. He was buying cheap, selling high, and netting the profits. He had no involvement with the final product the customer got. He was doing what he had always done best — he was trading.

One of the most remarkable characteristics of the Indian IT industry is how little of their income comes from domestic markets. The reason is obvious: this is not a “normal” services industry: this is a trading industry thriving on an arbitrage opportunity. There is no business case left if the customer and raw material (the programmer) are both in the same economy.

It is true that most of the Indian software companies have been built by young entrepreneurs from professional backgrounds, not from traditional business communities. The very first (and today’s largest) significant software services company was built by a mature diversified business group in the 1980s. Many of those which followed were built by individuals from professional backgrounds. Yet, the business model applied was that of trading in skills and wage arbitrage.

Quo vadis?
Trading. Manufacturing. Services. None of these are what they seem, if you look beneath the surface of the Indian IT industry. And the trading roots of our business culture shine through. Irrespective of the century or the business space, they play to their strengths.

In my view, a so-called software services company has three business models:

  • T&M contracts: called “time and material” contracts, where the company provides programmers and bills per hour or per month. This is trading. I am guessing that this accounts for 70-80% of the industry revenue. This segment is strong on job creation and in rapid creation of free cash flow. This model has the lowest risk and thus appeals to our trading mentality the most.
  • Fixed-scope projects: this is a services business. This may account for 10-20% of industry revenue, I guess. I would include consulting here too. This segment is strong on creation of expertise. (Only those in the industry know how little is the depth of expertise created through T&M businesses.) This segment is much more risky than the T&M model, and margins are harder to predict.
  • Products: this is pure manufacturing. This is the only segment which builds assets and creates opportunities for non-linear growth. This segment is strongest in wealth creation — compare the valuation of TCS with that of Google or Amazon. This is also the riskiest of the three models.

The India of the 1980s and 1990s needed rapid job creation to provide a direction to, and meet aspirations of the growing educated middle class. In the 2010s and later, the industry needs to move towards creation of deeper assets, through projects and products. We need to outgrow our short-term, risk-averse trading roots.

This won’t be easy. We have populated our industry with technicians; we will need genuine techies to succeed in the product segment. Our engineering education infrastructure is not up to the challenge today. We will also need to move away from the business owner’s “I am God” mindset to a more flat ownership and rewards structure where techies without money can get rewards proportionate to their value, not their cash reserves. But it’s the only way forward if we the engineers and product creators want to emerge from the shadow of the industry’s trading past and claim our identity as a community of sharp, proud engineers.