The Dao of Outsourcing

This post discusses best practices for evaluating financial stability of an offshore software outsourcing company.  I will focus on evaluation of midsized vendors which are not public.  These  are best practices for choosing vendors, based on my experience with Chinese software outsourcing companies.

There are advantages choosing small or midsized software outsourcing vendors along with increased risk.  One risk which is difficult to evaluate is the financial stability of the vendor.  Outsourcing companies under financial pressure can endanger the buyers offshore initiative if they become interested in clients IP for increasing revenue, change business strategies, or shut down operations.  When selecting an outsourcing company the buyer needs to consider internal and external pressures on the vendor and cross check any information provided during due diligence.  This will save significant time in the long run and increase the likelihood of a successful offshore outsourcing initiative.

The first step is to consider the services delivery location, both country and city.  Look at current inflationary trends that will increase the vendors costs over time.  All increasing vendor costs are passed on to the buyer through rate increases or decreases in quality so it is important to take note.

• Salary - First tier cities in China have much higher salary inflation than second tier cities.
• Office space - Offshoring companies in China automatically get the first two years free office space for setting up in a designated technology park.  The free rent will be extended if the company has a good relationship with the government.  However, it is not indefinite so check the rates for office space in the city.
• Turnover - Recruiting is expensive, offshoring companies in cities with higher turnover rates have higher HR costs which are passed on to the buyer.

After evaluating the outsourcing location, make sure to properly evaluate the vendor on these criteria

• Headcount - This is a reasonable assumption but do not weight it heavily.  A large unprofitable vendor is still unstable.
• Years in business - This is a better indicator as many offshore companies struggle with cash flow the first couple of years in business.
• Growth - Look for stable growth rate rather than rate of growth.
• Funding - Funding is extremely important, especially in these turbulent economic times.  If the vendor runs into financial troubles will they have access to additional capital?
• Leadership team - Companies change senior managers when there are financial challenges.  Look at how often the management team has been working together.
• # of customers - It is dangerous to have all your eggs in one basket, especially in a cash flow sensitive industry like outsourcing.  When selecting a vendor, more customers means more stable.
• # of delivery centers - Expanding companies do so out of profit, if the vendor is not expanding, they may be facing cash flow problems.

Most of the information listed will be provided by the outsourcing companies sales team.  There are many professional sales teams working with offshore outsourcing vendors, however as with anything, there are some bad apples.  Thus it is important to cross check information provided from the sales team for consistency.  This step is consuming and is best done once the vendor has been chosen but before the contract has been negotiated.  Keep accurate notes on information provided during the selection process then after selecting the preferred outsourcing company obtain:

• Credit history
• Audited financial statements
• References

Cross check your notes against these three sources to validate the information

Delivery capability and price points do not matter when your selected offshore outsourcing partner goes out of business, so always plan for a full financial due diligence when selecting an offshore outsourcing company.  Vendors with razer thin profit margins is often down played by outsourcing buyers as, “well that’s their problem”.  It takes buyer side investment to setup a offshore partnership and when business is not good for outsourcing companies their customer will notice and it does become the clients problem.

Related posts:

1. Advice for selecting a Chinese software outsourcing company
2. Terms of use and Disclaimer
3. 5 things to know before offshoring software outsourcing to China