Is One Country Good Enough to Handle Your Outsourcing Business?

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Recently, I touched on the idea of building a vendor portfolio to help manage risks associated with software outsourcing practices in the article Should North Americans Send More Software Development Work to China? I’d like to use this blog post to give some complementary readings for those who read the article and felt the vendor portfolio idea interesting.

The concept of “portfolio” is very prominent in the finance world. “In finance, a portfolio is an appropriate mix of or collection of investments held by an institution or a private individual.” (Wikipedia) The practices of portfolio management now have many different models; some have become very complicated and need tremendous analysis. Simply speaking, the purpose of investing in different assets instead of betting all the money on one arises because different assets have different return potentials and different risk exposures. If you can build your portfolio appropriately, the diversity of your assets may help you to offset individual risks while maintaining an acceptable return.

Let’s take a look at this extremely simplified example: If you have the opportunity to buy a bond (low return but risk free) and a stock (high return but associated with high risk), what is your investment decision? The absolutely risk-averse people will only buy the bond and the opposite (extreme risk-takers) will only buy the stock. However, most of people are more likely to take some risks (but not too many or too high) while having higher return expectations than what the bond can yield. Thus, a mix of the two assets makes sense, and the proportion of each depends on what your return expectation is, or in other words, how much risk you are willing to take.

In the investment area, a “hedge” is a widely used method to manage risks. The main idea of hedge is to include two different types of assets in one portfolio. There should be a relationship between the two – when one tends to go down, the other goes up and vice versa. Hence, no matter what the economic and market situation are, the risk of your investment portfolio will be manageable.

Having provided the two examples above, I hope the idea of vendor portfolios becomes easier to understand. First of all, let’s take a look at risks that are associated with software outsourcing. Besides quality, delivery, support and such issues as are more related to individual vendors, there are also risks from the macro-environment:

  • Physical risks: natural disasters (e.g. earthquakes, floods, and tornadoes) that will cease or temporarily impede your vendors’ development activities

  • Regulatory risks: regulations (e.g. import/export tariffs, taxes, and employee compensation requirements) that will impact your vendors’ business costs and as a result, your cost

  • Economic risks: such as exchange rates, employment levels, and vendor domestic market demands that will influence vendors’ pricing policies

  • Societal and political risks: caused by political events, strikes, and culture shifts that will directly or indirectly change your vendors’ ability to provide service.

The vendor-specific risks (or, let’s call them micro risks) vary from vendor to vendor, but the macro risks are more related to the macro-environment in which vendors operate. In many cases, it is convenient to examine these risks at a country level.

If we agree that macro risks exist and that many of them vary from country to country, we may draw a conclusion that too much reliance on one single country is like investing all your money in one stock.

By building a portfolio that includes vendors from different countries, a company should be in a better position to manage macro risks. If there are complementary elements amongst those countries, you may expect a hedging situation. For example, when you discover that outsourcing to a certain country becomes unprofitable due to increased programmer wages, you may find that in another country wages are going down due to the surplus of programmers.

Country diversity helps you manage risks, but we should also realize that there are costs associated with expanding your outsourcing destinations. Dealing with vendors from different countries requires more resources and may increase your operation costs. Thus, it is important for you to find a tradeoff between cost and risk. Nevertheless, when the global economy is not so stable and outsourcing has become very critical to your business, vendor portfolio might be a considerable strategy for you. Just think about insurance. It is also a cost, but you are willing to pay for it because you want to feel safe.
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