IT Outsourcing

IT Outsourcing: The growth opportunity. The business risk. And the contract that best regulates it all.

by Aurora Abt

Sometimes it is best to leave technical matters to an expert. Such is the logic behind information technology outsourcing. ITO (as it is called) is the act of farming out information systems services to capabilities. Moreover, ITO frees management to focus more attention on marketing, sales strategies,

The pairing of a company with a vendor eager to proceed forward. However, without guidelines stated, understood, and agreed upon at the outset, discord is likely just a matter a technology assets are transferred to the vendor. ITO is a risky business, indeed – for all involved.

Fail to plan, plan to fail

A new study in MIS Quarterly examined the role of contracts in reducing the most common business risks associated with ITO deals: missed performance targets and constraints on the ability of the business to innovate. In many ITO arrangements, corporate technology assets previously used by in-house technology groups are sold to the vendor. In the study, titled, Information Technology Outsourcing: Asset

Professor Young Bong Chang (Sungkyunkwan Business School), link the transfer of these assets into an ITO arrangement with a vendor, even though it was selected after a rigorous bidding process, both sides become captive to the other. Perhaps the vendor overcharges for new work make the best use of assets on behalf of the client. Alternatively, the client may choose to renege on the arrangement leaving the vendor with a large investment in unneeded assets. Either way these are weighty concerns for managers tasked with spearheading and approving ITO contracts.

To understand ways to reduce the risk of opportunistic behavior and increase the likelihood team surveyed large-company executives who had hired a vendor to operate formerly in-house IT functions. This group represented a valuable knowledge base of executed ITO contracts. From there the survey data was separated into two groups for comparison: companies that had transferred assets to an IT vendor and those that had not. The study highlighted two consistent themes: concern for opportunistic behavior and contracts containing explicit clauses to limit risk. elicited strong reactions from both parties.

Asset Transfer: A Litmus Test for ClientVendor Relationships

One reason for IT outsourcing is the cost savings it provides the client. However, certain costs – for systems maintenance and upgrades external service provider. On the other hand, when assets are not transferred, the vendor you pay to have a rental car serviced (or even in-house assets goes a long way in moderating better performance.

Spurring the Horse: Asset Ownership as Performance Incentive

team in this study. Property rights theory suggests that vendors can be incentivized if, when transferring assets, any residual rights (including the right to ownership) are also transferred. In contrast, transaction cost economics points to the risk of transferring rights to ownership, as it may embolden the vendor to exploit the client since the client no longer has a way to quickly source services if it chooses to cancel the contract. In addition to asset ownership, he suggests

In cases of asset transfer, the choice of ongoing investment decisions made by the vendor can result in improved performance. A client should incentivize these investments by rewarding decisions to invest in a manner consistent with its goals and by allowing the vendor to capture a share of the higher net value.

motivating vendors through a compensation scale with rewards or penalties, should they exceed or miss established performance targets.

A comprehensive incentive program can also reward vendors for ongoing investment to maintain and upgrade assets. As the study team ongoing investment decisions made by the vendor can result in improved performance. A client should incentivize these investments by rewarding decisions to invest in a manner consistent with its goals and by allowing the vendor to capture a

Contracts: The “Clause” of it All

An insight revealed by the survey data was in the ITO contract. Each clause was designed to outcomes. This begs the question, which issues

Previous research has found that contracts the likelihood of opportunistic behavior on the part payments will promote cooperative behavior. More importantly, the use of direct language in a contract to address concerns of all parties has shown to lead to the success of IT outsourcing.

In all, the study recorded 18 clauses, 11 of

detail the degree of management control. Seven additional clauses are designed to eliminate opportunism by the client and vendor. As the study in future technology costs, will want assurance of the best price via a most favored customer provision. The vendor may require a preferred supplier clause, which requires the client to negotiate exclusively with the vendor in good faith for any new business, which further incentivizes additional investments and avoids opportunistic with its competitors using an exclusivity clause

The team found that contracts that did not involve asset transfer were larger in total contract value, annualized value, and the number of clauses. However, contracts with transferred more, contracts with transferred assets averaged 15.7 risk-averting clauses versus 11 for its nonasset counterpart, contract duration of 8.3 years versus 5.3 years, and 3.2 objectives versus 2.7. From this, it may be inferred that a client willing to transfer its assets to a vendor has higher expectations of meeting the contract objectives and is willing to commit for a longer period.

ITO has become a standard business practice. However, risk is apparent as indicated by contract disputes and early cancellations. Such occurrences are not uncommon.* Still, the study the learning curve in how to use clauses to protect turn, the study provides IT vendors with insight into potential client concerns and ways to limit their own business risk. This awareness can shorten the contract negotiation process, and perhaps reduce the amount of client-vendor

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Vijay Gurbaxani is Director of the Center for Digital Transformation and Taco Bell Endowed Professor of Information Technology and Computer Science at the UCI Paul Merage School of Business. His research interests are in the economics of digital technologies. He has authored the book Managing Information Systems Costs and published numerous articles in premier academic journals including MIS Quarterly, Information Systems Research, and Management Science.