KEY CONCEPT

The digital revolution and the rapid economic development of countries in Asia and elsewhere have encouraged companies in the west to outsource IT services overseas. But large numbers of offshore projects for information systems fail. A study focusing on contract specification and different modes of contract implementation has highlighted ways companies can better control the quality and costs of long-distance outsourcing.

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IDEA SUMMARY

New technologies and the digitization of the economy have extended the use of offshore outsourcing beyond manufacturing to services. India, which has its own ‘Silicon Valley’ in Bangalore, has become a leading centre for IT and now takes care of around 60 per cent of the world’s information systems development. However, around half of such projects either fail outright or do not meet client requirements.

How can the success rate be improved?

Academic literature has attempted to answer that question by examining formal and informal modes of control (such as contracts, shared norms, and so on). New research builds on this by looking at the way controls are used.

The researchers distinguished between two types of methods for managing formal contracts: mechanistic governance and relational governance. The former involves strict adherence to contract specifics such as outcomes and procedures; the latter relies more on mutual trust between vendor and client to deal with operational situations as they emerge.

Basing their analysis on data collected from eight vendors and the responses to questionnaires about 160 recently completed development projects in India, they found that:

• Mechanistic governance is a good complement to contract specificity, enhancing performance in terms of both quality and cost;
• Relational governance is slightly more effective at improving cost performance.

The second result can be explained by the fact that relational governance is a more dynamic and flexible model. It allows a client to negotiate the price down if they see that one of the vendor’s competitors is offering a lower rate. And it creates more opportunities for ‘reciprocity’: if a vendor sees that the client is not enforcing penalties despite delays they might be persuaded to work harder in exchange.

The researchers fine-tuned their results by distinguishing between the two main types of contracts used in the industry: fixed-price contracts, whereby an agreed sum is paid for the final product regardless of the actual costs incurred by the vendor; time and material contracts, whereby the client pays a daily (or hourly) rate for the work provided and, consequently, bears most of the risk.

The findings for performance were broadly similar to those for the full model. The only major difference was that relational governance seemed to have an adverse effect on cost performance for time and material projects.

This can be explained by the fact that time and material contracts tend to be used in two very different cases: either when clients have clear knowledge of the work requirements and effectively manage the project themselves, using vendors merely as additional human resources; or when the task is pure development work and outcomes and standards cannot be precisely defined. (In the latter case, process control — either mechanistic or relational — adds no value.)

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BUSINESS APPLICATION

Companies’ decisions will depend on:

• The type of development project being outsourced
• Whether the focus is on cost or quality

The first step to improving performance, however, is probably increasing contract specificity. The contract is the structural control mechanism that defines client expectations and the delivery date, etc. While it would be impossible for it to cover every possible eventuality, precise specification helps remove uncertainty and — under the relational governance model — offers ‘freedom within a frame’.

In offshore outsourcing, the contract is the main instrument for co-ordinating work between clients and vendors separated by time zones, languages and cultures. Getting the details right is vital — and it won’t, necessarily, limit flexibility or ‘send a bad message’ to vendors.

While contract implementation has not really been conceptualized as a control sub-mechanism, it’s an important tool for the management of outsourcing. Since mechanistic governance interacts well with contract specification, it’s an option managers should consider.

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REFERENCES

This Idea is adapted from the article ‘How to improve performance when managing offshore contracts’, authored by Business Digest and published in Research@HEC, No. 33, May-June, 2013, © HEC Paris.

The original was based on an interview with Shirish Srivastava and the article ‘Contract Performance in Offshore Systems Developments: Role of Control Mechanisms' (Journal of Management Information Systems, 2012), co-written with Thompson Teo of the National University of Singapore.

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