CONTRACTUAL AGREEMENTS AND OUTSOURCING: A MODIFIED TRANSACTION-COST ANALYSIS
Jerome Barthelemy
AUDENCIA Nantes Graduate School of Management 8, route de la Joneliere
44312 Nantes Cedex 3 - France Tel.: +33.(0)2.40.37.34.74 e-mail: jbarthelemy@escna.fr
Bertrand V. Quelin *
HEC Paris – Graduate Business School 78351 Jouy-en-Josas Cedex – France
Tel.: +33.(0)1.39.67.72.36 e-mail: quelin@hec.fr
March 2001
Key words: contractual agreements, contract duration, outsourcing, services
* Correspondence to: Bertrand Quelin – HEC – 78351 Jouy-en-Josas Cedex – France
The authors would like to thank two anonymous referees of the Academy of Management Conference (Business Policy and Strategy Division) at Toronto for their comments and advice.
Contractual agreements and outsourcing: A modified transaction-cost analysis
Abstract
While organizational boundaries have attracted an increasing amount of theoretical and empirical attention in recent years, little is known about service outsourcing strategies. In this paper, we use a modified version of the Transaction Cost Economics (TCE) approach to empirically examine service outsourcing contracts. We test the link between contractual hazards (i.e., asset specificity, internal uncertainty and external uncertainty), the contractual aspects of outsourcing (i.e., contract duration and contractual density) and the level of ex post transaction costs. While TCE proponents generally link contractual hazards to governance forms, we propose a modified TCE framework linking contractual hazards, governance forms and transaction costs. The results of the three-tier model reveal that contractual hazards have both a direct and indirect effect on ex post transaction costs. It also shows that contract duration, an often-neglected dimension in TCE literature, is positively related to contractual density. Finally, outsourcing is a bilateral governance with an intermediate level of specificity which requires contractual safeguards.
INTRODUCTION
Boundary choices are major strategic decisions. Over the past 25 years, Transaction Cost Economics (TCE) (Williamson, 1975, 1985, 1996) has emerged as the most widely used theoretical explanation for boundary choices. In this paper, we use a modified TCE analysis to study outsourcing relationships.
Outsourcing is hardly a new idea in management. In existing literature, two types of outsourcing can be defined: (1) outsourcing as an alternative to vertical integration and (2) outsourcing as a means to vertically disintegrate (i.e., allowing suppliers to assume activities that were once undertaken in-house) (Quinn, 1992; Quinn and Hilmer, 1994). Outsourcing as an alternative to vertical integration refers to the classical “make or buy” issue. This topic has been extensively studied both theoretically and empirically since the early 1980s (Monteverde and Teece, 1982; Anderson and Schmittlein, 1984; Walker and Weber, 1984, 1987; Walker and Poppo, 1991; Shelanski and Klein, 1995). While earlier papers test the main TCE hypotheses, more recent ones are also beginning to consider governance and performance issues (Masten, Meehan and Snyder, 1991; D’Aveni and Ravenscraft, 1994; Poppo and Zenger, 1998). The second definition of outsourcing, as an instance of vertical disintegration, has been extensively covered in managerial literature (Lacity and Hirschheim, 1993; Lacity, Willcocks and Feeny, 1995; Willcocks and Choi, 1995; Willcocks, Fitzgerald and Feeny, 1995; Saunders, Gebelt and Hu, 1997; Useem and Harder, 2000), but is largely neglected in academic literature (Domberger and Li, 1995; Lei and Hitt, 1995). In this paper, we focus on this second type of outsourcing.
Vertical disintegration through outsourcing is currently booming in service activities (Quinn, 1992; Outsourcing Institute, 1997). Service outsourcing has moved beyond basic activities (e.g., gardening, catering and cleaning) to encompass more elaborate ones in the value chain (e.g., information technology systems, telecommunications, transportation and logistics). Outsourcing
is the process of externalizing tasks and services previously performed in-house to outside vendors. Outsourcing is a case of vertical disintegration with transfer of an in-house activity with employees, long-term dependence on the vendor, continued need to access the service. The goal of companies that outsource is to enhance competitiveness by achieving a higher profitability with less in-house resources.
Basically, as outsourcing is an instance of vertical disintegration, once human and physical assets have been transferred to an outside supplier, the relationship with this supplier must be managed through a contract. Despite the prominent literature on long-term contracts (Wiggins, 1991), there is a dearth of in-depth studies on contractual agreements in outsourcing activities. Most of the empirical research in TCE focuses on the link between transaction attributes and governance structures (i.e., market, hybrid forms and firms) (Shelanski and Klein, 1995). Empirical studies, excepting Masten, Meehan and Snyder’s (1991) eminent research, have rarely directly measured transaction costs. Our aim is to test the impact of contractual hazards and contracting practices on ex post transaction costs in an integrated three-tier model.
Another key issue in this paper is the introduction of Partial Least Squares (PLS) regression (Umetri, 1996). While PLS has been used in strategic management for over ten years (Hulland, 1999), PLS regression has never been used in this field. PLS regression is an advanced statistical method specially designed to overcome multicollinearity problems, particularly the difficulty of using dependent variables in multiple regression. PLS regression will be especially useful in the testing of our multi-tier model with built-in multicollinearity.
In the first section of this paper, we introduce the theoretical background of our study, then propose our hypotheses. Thereafter, we explain our methodology. In the third section, we present and discuss the empirical results of our research, and finally, conclude with the implications and limitations of the study.
CONCEPTUAL FRAMEWORK
Transaction costs: monitoring and enforcement
TCE seeks to explain when an internal organizational mode (i.e., hierarchy) may be preferable to an external one (i.e., market). TCE suggests that three conditions are necessary for a transaction to be internalized: (1) the assets involved must be highly specific to the transaction, (2) the level of uncertainty surrounding the transaction must be high, and (3) the transaction must occur frequently (Williamson, 1985). Then, Williamson (1991) moves beyond the dichotomy of the market and hierarchy, arguing that a wide range of hybrid governance forms exists between these two extremes.
According to TCE, the total cost of carrying out an activity includes production and transaction costs. Transaction costs can be decomposed into four categories (Williamson, 1985; Hennart, 1993; Dyer, 1997): (1) search costs (i.e., the costs of gathering information to identify and evaluate an outsourcing supplier), (2) contracting costs (i.e., the costs of negotiating and writing the contract), (3) monitoring costs (i.e., the costs of monitoring the agreement to ensure that the outsourcing supplier fulfills its contractual obligations), (4) enforcement costs (i.e., the costs associated with ex post bargaining and with the sanctioning of the outsourcing supplier when it does not perform according to the contract). Search and contracting costs are generally termed ex ante transaction costs whereas monitoring and enforcement costs are usually termed ex post transaction costs. The best mode for organizing transactions is the one that minimizes the sum of transaction and production costs.
TCE and Outsourcing
Certainly, there have been quite a few changes since Joskow’s (1985: 33) remark: “Most of the empirical work (using TCE) has focused on examining the choice between vertical integration and
the market (...) Analysis of contracts has been minimal.” A major advance in economics is the recognition that contracts are incomplete (Berheim and Whinston, 1998) and that self-enforcement mechanisms are developed to ensure performance (Klein and Leffler, 1981; Cusumano and Takeishi, 1991; Sako and Helper, 1998).
Nonetheless, the TCE approach is limited in two important ways. First, it remains vague insofar as actual contractual clauses are concerned. As TCE is still used essentially to study “make or buy” issues, an in-depth study of outsourcing agreements requires insights from contract literature (Joskow, 1985, 1987, 1988a, b, 1990; Masten et Crocker, 1985; Mulherin, 1986; Goldberg and Erickson, 1987; Crocker and Masten, 1988, 1991). Contract literature, although focused largely on raw materials and transportation activities, does investigate the links between transaction attributes (i.e., specificity, uncertainty, and frequency) and contractual clauses such as contract duration, prices and quantities. In this sense, it can be considered as an extension of TCE.
The second limitation is that TCE does not really recognize that outsourcing as an instance of vertical disintegration is different from outsourcing as an alternative to vertical integration. Activities that have been carried out internally always show a minimum level of idiosyncrasy. Site specificity is generally high because assets were located inside or near a company’s premises. Physical specificity is generally high because equipment was customized to a company’s needs. Human specificity is generally high because internal employees were used to working with the firm’s precise needs. As the level of asset specificity is never entirely negligible, outsourcing is a hybrid governance form that requires medium- or long-term contracts (Williamson, 1979, 1991). Such outsourcing contracts are generally complex. First, they must help mitigate potential opportunistic behaviors from the vendor (Klein, 1996, 2000). Second, they must enable the client to avoid over-dependence on the vendor. Third, as economic conditions may evolve, the contract must be sufficiently flexible in order to respond to these possible changes.
The complexity of these contracts can be expressed in terms of contractual density, or the extent to which outsourcing contracts are comprised of elaborate clauses. Literature in law and economics identifies four types of clauses paramount in outsourcing contracts: (1) vendor management clauses (Halvey and Melby, 1996), (2) clauses for environmental changes (Joskow, 1988a), (3) price clauses (Joskow, 1988b ; Crocker and Masten, 1991), and (4) contract termination clauses (Masten, 1988; Wiggins, 1991). One of this paper’s contributions is to test whether these clauses and rules apply to outsourcing in service activities.
HYPOTHESES
In this section, we propose a three-tier model based on TCE and contract literature. The first stage focuses on the three main transaction attributes: asset specificity, internal uncertainty and external uncertainty. The second stage focuses on the outsourcing contract (i.e., contract duration and contractual density). The third centers on ex post transaction costs.
Impact of transaction attributes on ex post transaction costs
Williamson states (1991: 282): “Asset specificity increases the transaction costs of all forms of governance”. Outsourcing as vertical disintegration creates an inter-organizational relationship between the client and the outside vendor. More precisely, a transfer of in-house specific assets would increase the client’s transaction costs. For instance, suppliers may seek to standardize the transferred assets to benefit from economies of scale (Ang and Cummings, 1997: 250), but their actions may create commodity services and lead to poor performance (Dyer, 1996) or low quality goods rendered to the client. So, the client will have to bear monitoring and enforcement costs.
This supposition that high levels of asset specificity increase transaction costs has not often been tested in case of outsourcing decision. In fact, most TCE empirical studies test whether the
level of asset specificity has an impact on the decision to vertically integrate but does not explicitly consider transaction costs (Klein, Frazier and Roth, 1990; Whyte, 1994).
Hypothesis 1a: The higher the asset specificity, the higher the ex post transaction costs.
Like Williamson (1985), when evaluation uncertainty, we distinguish between internal (i.e., behavioral) and external (i.e., environmental) uncertainty. Internal uncertainty arises from the difficulty in predicting the outsourcing vendor’s actions, particularly its potentially opportunistic behavior. This type of uncertainty creates information asymmetry between the partners (Klein, 1996). Outsourcing vendors can take advantage of thisasymmetry to act opportunistically, which eventually results in increased transaction costs (Klein, Crawford and Alchian, 1978). Few empirical studies (Anderson and Schmittlein, 1984; John and Weitz, 1988) have focused on the link between internal uncertainty and transaction costs even if this is a core issue in TCE. One exception is Heide and John’s (1990) article in which the authors contend that performance ambiguity increases the level of “verification efforts”, which can be assumed to be a proxy for ex post transaction costs.
The TCE approach argues that when asset specificity is low, internal uncertainty has no impact on transaction costs: “No-specific transactions are ones for which continuity has little value, since trading relations are easily arranged. Increasing the degree of uncertainty does not alter this. Accordingly, market exchange continues and holds across standardized transaction of all kinds, whatever the degree of uncertainty” (Williamson, 1975: 254). However, if we consider outsourcing as a manner to vertically disintegrate, then the firm already has a certain level of asset specificity because its assets had been developed in-house and customized (Quinn, 2000: 16). To complete, a number of empirical studies (Anderson and Schmittlein, 1984; Balakrishnan and Wernerfelt, 1986; John and Weitz, 1986; Heide and John, 1990) show that regardless the level of
asset specificity, internal uncertainty has an impact on vertical integration. Hence, we expect an impact of internal uncertainty on ex post transaction costs.
Hypothesis 1b: The higher the internal uncertainty, the higher the ex post transaction costs.
Though early TCE work (Williamson, 1975) focused exclusively on internal uncertainty, the need to distinguish internal from external uncertainty is now widely recognized (Crawford, Alchian, and Klein, 1978). External uncertainty reflects the lack of knowledge about events that may occur in the environment. This type of uncertainty has many characteristics and is multi-dimensional (Joskow, 1988a, b; Klein, 1988; Sutcliffe and Zaheer, 1998).
Empirical studies have confirmed that vertical integration is an efficient response to environmental uncertainty (Anderson, 1985; Walker and Weber, 1984, 1987; John and Weitz, 1988). However, the assumption that high external uncertainty results in higher transaction costs has remained untested despite claims such as the following: “Full contingent claims contracts become more costly to write, monitor and enforce when uncertainty and complexity increase (that is, there are more contingencies)” (Joskow, 1988b: 101). We will hereafter test this argument to determine whether or not a relationship exists between the level of external uncertainty and ex post transaction costs in outsourcing relationships.
Hypothesis 1c: The higher the external uncertainty, the higher the ex post transaction costs.
Impact of transaction cost attributes on contract duration
between asset specificity and contract duration (Joskow, 1985, 1987, 1988a, b and 1990). The underlying rationale is that: “Buyers and sellers make longer ex ante commitments to the terms of future trade, and rely less on repeated negotiations over time, when relation-specific investments are more important” (Joskow, 1987: 168). When specific assets have been transferred to outside vendors, these vendors may take advantage of renegotiations to act opportunistically. Regardless the type of asset specificity (i.e., site, human asset or physical assets), longer contracts are necessary to space out renegotiations and leave room for flexibility (Goldberg and Erikson, 1987; Crocker and Masten, 1991). We assume, then, that asset specificity is positively linked to the term of outsourcing contracts.
Hypothesis 2a: The higher the asset specificity, the longer the contract.
We also hypothesize that internal uncertainty has a positive effect on the term of the contract. When the level of internal uncertainty is high, outsourcing vendors are likely to behave opportunistically by taking advantage of information asymmetries (Macleod and Malcomson, 1993). In such cases, the use of long-term contracts has several advantages. First, when performance is difficult to measure, long-term contracts enable outsourcing clients to become more familiar with their suppliers and to gather useful information (Sako and Helper, 1998). This increased familiarity between the parties may alleviate performance measurement problems. Generally, it is preferable to deal with the same vendor over time rather than with several different vendors sequentially (Bernheim and Whinston, 1998). Second, long-term contracts enable outsourcing clients to space out renegotiations because it is during this time that vendors are most likely to take advantage of information asymmetries (Joskow, 1988a, b, 1990; Putterman, 1995).
Finally, the use of formal contracts is highly influenced by the percentage of output specifically designed to the client (where production required significant investments in specific capital)
(Lyons, 1994). This is consistent with transaction cost predictions regarding the benefits of contracting in the presence of relationship-specific investments. Joskow’s early and well-known study (1987) provides evidence that contract duration varies with the benefits of contracting. Crocker and Masten’s (1988) assesses the impact of the costs and benefits of contracting on the duration of contractual agreements. They found an evidence of a positive relation between contract duration and appropriation hazards. For these reasons, long-term contracts offer a couple of advantages for outsourcing.
Hypothesis 2b: The higher the internal uncertainty, the longer the term of the contract will tend to be.
It has generally been suggested that when a high level of external uncertainty surrounds a transaction, contracts tend to be shorter. Short-term contracts is a way to avoid being trapped in a bad long-term natural contract (Crocker and Masten, 1988). However, in outsourcing operations, previously noted, the level of asset specificity is never negligible. Some scholars analyze the duration of franchise contracts in which external uncertainty is high and found that the duration of franchised contracts is significantly influenced both by the amount of initial investments and uncertainty level (Bercovitz, 1999). For coal provision, the duration of contracts is also positively related to the value of investments in relationship-specific assets (Saussier, 2000). In these two studies, the level of demand, technological substitutes and future volume of activity are related to external uncertainty. Long-term contracts can deal with specific assets and external uncertainty provided they contain adequate clauses (Joskow, 1985, 1987; Wiggins, 1991). Hence, we suggest that external uncertainty will have a positive impact on the duration of the contract.
Impact of transaction cost attributes on contractual density
According to Dyer (1997: 535): “The standard (transaction cost) reasoning is that as asset specificity increase, more complex governance structures (i.e., more complex contracts) are required to eliminate or attenuate costly bargaining over profits from specialized assets”. Complex governance structures require elaborate contracts with detailed clauses. While most empirical studies using TCE have tested the link between asset specificity and one of the three governance structures (i.e., market, hybrid form and firm), no study has empirically explored the impact of asset specificity on contractual clauses except for Joskow’s “contract duration” clause (1985, 1987). By extending the Joskow’s approach to other clauses (e.g., pricing, incentives, penalties – see Appendix), we suggest that the benefits of contracting and the likelihood of dense contracts increase with the value of relationship-specific investments.
Hypothesis 3a: The higher the level of asset specificity, the higher the contractual density.
While the relationship between internal uncertainty and contracts is clearly at the core of TCE, empirical studies (Anderson and Schmittlein, 1984) have generally focused on the link between this type of uncertainty and the decision to vertically integrate. Thus far, the impact of internal uncertainty on hybrid governance forms such as outsourcing has not been sufficiently considered (Jones, 1987; John and Weitz, 1988). When the level of internal uncertainty is high, the outsourcing vendor is very likely to behave opportunistically (Williamson, 1985; Aersten, 1993). Consequently, monitoring and control mechanisms and incentive clauses must be included in the contract (e.g., service level reports, cash penalties, and end-user surveys…), not only to encourage both parties to take actions with consequences that depend on the other party’s behavior, but also to reduce the costs of repeated bargaining.
density.
Williamson (1991) suggests that hybrid governance forms such as outsourcing are very sensitive to external uncertainty. As adaptations cannot be made unilaterally (as by the market) or by fiat (as through hierarchy), hybrid forms require mutual consent. The contractual costs are numerous and include: i) the cost of devising optimal responses to future contingencies; ii) the cost of renegotiating the terms of the contract; iii) the costs of failing to adjust the contract to new circumstances. External uncertainty requires that the outsourcing vendor’s performance and efforts be clearly specified and verified. In these cases of high uncertainty, then, outsourcing contracts should be very detailed to facilitate monitoring activities and the making of adjustments (Klein, 1988; MacLeod and Malcomson, 1993). Complex contractual clauses should be built in the contract to permit adjustments as events unfold (Masten, 1984) and to avoid constant renegotiations which require mutual consent (Walker and Weber, 1984). Hence, we propose that external, like internal, uncertainty is also positively linked to contractual density.
Hypothesis 3c: The higher the level of external uncertainty, the higher the contractual density.
Impact of contract duration on contractual density
The link between contract duration and contractual density has been empirically tested in literature on long-term contracts. Mulherin (1986), Joskow (1988a) and Crocker and Masten (1991) show that price clauses (e.g., “fixed price”, “market price” and “escalating price” contracts) and quantity clauses (e.g., “most favored nation” clauses) are strongly dependent on the duration of the contract. In the case of outsourcing, we believe that the longer the term of the contract, the more elaborate this contract will tend to be because of the extra clauses required to respond to
unexpected contingencies. Building onto contract literature, we focus on all types of clauses and not merely on price and quantity clauses.
Hypothesis 4: The longer the term of the contract, the higher the contractual density.
Impact of contract duration and contractual density on ex post transaction costs
There is interplay between the duration of the contract and transaction costs. Crocker (1996: 92) states that “transaction cost analysis predicts that the duration of a contract reflects an underlying trade off between the marginal cost of writing longer agreements and the marginal benefits of mitigating opportunism by extending the agreement for an additional period”. So, the duration of an outsourcing contract can be interpreted both in terms of ex ante and ex post transaction costs. Longer contracts are not only more costly to write and specify (i.e., ex ante transaction costs) but also to monitor and adjust (i.e., ex post transaction costs). Accordingly, we propose:
Hypothesis 5a: The longer the term of the contract, the higher the ex post transaction costs.
As long-term contracts also imply denser contracts, the link between the content of contracts and transaction costs is quite straightforward. According to Balakrishnan and Wernerfelt (1986: 348): “As the number of contingencies in the contract goes up, it becomes more expensive to write, monitor and enforce”. When a contract contains many clauses, the ex post transaction costs are high because of the expenses involved in ensuring that the vendor fulfills all the contractual requirements (i.e., monitoring costs) and in enforcing all of the contractual clauses (i.e., enforcement costs) (Williamson, 1991). The more complex the contracts, the more expensive it becomes to manage the relationship with the outsourcing vendor.
Hypothesis 5b: The higher the contractual density, the higher the ex post transaction costs.
Our hypotheses are summarized in the theoretical model (Figure 1).
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RESEARCH METHOD Sample and data collection
We collected detailed primary data on outsourcing operations from a survey of European and American firms. As there was no systematic database on “vertical disintegration” operations, we extensively analyzed press clippings (i.e., in international newspapers and specialized magazines) from 1990 and 1998 to obtain a large overview. In order to detect announcements for outsourcing contracts, we conducted an exhaustive electronic search of two major databases: ABI/INFORM-GLOBAL and REUTERS. We were able to compile an initial sample of 816 “vertical disintegration” outsourcing contracts signed between 1992 and 1997. We chose this time frame because we wanted to exclude older outsourcing contracts, as the managerial turnover for these contracts would have led us to gather inaccurate information on the conditions under which the contracts were signed.
The survey was carried out in four phases. First, measurement scales were developed based on relevant literature and interviews with 15 European and non-European managers responsible for outsourcing contracts. Thereafter, the questionnaire was tested with three European managers. Based on their responses, the pre-test was revised, then and re-tested with three Anglo-Saxon managers (i.e., one American, one British and one Australian). Finally, we mailed the
questionnaires to the senior executives responsible for the outsourced activity in the 816 companies in our initial sample. According to the single respondent approach, these executives are those most apt to provide us with the necessary information (John and Reves, 1982). Two follow-up letters were sent after the initial mailing.
We received a total of 91 completed questionnaires, representing a response rate of approximately 11%. However, of these 91 questionnaires (i.e., collected from 91 firms), 9 could not be used because they were incomplete, leaving us then with 82 useful questionnaires. As the dependent variables were measured with the same questionnaire as the independent variables, common methods may skew the results (i.e., respondents may give self-justifying answers). In order to overcome the methodological limitations of self-report measures, we sought to develop “objective” measures for all the dependent variables (i.e., contract duration, contract clauses and transaction costs). We were also concerned about the validity of our measurements because we relied on questionnaires completed solely by outsourcing clients. However, Heide and John (1990) had found that buyers and suppliers share consistent perceptions of exchange relationship attributes. In our research, we chose to question the managers in the client firm because we believe them to be more knowledgeable than those in the outsourcing firm, which is often involved in a large number of outsourcing operations simultaneously (Khosrowpour, 1995). We tested for a potential response bias by comparing the respondents and non-respondents on two key criteria: total sales and number of employees. The data were obtained from Compact Disclosure and Kompass Europe (i.e., its European equivalent). This common technique is used in outsourcing studies such as Teng, Cheon and Grover’s (1995) and Ang and Cummings’s (1997). Like Teng, Cheon and Grover (1995), we randomly selected a sub-sample of 30 non-respondents and compared their total sales and number of employees with those of the 82 respondents. The results of the t-tests (respectively t = 0.346 for total sales and t = 0.625 for number of employees)
showed no difference at the significance level of 0.05, so we were able to generalize the results of our study to the entire sample.
Control for response bias and data heterogeneity Industry
Data was collected in randomly selected industries. Despite the evidence indicating that industry type has no impact on outsourcing strategies (Loh and Venkatraman, 1992; Teng, Cheon and Grover, 1995), we nonetheless opted to include a binary dummy variable for service and industrial sectors (see Table 1).
Type of activity outsourced
Most empirical studies on service outsourcing focus on Information Technology (IT) (Saunders, Gebelt and Hu, 1997; Lacity and Willcocks, 1998) and Research and Development (R&D) activities (Pisano, 1990; Ulset, 1996). Contrary to these studies, we used a sample composed of different service activities because we believe the TCE framework to be sufficiently powerful to simultaneously handle these different activities. As IT and telecommunications are the most “pervasive” activities, we included a dummy variable for IT and non-IT activities (Applegate, McFarlan and McKenney, 1999).
Country
As we collected data both in Europe and North America, we needed to include a binary dummy variable (i.e., European and American outsourcing contracts) to control for the impact of the country of origin.
Measures and Variables
The constructs were operationalized with a mix of original and adapted scales derived from the conceptual definition of each construct, relevant literature and field interviews.
Independent variables Asset specificity
While asset specificity is probably the most important attribute of TCE, there is no commonly accepted method for operationalizing this concept (Lohtia, Brooks and Krapfel, 1994; Klein and Shelanski, 1995). It has been operationalized as the “degree to which a part is complex” (Masten, 1984) or the “degree of sunk engineering” (Monteverde and Teece, 1982). Generally, though, assets are considered to be specific when they cannot be redeployed for alternative uses (Klein and Leffler, 1981; Williamson, 1985: 53). In the case of outsourcing, dedicated employees and equipment have generally been transferred to the vendor. The “redeployability” criterion does not make much sense in this context because the vendor tends to maintain the level of specificity (at least at the beginning). In this study, and consistent with other research (Anderson and Weitz, 1986; Poppo and Zenger, 1998), we operationalized asset specificity as (1) the cost of switching vendors; (2) the time needed to switch vendors; (3) the cost of reintegrating the outsourced activity; (4) the time needed to reintegrate the outsourced activity. All four variables were measured on a five-point Likert scale ranging from “very low” to “very high”.
Internal uncertainty
We operationalized internal uncertainty as the difficulty in evaluating the supplier’s performance (Anderson and Schmittlein, 1984; Aersten 1993). Three indicators were used: (1) overall performance; (2) cost competitiveness; and (3) human and technological competencies. All three were assessed on a five-point Likert scale ranging from “very easy to assess” to “very hard to assess”.
External uncertainty
We operationalized external uncertainty as the difficulty in evaluating the future needs of the outsourcing clients. We gauged this type of uncertainty based on the following: (1) uncertainty about the expected technology (Balakrishnan and Wernerfelt, 1986; Walker and Weber, 1984, 1987), (2) uncertainty about the expected volume and activity levels (Anderson and Schmittlein, 1984; Walker and Weber, 1984; John and Weitz, 1988), (3) uncertainty about the expected performance, and (4) uncertainty about the expected human competencies. The last two indicators were included in our research upon the suggestion of managers from the field interviews. All four indicators of external uncertainty were evaluated on a five-point Likert scale ranging from “very easy to assess” to “very hard to assess”.
Dependent variables Contract duration
The questionnaire asked the respondent to note the term of the outsourcing contract (in years). Contractual density
To our knowledge, research has yet to be conducted on the operationalization of contractual density. Therefore, we needed to develop our own measures based on the literature on long-term contracts and literature on the legal aspects of outsourcing contracts (Halvey and Melby, 1996). Similar to Parkhe’s methodology (1993: 813), we operationalized four clauses to develop a precise measure for the density of outsourcing contracts: (1) clauses concerning the management of the supplier, (2) clauses concerning the adaptation to the changing environment, (3) price clauses, and (4) clauses concerning the contract’s termination. Each type of clause (i.e., management, adaptation to changes, prices and termination) was operationalized with six dummies derived from literature. For each type of clause, we arranged the dummies in an increasing order, based on their complexity. For instance, in the case of price clauses, we used the following six dummies: (1)
“fixed price” clause, (2) “cost plus” clause, (3) “market average cost” clause, (4) “benchmarking”, (5) “risk reward sharing” clause, and (6) “price indexing on the generated turnover” clause. Based on law literature (Halvey and Melby, 1996) and literature on long-term contracts (Joskow, 1988b) and on outsourcing (Lacity and Hirschheim, 1993; Saunders, Gebelt and Hu, 1997), we assigned a value of ‘1’ to the “fixed price” clause, a value of ‘2’ to the “cost plus” clause, a value of ‘3’ to the “market average cost” and “benchmarking” clauses, a value of ‘4’ to the “risk reward sharing” and “price indexing on the generated turnover” clauses (see Appendix).
Transaction costs
Our measure for transaction costs is based on Williamson’s (1985) and Wallis and North’s (1986) studies. These authors suggest that the costs associated with employees working in transaction functions (i.e., functions not directly associated with production) can be used as a direct estimate of transaction costs. Consequently, we operationalized the ex post transaction costs of outsourcing relationships as: (1) the number of employees responsible for monitoring the contract and managing the relationship with the outsourcing vendor, (2) the annual cost of monitoring the contract and managing the relationship with the outsourcing vendor. In order to avoid heteroscedasticity problems (i.e., disproportionate effect from a skewed distribution), the log transform of both variables was used in the analyses. Finally, it should be noted that our measures do not capture the remaining residual loss from choosing outsourcing over vertical integration (Hill, 1995). We focus exclusively on the cost borne to reduce “shirking” in outsourcing relationships.
Statistical method
We used two statistical techniques to test our model. The first, Partial Least Squares (PLS) (Lohmöller, 1989; Hulland, 1999), was preferred over LISREL (Jöreskog and Sörbom, 1989)
because it requires less stringent assumptions about the randomness of the sample and the distribution of variables. It is also better suited for small data samples (Fornell, 1982; Wold, 1982, 1985). The second statistical technique, PLS regression (Umetri, 1996), uses multiple regression to test the links between variables. When there are high inter-correlations between independent variables, multicollinearity becomes a concern, but our three-tier model has built-in multicollinearity. For instance, we simultaneously expect: (1) asset specificity to affect contract duration, (2) asset specificity and contract duration to affect contractual density. The PLS regression algorithm, initially developed by Wold, Martens and Wold (1983) and Wold, Albano, Dunn, Esbensen, Hellberg, Johansson and Sjöström (1983), while frequently used in chemistry, can also be very useful in management. Its mathematical properties are described in Helland’s (1988) and Höskuldsson’s (1987) works.
ANALYSIS AND RESULTS
The model was estimated in two stages. First, we used PLS to evaluate the reliability and validity of the measurement model (i.e., links between manifest and latent variables). Second, we used PLS regression to study the causal relationships within the structural model (i.e., links between the latent variables).
Measurement model results
Three criteria must be used to assess the adequacy of the measurement model (Hulland, 1999), the results of which were obtained through PLS (Lohmöller, 1989). Individual item reliability was assessed by examining the correlations (i.e., loadings) of the manifest variables with their respective latent variable. Individual item reliability is usually deemed acceptable when it is higher than 0.7 (Carmines and Zeller, 1979). The item “cost to reintegrate the outsourced activity”
was dropped as its loading was only 0.57. All the other items have loadings higher than 0.7 except “time to reintegrate the outsourced activity”, “difficulty of evaluating the supplier in terms of cost competitiveness”, “density of clauses regarding adaptation to the changing environment” and “density of clauses regarding termination of the contract”. These four items, however, were kept in the model because they have loadings ranging between 0.66 and 0.7 (see Table 2). Convergent validity was assessed through the “internal consistency” measure1 (Fornell and Larcker, 1981). Internal consistency is deemed acceptable when higher than 0.7. As shown in Table 3, our constructs all have acceptable internal consistency. Discriminate validity was assessed through Average Variance Extracted (AVE)2 (Fornell and Larcker, 1981). For discriminant validity to be acceptable, the correlation between two latent variables must be inferior to the square root of the AVE of two latent variables. As shown in Table 4, this criterion is met for all pairs of constructs.
Structural model results
The structural model results were obtained through PLS regression (Umetri, 1996). The PLS regression coefficients and R2 can be interpreted as multiple regression coefficients and R2 (see Table 5).
Impact of transaction attributes on ex post transaction costs
Hypothesis 1a is supported. The higher the level of asset specificity, the higher the ex post transaction costs (β = 0.17; p < 0.01). The core assumption of TCE, then, is confirmed for the
1 Internal consistency = (Σ λ
yi)2 / ((Σ λyi2) + Σ var (εi)) 2 Average Variance Extracted = Σ λ
case of outsourcing. Hypothesis 1b is also supported. Internal uncertainty has a direct impact on ex post transaction costs (β = 0.09; p < 0.10). The difficulty in measuring the vendor’s performance has clear cost implications. Finally, Hypothesis 1c is also supported (β = 0.09; p < 0.10). Like asset specificity and internal uncertainty, there seems to be a linear relationship between external uncertainty and ex post transaction costs for the case of outsourcing.
Impact of transaction cost attributes on contract duration
Hypothesis 2a is supported (β = 0.31; p < 0.01). Asset specificity is positively related to the term of outsourcing contracts. These results corroborate with Joskow’s (1985, 1987, 1988a, b and 1990) for the case of service activities outsourcing. Hypothesis 2b is also supported (β = 0.19; p < 0.01). When the level of internal uncertainty is high, long-term contracts are necessary because they enable clients to learn about their vendors and space out renegotiations (i.e., especially when vendors are likely to take advantage of their information asymmetries). In this way, the likelihood that vendors behave opportunistically can be significantly reduced. Finally, hypothesis 2c is supported (β = 0.23; p < 0.01). External uncertainty is positively linked to the term of outsourcing contracts. At first glance, this result appears to be counterintuitive (Crocker and Masten, 1988). However, even if the level of asset specificity is moderate in outsourcing operations, reintegrating the outsourced activity or switching suppliers is expensive. Consequently, long-term contracts must be designed to adapt to unexpected changes in the future.
Impact of transaction cost attributes on contractual density
Hypothesis 3a is supported (β = 0.17; p < 0.01). Asset specificity causes transaction costs to increase via an increase in contractual density. The higher the level of asset specificity, the higher the “hold up” risk (Klein, Crawford and Alchian, 1978). In order to deal with a potentially opportunistic vendor, contractual safeguards must be developed. Hypothesis 3b is also supported
(β = 0.12; p < 0.05), suggesting that internal uncertainty has an impact on contractual density. When a high level of uncertainty surrounds the behavior of the vendor, a detailed contract is necessary to curtail its potential opportunism. Finally, hypothesis 3c is supported (β = 0.15; p < 0.01). The higher the uncertainty about the future needs of the outsourcing client, the more clauses must be included in the contract in order to deal with unexpected contingencies.
Impact of contract duration on contractual density
Hypothesis 4 is supported (β = 0.33; p < 0.01). We confirm and extend Joskow’s (1988a), Masten and Crocker’s (1991) and Mulherin’s (1986) findings. Unlike studies in contract literature, we do not focus exclusively on the link between contract duration, price and quantity clauses. Our contractual density variable is far more comprehensive than price and quantity clauses.
Impact of contract duration and contractual density on ex post transaction costs
Hypothesis 5a is supported (β = 0.18; p < 0.01). Contract duration can indeed be interpreted in terms of costs (Crocker, 1996). The main advantage of longer contracts is that they space out renegotiations. On the other hand, they entail high ex post transaction costs. Hypothesis 5b was also empirically supported (β = 0.14; p < 0.01). The denser the outsourcing contracts, the higher the monitoring and enforcement costs. Our test clearly shows that every contractual clause has a cost. For instance, benchmarking price clauses are more expensive than “cost plus” clauses and “cost plus” clauses are more expensive than “fixed price” clauses. Quite noticeably, our results contradict the conclusions that managerial literature draws on outsourcing. For example, Lacity and Willcocks (1998) and Harris, Giunipero and Hult (1998) argue that short-term contracts are always better than longer ones. On the contrary, our results suggest that there is no “one best way” such as a “flexible contract”. The effectiveness of clauses must always be compared with
their actual costs. Control variables
Most of the TCE empirical work focuses on single industries in single countries. As the data used in this paper was far more heterogeneous, we wanted to test whether our findings could apply to different countries, industries and activities. We ran PLS regressions with control variables on the three dependent variables (see Table 6). Of the three variables, only “activity” has a positive and significant impact on the dependent variables. In order to further explore the impact of this variable, we re-ran the model on two sub-samples (IT activities vs. non-IT activities). Our findings turned out to be convincing even after splitting the sample into IT outsourcing vs. non-IT outsourcing operations. It appears, then, that IT outsourcing operations are characterized by higher asset specificity, internal uncertainty and external uncertainty than non-IT outsourcing operations. The contractual hazards of IT outsourcing are high. This results in longer and more complex contracts (Lacity and Hirschheim, 1993) and eventually in higher ex post transaction costs. All in all, our model is valid for the characteristics of any industry, country or activity.
CONCLUSION
Managerial implications
One of the most important issues in outsourcing is the management of the outsourced resources. Recently, several empirical studies stressed the importance of relationships between outsourcing clients and their vendors, especially in services that have direct connections with manufacturing and core businesses (Huber, 1993; Quinn and Hilmer, 1994; Cross, 1995; Quinn, 2000).
The main objective of this study was to examine the effects of several variables on ex post transaction costs (as hypothesized by TCE). We also evaluated the effects of asset specificity and both types of uncertainty on contract duration and contractual density. The relationship between
asset specificity and contractual density was a positive one. Our results suggest that it may be appropriate to outsource service activities even when the level of asset specificity is high if the contract is enough dense. In other words, outsourcing is a viable alternative to keep inside activities even if uncertainty makes performance specification, verification and monitoring difficult. Therefore, even if they may help reinforce the core business, support activities (Porter, 1985) and services (Quinn and Hilmer, 1994) do not necessarily need to be internalized, especially when external uncertainty is high. In fact, it has been reported that firms actively seek to outsource activities based on specific assets, provided this can help them focus on their core competencies without diverting resources on non-core activities (Lacity and Hirschheim, 1993; The Outsourcing Institute, 1997).
Hill (1990) questions Williamson’s (1979) assumption that if asset specificity is high, hybrid organizational forms should be replaced by vertical integration because of the risk of opportunism. Some scholars (Coase, 1988; Walker and Poppo, 1991) argue that asset specificity is not a sufficient condition for vertical integration. Others maintain that relational contracting diminishes the role of asset specificity as a necessary condition for low transaction costs (with internal sourcing) and as a sufficient condition for high transaction costs (with external sourcing). The case of General Motors and Ford illustrates that “vertical integration, by giving in-house incentives for in-house suppliers a captive market, has attenuated incentives for in-house suppliers to maximize efficiency” (Hill, 1990: 508). Our study sheds light on the choice between formal contracting and informal agreement. Indeed, we showed that outsourcing clients adopt a formal contract when the service is specifically designed for its requirements (Lyons, 1994). The evidence is thus consistent with TCE predictions regarding the liabilities of contracting in a complex and uncertain environment.
should not simply evaluate the level of asset specificity to make their outsourcing decisions. Internal and external uncertainty should also be considered. When faced with high ex post transaction costs, managers should compare them with the costs of carrying out the activity internally. Although beyond the scope of this study, benchmarking outsourcing costs with vertical integration costs would be helpful in comparing the sum of production and transaction costs for these two organizational choices.
Theoretical implications
Empirical literature in TCE consistently prefers vertical integration to contracting as the level of asset specificity increases. Evidence indicates that uncertainty and contract complexity diminish the attractiveness of contracting as compared to integration (Anderson and Schmittlein, 1984; Masten, 1984). Our findings suggest that in cases involving specific assets, contracts are a flexible way to accommodate possible future adaptations in outsourcing decisions.
This study used constructs from Williamson’s works (1979, 1985) to examine outsourcing and outsourcing contracts between clients and their vendors. TCE is the main framework used to distinguish between transactions that need to be internalized and those that do not. However, it is limited insofar as outsourcing is concerned because of the unique characteristics of this type of governance form (e.g., transfer of an in-house activity with employees, long-term dependence on the vendor, continued need to access the service). Outsourcing addresses the paradox of organizations that had invested in-house in the past and then afterwards, decided to enter into a long-term contractual agreement (Walker and Poppo, 1991). To better understand contracts, it is necessary to shed light on how they actually work. In particular, one must recognize that the goal of contract specification is not only to create incentives. The analysis of contract content must also consider how contract clauses can be used to favor self-enforcement (Klein, 1996). As contracts are always incomplete, it is necessary to make the relationship self-enforcing over the
large range of post-contractual conditions. This is why our construct includes both control and flexibility clauses.
Another important implication of this study, particularly for emerging conceptual frameworks, is the empirical support that contractual density and the interrelationships between incentives and contract duration all contribute to increase transaction costs. We thus needed develop a new construct called “contractual density”. Even if this construct is restrictive (due to the precise nature of the study), it extends the theoretical benefit of such a dimension to the long-term contract literature.
Limitations
While this study provides important managerial implications, one should note that it has several limitations. First, our “contractual density” variable did not capture the increasing role of alliances and partnerships between outsourcing clients and vendors. Second, since we wanted to avoid crude and imprecise proxies, some of the constructs were developed based on the personal evaluation of managers involved in the outsourcing decision. Although well-informed executives responded to the survey, meaning that the quality of their responses is assured, the reliability of our variables was not tested on a very large sample. Third, we did not focus on the outsourcing decision, so we did not compare the internal and external production costs. Despite these limitations, this study is one of the first attempts to empirically investigate outsourcing, and hopefully, will open doors for further research.
Future research
This study invites us to develop a complementary analysis to properly interpret the relative costs of contracting out versus supplying in-house. The customer opts for contracting only when production savings exceed the sum of monitoring expenses, costs, and the loss expected from undetected cheating with the risk-averse contracting vendor. Due to opportunism, these costs must
be added when balancing out in-house versus outsourcing decisions.
Another research area is the use of appropriate contracting strategies. Among private contracting arrangements, transparency plays a vital role, so a sophisticated contracting approach can be used. Our analysis here implies that reputations and technical qualifications to perform the desired task must first be considered. Moreover, the customer should explicitly consider the responsibility and responsiveness of outsourcing contractors. A verification of a potential contractor’s past behavior can convey useful information. In fact, a scoring approach could be developed to weigh responsibility by combining reputation, past performance and contract monitoring conditions.
Finally, according to the transaction cost logic, firms can use governance mechanisms to mitigate the threat of opportunism. In general, the more elaborate the governance mechanism, the more effective it is in reducing the opportunism threat. Our study implies a temporal dimension of both transaction costs and firm competencies because the firm’s core resources and the strategic decision simply do not play a sufficiently significant role in traditional transaction cost economics. We show that some intermediate governance forms are costly in and of themselves. In this setting, the decision about how to outsource the capabilities that the firm does not need to maintain in-house depends not only on the required level of specific investment, but also on the cost of maintaining arm’s length relationships with outsourcing vendors. A firm might want to choose the outsourcing approach to gain flexibility and reduce fixed costs even if its activities are still mainly transaction-specific investments. In-house resources and competencies play a significant role in determining a firm’s boundary.
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Figure 1. Theoretical model Ex post transaction costs Contract duration Contractual density Internal uncertainty External uncertainty Asset specificity H1a (+) H1c (+) H1b (+) H3c (+) H3a (+) H3b (+) H4 (+) H5b (+) H5a (+) H2a (+) H2b (+) H2c (+)
Table 1. Sample description Industry N % of sample Manufacturing 52 63% Services 30 27% Country Europe 62 76% North America 20 24% Activity Information Technology 44 54% Non-Information Technology 38 46%
