The other observation is founded on the agency theory. Agency theory describes the behaviour of people who work with either the buyer or supplier organization. This ‘human’ behaviour is demonstrated very clearly in the RDS profiles in almost all the risk dimensions. It is possibly the most significant cause of risks within the ITO framework and is described below.
4.7
Winner’s curse
Very often, in search of cost savings, the buyer drives the supplier’s prices down, resulting in winner’s curse (which is also a loss for the buyer as services deteriorate in compensation).
Alternatively the process is abandoned because the costs of providing the services are too high.
The tender process described is quite similar to a bidding or auction process where the lowest price (not the highest) is 110
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Understanding Risks When Outsourcing the IT Function sought by the buyer of outsourcing services. Acceptance of a bid is often based on the information provided by the buyer. Failure to incorporate relevant and correct information into the bidding strategy can lead to excessively low bids and subsequent losses.
Each bidder then works through a series of decisions to price the outsourcing services. As information is not always forth-coming, the risk of the winner paying more, on average, than the prize is worth, is something found to happen quite often in practice. This series of actions leads to the ‘winner’s curse’ phenomenon. It occurs in normal auctions, in which the auctioneer is the seller or represents the seller and the bidders are the buyers, who have evaluated the object(s) sold.
The incidence of this phenomenon has been increasing with the recent development of business-to-business (B2B) exchanges and on-line auctions. In all sorts of markets, a winner’s curse can have consequences for several parties, over months or even years. In such circumstances, auctions themselves may well be better conceived as relationship-building exercises rather than one-off bids.
The theory of auctions would suggest that the winner’s curse is asymmetric, i.e. it only affects the supplier or the winning bid.
In this case however, the winner’s curse in a procurement auction of ITO contracts and its impact on and consequences for the relationship between the customer and the winning bidder starts the interplay of risk-shifting. The supplier winning a
‘cursed’ deal may well cut losses by supplying lower-quality products or services to the customer. Then the buyer, winning what turns out to be a cursed deal, may well drive a much harder bargain in terms of service guarantee rather than price.
The upshot may be that the buyer removes the offending supplier from its supplier listing.
Inexperienced suppliers tend to make unrealistic bids. Other suppliers make bidding promises to ‘buy’ the contract.
Subsequently however, the risks on not being able to recover their tendering, business, and operational costs could become significant problems. The risk therefore has shifted back from the buyer to the supplier.
In an effort to recover their costs, the suppliers would either attempt to offer additional services from their portfolio of technology capabilities, service management, and consultancy services over the life of the contract or, under pressure, to make sufficient margins in unfavourable circumstances and trade-offs in the quality of service. The risk, hence, is shifted back from the supplier to the buyer. Case studies confirm that when a supplier 111
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seeks to decrease its costs, this can result in decreases in service quality and additional costs for the client.
Further, the supplier’s disproportionate concern for keeping its costs down could lead to inflexibility in the interpretation of the contract, and subsequently lead to adversarial relationships.
Operational performance and the client–buyer relationship will receive less attention and suffer; the success and effectiveness of the operations and outsourcing relationship will be compromised. The focus of the supplier will be primarily on recovering costs, and not on developing and maintaining the relationship and mutual objectives.
The process wherein suppliers are asked to bid in an ‘auction’
provides a mechanism whereby the procurement of ITO services from lowest supplier induces the suppliers to disclose their privately known cost structures. As illustrated earlier, the auction mechanism enables the buyer and supplier to match services and goods with an optimal price, especially in this instance where a standard market price is unavailable. While a discussion on auction mechanisms and variations in auction designs are not dealt with here, the risk profile identifies the tolerance limits for both the supplier and the buyer organizations as input into the design for auction mechanisms. Costs and the related financial risks are important factors for a business organization and the auction allows it to procure services at more competitive prices. In addition, ‘market solutions are viable for reducing differences in information and hidden action when these differences are limited to a single dimension or when intermediaries exist to disseminate credible information regarding counterparty behaviour’. The supplier governance procedures are constructed by the organization to mitigate informational and legal risks. The RDS, once again, reveals this to the managers at an early stage in both supplier and buyer organizations if the tool is used.
4.8
Agency theory
Agency theory provides a background to the interaction and motivation of the supplier and buyer of outsourcing services.
Opportunism, or the tendency to cheat as a means to gain advantage, is an inherent characteristic of many relationships where there is an agent and ‘buyer’. In the outsourcing relationship, this leads the supplier to adopt opportunistic behaviour whenever the chance arises, to its own benefit. The assumption is the tendency of the supplier to behave in this way despite the 112
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Understanding Risks When Outsourcing the IT Function existence of moral and social norms as well as the constant risk of prosecution. Opportunism in turn manifests in terms of moral hazard, adverse selection, and imperfect commitment.
An essential area in the discussion of the main relationship risks in an ITO scenario is the relationship itself, from the viewpoint of agency theory. This applies to both participants (the buyer and the supplier) within the ITO scenario. Agency theory mentioned earlier postulates that because people are self-interested, they will have conflicts of interests over at least some issues.
This occurs any time they attempt to engage in co-operative endeavours. Some of the salient points of the behaviours that manifest are summarized in Figure 4.6.
Asset specificity
Uncertainty
Measurement problems
Frequency
Interdependence of activities
Proximity of core competencies
Technological discontinuity
Opportunism (moral hazard,
adverse selection, imperfect
commitment)
Lack of experience/
expertise with the
Lack of experience/
activity to be outsourced
expertise with the activity
Buyer
Supplier
to be outsourced
Lack of experience/
Lack of experience/expertise
expertise in managing
in managing outsourcing
outsourcing contracts
contracts
Supplier interface
Figure 4.6
IT outsourcing risk factors between buyer and supplier (Tho, 2003) Moral hazard arises as a consequence of the buyer not being able to accurately monitor the activities of the supplier without incurring prohibitive costs. The buyer hence cannot easily determine whether a problem is the result of negligence on the part of its supplier or to an unforeseeable event. This is a significant risk factor borne by the buyer, as the supplier has the
‘excuse’ that poor performance is beyond its control. This leads to an increased risk for the buyer over the supplier. The supplier can choose to assign his best staff to a project or use his most inexperienced teams without a thorough background check on every person placed on a project at every point in time. The existence 113
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Managing the Risks of IT Outsourcing
of the latter scenario is difficult to detect, but it may manifest itself in decreased reliability, excessive cost or project delays.
It can also manifest itself as a consequence of the supplier not being able to monitor the buyer. A buyer of outsourcing services may undertake hidden investments even before the contract is signed. Many outsourcing agreements are based on an initial benchmarking period where actual cost is measured, and the supplier is given a bonus for cost reduction. Buyers excessively invest in cost reduction before contract initiation in order to limit supplier bonuses from cost de-escalation clauses.
Given the contractual nature of outsourcing, the service quality is not as flexible as would be the case if the services were to be delivered without the outsourcing services. These services, however, change over time, leading to discrepancies in the services requested and delivered. Switching-costs are high, and the inevitable loss of competence arises at all stages of the outsourcing exercise.
The heterogeneity of the ITO market justifies the examination of different facets of the outsourcing market. For each segment of the market, different relationships between client and supplier form a vital portion of the framework in which risks in this environment are examined. Contractual risks between the buyer and supplier are a prime source of risks and a factor in the outsourcing decision. The fundamental drivers of risk are information asymmetries before contracting, inability to monitor partners’