Hands-off the mess: Contract choice for business process outsourcing

An appropriate contract is critical for the success of business process outsourcing (BPO). We investigated how coordination and negotiation costs impact choices of contract types. We characterized three types of contracts in terms of vendor incentives for cost savings and flexibility to change besides payment schedule. There is a trade-off between levels of incentive to reduce costs and flexibility to change. Thus firms need to choose the appropriate type of contract by weighing one type of concern against another based on the characteristics of transactions. Using data from US companies, we found that the concerns of managing interdependence are better mitigated with high incentive contracts with detailed service descriptions such as Fixed Price contracts while the concerns of opportunistic behavior in ex post adaptation should increase the preference to contracts with more flexibility for changes such as Time and Materials contracts.