Project Milestones for Managing Risk in Software Development Outsourcing: A Real Options Perspective

Organizations are increasingly turning to outsourcing for software development, in part, to control cost and lower the likelihood of project failure. However, application outsourcing is not without risk. Milestones coupled with gateway reviews are a common mechanism for controlling these risks. Yet, the benefit of milestones must be assessed in light of their associated costs. This paper uses real options theory (ROT) to analyze 15 real world software development projects outsourced by three large organizations. It finds empirical support for the theorized relationship between the number of milestones used in these projects and the degree (and kinds) of risks affecting the projects. This finding indicates that the practices of contract managers in these organizations are consistent with the logic of ROT in planning project milestones. This paper therefore argues that ROT could serve as a basis for enabling managers to plan project milestones in an economically efficient manner.