Information Technology Outsourcing: Asset Transfer and the Role of Contract

Information Technology Outsourcing (ITO) has become the predominant mode of acquiring information systems services, providing clear evidence that the economics of service delivery favor external service providers over in-house information systems departments. An interesting feature of many large ITO arrangements is that assets necessary for service delivery are transferred to the vendor. The argument in favor of such asset transfers, based in Property Rights Theory, is that they are necessary to incentivize vendors to continue to invest in the transaction-specific assets to improve service. On the other hand, Transaction Cost Economics predicts that transferring such assets increases bilateral dependence and will elevate the risk of post-contractual opportunistic behavior. The contracting challenge is to specify the terms of exchange to achieve the client’s objectives for outsourcing while managing the transaction risks. Given the role of asset transfer in ITO engagements, we develop a theoretical framework to derive propositions on contract design in the presence of asset transfer. In particular, we recognize the complementary role of compensation mechanisms, specifically the pricing scheme and the use of performance incentives. We have compiled a unique dataset that provides an opportunity to examine sensitive information on contract structure. We test our propositions by comparing large ITO contracts that include asset transfer to those that do not. We find that asset transfer does significantly affect contract design, manifested in the inclusion of clauses that protect both clients and vendors. Outsourcing objectives are more likely to be met when contracts include compensation mechanisms that complement asset transfer.