outsourcing as Relational
contracting: trust and incentive
The answer to the question of shared
services as an end point without proceeding to outsourcing depends on
the second key feature of business
service outsourcing, and that is the
nature of “relational contracting.” For
example, in an M&A deal the signing
of the contract closes the deal. By contrast, in outsourcing, such “closing” is
just the start of a long-term collaborative relationship between two firms.
In order for such a relationship to operate well, it relies on trust and incentives. In fact, incentive and trust may
be structured better in outsourcing in
some cases, but in internal shared services in other cases.
Organizational economists define
a relational contract as a contract that
is incomplete (due to difficulty of full
specification) and informal (due to
difficulty in third-party enforcement,
for example in courts). 2, 6 A multiyear
business service outsourcing deal is
a perfect example of a relational con-
tract. It is typically incomplete due to
two reasons. First, future contingen-
cies are difficult to specify in the face
of unknown market conditions and
new technology in several years’ time.
Second, quality of business services to
be delivered is sometimes difficult to
describe and verify. Indeed, both par-
ties may wish to retain a certain de-
gree of post-contractual flexibility. If a
contract is incomplete, then it is also
difficult for a third party to enforce it.
Parties to the contract must rely on al-
ternative enforcement mechanisms.
One of these mechanisms is to rely on
trust as a social norm to work things
out through discussion, with social
sanctions in the event of untrust-
worthy or unethical behavior.b This
works well in stable business commu-
nities, and where parties are chosen
for their “cultural fit.”
Another enforcement mechanism
is incentive alignment. Service Level
Agreements (SLAs) are employed to
secure high performance in outsourc-
ing and shared services. With stable
processes, performance is easily mea-
sured, and the bonus and penalty re-
gime gives a good incentive for provid-
b There is a large body of work on the topic of
trust in business relations.
there may well
be a timing effect,
with pioneers opting
for the introduction
of shared services
and followers opting
ers to perform well. But the credibility
of the client firm to commit to paying
a bonus is different for external and
internal providers. Outsourcing faces
“high-powered” incentives, with the
client able to credibly threaten to terminate the contract when the provider
underperforms; with an internal SLA,
it is not easy to do anything if the internal shared services center does not
perform. And what’s worse, the internal operation is often a cost center
rather than a profit center. At the same
time, whenever a provider is offering
standardized processes that could be
delivered to more than one client, SLA
acts as a powerful incentive to perform
well for a specific client offering the
bonus. By contrast, with processes
that are customized for a specific client, SLA does not create as powerful
To summarize, the following is the
implication from a perspective based
purely on incentives. Outsourcing
works best to make an external provid-
er truly accountable for performance,
whenever processes are standardized
and stable for easy SLA specification.
By contrast, an internal shared ser-
vice is a better option in cases where
processes are either customized or
being transformed. The incentive-
based argument highlights the fact
that parties must rely more on other
mechanisms such as trust if outsourc-
ing is applied to processes requiring
customization or transformation.
Thus, an optimal degree of contrac-
tual incompleteness—somewhere be-
tween a “blank check” and a “nail it all
down” level of detail—depends on the
task at hand (service delivery versus
transformation) as well as the avail-
ability of incentive alignment mecha-
nisms and trust.
The jury is still out on whether or not
outsourcing or shared services is ultimately the best service delivery model.
I have argued in this column that, amid
all the management fads and fashion, there is more than one way to do
things, and that each way has its merits and demerits, with associated risks
Outsourcing and shared services
are both part of organization redesign
to give primacy to the efficiency of corporate functions. Compared to shared
services, outsourcing is a combination
of decisions about the firm’s external
boundary and its internal structure.
Outsourcing may take place at different stages in corporate activities, either
as an initial trigger to bring about fundamental restructuring in a “big bang”
mode or a next step after a period of
internal process transformation. Relational contracts, if well designed, can
service the maintenance of high-powered incentives to ensure the delivery
of high-quality service. However, the
firm may wish to retain internal shared
services without outsourcing if it anticipates instituting further business
changes in structure and scope of business services. The choice between outsourcing versus shared services is not
simply a matter of timing (in mature
versus immature markets). It is more
crucially a matter of long-term corporate strategy.
1. Adler, P.s. Making the hR outsourcing decision. MIT
Sloan Management Review (2003), 53–60.
2. baker, G. R., Gibbons, R., and Murphy, K.j. Relational
contracts and the theory of the firm. Quarterly Journal
of Economics 117, 1 (jan. 2002), 39–84.
3. Chandler, A. Strategy and Structure. MIT Press,
Cambridge, MA, 1962.
4. Galbraith, j.R. Designing Matrix Organizations
that Actually Work: How IBM, Procter & Gamble,
and Others Design for Success, jossey-bass, san
Francisco, CA, 2009.
5. lawler III, e.e. et al. Human Resources Business
Process Outsourcing: Transforming How HR Gets Its
Work Done. jossey-bass, san Francisco, CA, 2004.
6. Macneil, I.R. Contracts: Adjustments of long-term
economic relations under classical, neoclassical, and
relational contract law. Northwestern University Law
Review, 74 (1978), 854–906.
Mari Sako ( email@example.com) is Professor of
Management studies in said business school at the
university of oxford, u.K.
Copyright held by author.