Taking IT outsourcing to the next level

With businesses increasingly dependent on service providers to reduce costs, improve quality, and drive innovation, traditional contracts don’t work. In fact, they often undermine the partner-like relationships and trust needed to cope with external uncertainty. A better approach is to use what leading academics call a “formal relational contract.”

Why transactional contracts are a thing of the past

Over the years, outsourcing has become a popular way for companies to reduce costs, improve efficiency, and access specialized skills and technology. The conventional approach uses a transaction-based contract where the buyer pays the provider a negotiated price for set scope of work (e.g., price per billable hour of a software developer, price per licensed user for access to a SaaS product, price per call for desktop service support). 

The beauty of transactional contracts is their simplicity: use a competitive bid to negotiate the best price among all capable suppliers. But simplicity has trade-offs. 

Traditional contracting methods provide little room to accommodate changes in complex IT projects. While the fixed scope of work and clear deliverables and deadlines may seem straightforward, they can be limiting when technical challenges or changing business needs arise, unforeseen or otherwise. Even in the absence of a specific crisis, traditional contracts create room for three looming problems: hold-ups, incomplete contracts, and shading.

Hold-ups happen when one (or both) parties fear the other party will become opportunistic and use their power against the other. In essence, the weaker party feels trapped — especially if they feel they cannot easily get out of the relationship due to strict contract terms. Second, incomplete contracts amplify the problem in complex outsourcing relationships because complex contracts almost always contain gaps, omissions, and ambiguities. Third, shading manifests in the form of negative behaviors triggered in response to a party not meeting contractual expectations. For example, a supplier might make countermoves such as replacing the A-team on an account with the C-team to lower costs and increase profit. 

Trying to constrain a partnership on a complex IT project within rigid contractual terms will likely yield frustration on both sides. Relational contracts are more flexible and adaptable, enabling the parties to work together to address these changes.