Design and Analysis of Contracts for Software Outsourcing

Abstract

Outsourcing of software development allows a business to focus on its core competency and take advantage of vendors' technical expertise, economies of scale and scope, and their ability to smooth labor demand fluctuations across several clients. However, contracting a software project to an outside developer is often quite challenging because of information asymmetry and incentive divergence. A typical software development contract must deal with a variety of interrelated issues such as the quality of the developed system, the timeliness of delivery, the effort and cost associated with the project, the contract payment, and the postdelivery software support. This paper presents a contract-theoretic model that incorporates these factors to analyze how software outsourcing contracts can be designed. We find that despite their relative inefficiency, fixed-price contracts are often appropriate for simple software projects that require short development time. Time-and-materials contracts work well for more complex projects when the auditing process is efficient and effective. We also examine a type of performance-based contract called quality-level agreement and find that the first-best solution can be reached with such a contract. Finally, we consider profit-sharing contracts that are useful in situations where the developer has more bargaining power.

Strategic innovation through outsourcing: The role of relational and contractual governance

“…A supplier may mitigate this risk of endangering its profitability if the parties agree to mutually adjust their obligations, expectations and interpretation of the fixed-price contractual term in what Gopal and Koka (2012) coined "relational flexibility". However, unlike in IT operational or business process innovations (Weeks and Feeny 2008) where there is limited uncertainty about the costs involved in implementing new technology or a new change programme, thus a limited number of adjustments in the fixed-price contract, in a strategic innovation project the client and supplier will face a high degree of uncertainty (Dey et al 2010;Dewar and Dutton 1986;McDermott and O'Connor 2002) requiring them to frequently adjust the contract. The likely result is a risk imbalance between the parties in favour of the client firm and a potential opportunism by the client.…”

Project Managers' Practical Intelligence and Project Performance in Software Offshore Outsourcing: A Field Study

“…Offshore vendors have strict contractual agreements that govern timely project completion (Dey et al 2010), and they have to work under tight schedules. Schedule compression shortens a previously determined schedule in a way that does not reduce and/or minimize the project scope (Project Management Institute 2008).…”

“…The literature on information technology (IT) outsourcing has focused on contracts and contractual governance as the primary means of addressing problems with information asymmetries in projects (Gopal et al 2003, Dey et al 2010, Gopal and Gosain 2010. Unfortunately, these problems cannot be resolved easily with contractual mechanisms: writing a complete contract is not only difficult and costly, it does not accommodate addressing dynamic incidents, whereas writing incomplete contracts that may allow for amendments exposes the clients and the vendors to agency issues and renegotiation costs (Williamson 1979, Hart andHolmstrom 1987).…”

On the Financification of Cloud Computing: An Agenda for Pricing and Service Delivery Mechanism Design Research

“…Software outsourcing contracts have a similar issue due to information asymmetry (Dey et al 2010). Enhancing the completeness of the contract can potentially overcome this problem, but at a high cost (Hart and Moore 1999).…”