Thesis on "Information Technology Outsourcing Risk a Transaction Cost and Agency Theory-Based Perspective"

Thesis 9 pages (2593 words) Sources: 14 Style: Harvard

[EXCERPT] . . . .

IT Outsourcing

This discussion is examined information technology outsourcing risk through a transaction cost and agency theory-based perspective. Information technology outsourcing and the outsourcing of other business processes is actually a $500 billion business. Transaction cost theory involves two precepts which are bounded rationality and opportunism. According to the authors bounded rationality is the failure of the mind to comprehend all of the information associated with a transaction. This creates a scenario in which transactions take place but there is some uncertainty associated with the process. Agency theory involves the process by which the relationship between agents and principles is managed. In the realm of IT outsourcing agency theory involves the idea that "each party in the relationship has their own profit motive, because the parties' goals are not congruent. The principal cannot monitor the actions of the agent perfectly and without cost (Sappington, 1991; Bahli & Rivard, 2003)." The research indicates that the risks associated with IT outsourcing seems to have a great deal to do with the expertise levels of clients and suppliers. If the client has a great deal of expertise they will have the ability to greatly minimize costs and therefore minimize risks associated with IT outsourcing. On the other hand if the supplier has a great deal of expertise and the client does not the supplier can use this expertise to act in ways that are opportunistic.

Introduction

Outsourcing has been a major issue of concern in recent years (Schultz, 2009). Many enterprises utilize outsourcing as a cost savings measure. However, there are also risks associated with outsourcing. The purpose of this discussion is to examine information technology outsourcing risk through a transaction cost and agency theory-based perspective.

Information technology outsourcing

There are many different business processes that can be outsourced. The most common types of outsourcing are customer service and information technology. Outsourcing is defined as

"Contracting, sub-contracting, or 'externalizing' non-core activities to free up cash, personnel, time, and facilities for activities where the firm holds competitive advantage. Firms having strengths in other areas may contract-out data processing, legal, manufacturing, marketing, payroll accounting, or other aspects of their businesses to concentrate on what they do best and thus reduce average unit cost.

Outsourcing is often an integral part of downsizing or reengineering. Also called contracting out ("Outsourcing")

According to Ketter (2008) information technology outsourcing and the outsourcing of other business processes is actually a $500 billion business. The author explains that this business is not going away any time soon. The author also asserts that the main reason why companies choose to outsource include "reducing costs in operations, development, and sales; tapping vendors' best practices and innovations;

gaining access to human capital; and increasing the flexibility and scalability of operations (Ketter 2008, 14) ." Indeed many large companies rely heavily upon the outsourcing of information technology functions. Although outsourcing is a popular business strategy it is not without risks.

According Bahli & Rivard (2003) although outsourcing can be and has been beneficial for many businesses it has also been detrimental for others. Some businesses have complained that IT outsourcing has not had the benefits that they hoped it would have. The author explains that in some cases the practice has led to the failure to meet the appropriate service level and has also failed to result in cost savings. These failures are just some of the risks that companies take when they choose to outsource IT functions.

Bahli & Rivard (2003) explain that there are many different definitions associated with the word risk. In general risks can be defined as "the probability of occurrence of an undesirable event, the severity of its consequences or the variability of returns on assets (Bahli & Rivard 2003) .' The authors also explain that there are economic and managerial definitions of risks. The economic perspective posits that risk is the "variance of a probability distribution of possible gains and losses associated with a given alternative." The managerial definition of risks is different in that it only tends to focus on the negative outcomes that can occur. That is the ambiguity concerning positive outcomes is largely ignored. Instead risks and that management of those risks is correlated to the negative outcomes that are viewed as hazards.

Risks associated with IT outsourcing are unique and therefore they have unique definitions and business associations. In addition Bahli & Rivard (2003) explain that IT outsourcing risks has to be explored in terms of specific theories. Theses theories are transaction cost theory and agency theory.

Transaction cost theory involves two precepts which are bounded rationality and opportunism (Aubert et al. 2003). According to the authors bounded rationality is the failure of the mind to comprehend all of the information associated with a transaction.(Aubert et al. 2003) This creates a scenario in which transactions take place but there is some uncertainty associated with the process (Aubert et al. 2003). According to Bahli & Rivard (2003), in the context of IT outsourcing the effect of bounded rationality is determined by the erudition and skills the client as it pertains to enumerate requirements, choosing the right suppliers and managing the relationship between the client and the supplier (213).

Opportunism involves a defense of one's own interest or value maximization (Aubert et al. 2003). In other words opportunism involves the seeking of self-interest in a manner that is deceitful. That is individuals or groups will go to any length to secure their self-interest. For example in the context of IT outsourcing suppliers may exaggerate the extent of their capabilities or even utilize their knowledge advantage to become outsourcers to clients that do not have much experience as it pertains to what they need or how much it costs (Bahli & Rivard, 2003. IT suppliers may also act in opportunistic ways because they view it as a way to dominate a market segment, gain the competitive advantage or enter a new market (Kern et al., 2002; Bahli & Rivard, 2003).

According to Aubert et al. (2003), the combination of these precepts results in information asymmetry.

That is, when parties do not have the same information, they will not share the information they possess, because they wish to use it strategically. In order to strike a better deal, sellers will hide negative characteristics of their products, and buyers will not reveal how much they are prepared to pay. Since both parties know that the other is opportunistic, each will engage in information seeking activities, for example having a product tested before buying it, or asking for warranties and safeguards to protect themselves from potentially false allegations from the other party. All these actions generate transaction costs

(Aubert et al. 2003) ."

The authors also explain that the transaction costs are usually divided into the following subsets

(1) The specificity of the assets needed for the transaction- this applies to the particular assets that will be needed to complete the tasks (Aubert et al. 2003).

(2 Uncertainty surrounding the transaction- the doubt or lack of knowledge associated with the transaction process (Aubert et al. 2003).

(3) the source of the essential investments needed for the transaction and their position as it relates to the disbursement of residual rights (Aubert et al. 2003).

Agency theory involves the process by which the relationship between agents and principles is managed. In the realm of IT outsourcing agency theory involves the idea that "each party in the relationship has their own profit motive, because the parties' goals are not congruent. The principal cannot monitor the actions of the agent perfectly and without cost (Sappington, 1991; Bahli & Rivard, 2003)."

Bahli & Rivard, (2003) explains that agency theory and transaction cost theory have several risks that can be associated with outsourcing:

1. Lock-in- this occurs when the client does not have the capacity to escape the relationship without experiencing some type of loss. There are three primary scenarios associated with lock-in risks.

(A) Asset specificity-this involves the investment that are created in lieu of a particular contract. These investments tend to have a more significant value because of the contract. This is a lock-in risk because if one parted decides not to honor the contract the value of the investment decreases. That is getting out of the relationship is impossible without incurring a great deal of loss. The level of asset specificity is dependent upon the type of outsourced function the parties are engaged in.

(B). Limited amount of suppliers- when there are a limited number of suppliers the suppliers have greater bargaining power. With this understood the client is more dependent on the supplier, than the supplier is dependent on the client. This can lead to more significant transaction costs and the supplier has the leverage to act in a manner that is opportunistic.

(C.). Lack of Expertise. When a client does not have the amount of expertise as it pertains to outsourcing contract that is needed a lock-in situation can occur. This expertise has to do with both the length of time and… READ MORE

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