D3

The strategic choice of contract types in business

process outsourcing Ling Ge

The University of Texas at Dallas, Richardson, Texas, USA

Xiaoyan Wang Shandong University at Weihai, Weihai, China, and

Zhilin Yang City University of Hong Kong, Kowloon Tong, Hong Kong

Abstract

Purpose – How to determine the appropriate contractual structure for an outsourcing relationship has been a major theme in the business process outsourcing (BPO) literature. Drawing on transaction cost economics, this study aims to examine how anticipated coordination and adaptation costs in a BPO relationship affect the choice of contract types. Specifically, this research categorizes contracts types (fixed-price, time and materials and hybrid contracts) based on levels of contract design comprehensiveness and flexibility to change. Design/methodology/approach – The research setting is the BPO for a focal firm, involving a contractor. Data from 153 US companies are collected using a structured questionnaire on senior executives of functional areas of marketing, IT and finance. Hypotheses were tested using ordered probit model. Findings – The results show that maturity is negatively associated with anticipated adaptation costs, while modularity and IT detachability are negatively related to anticipated coordination costs. Furthermore, adaptation costs have a direct impact on the choice, whereas the anticipated coordination costs do not have a significant direct impact on contract choice. The strength of adaptation costs’ impact, however, is significantly reduced when coordination costs are high. Originality/value – This study explicitly examines the role of anticipated coordination and adaptation costs in shaping the strategic choice of contract types in the BPO market. By differentiating the two types of anticipated transaction costs, this research enables a better understanding of the dynamics between transaction characteristics, anticipated transaction costs and contract types in complicated relationships such as BPO relationships.

Keywords Business process outsourcing, Contract choice, Coordination costs, Adaptation costs

Paper type Research paper

1. Introduction Business process outsourcing (BPO) refers to the practice of contracting the operations of a specific business process (e.g. IT, human resources, financial guidance, accounting and procurement) to an external service provider (Barua et al., 2009; Duan et al., 2009; Nadkarni and Herrmann, 2010; Narayanan et al., 2011). According to Deloitte’s Global Sourcing Survey 2014 (Deloitte, 2014), market sentiment has shifted away from the trend of insourcing (e.g. internal sourcing of business activities) after the 2008 recession, marking a net increase in outsourcing consumption. Although it is a prevalent business practice, many firms fail to realize its potentials (Handley and Benton, 2009, 2013). As BPO delegates business processes that are originally intertwined with a focal firm’s organizational structure to outside service providers, a prominent challenge of such arrangements is constant coordination and

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The authors gratefully acknowledge a grant fromNational Natural Science Foundation of China (project 71672164) and City University of Hong Kong (CityU 11502218) for financial support.

The author also wants to extend enormous thanks to Dr. Prabhudev Konana and Huseyin Tanriverdi for their support.

The current issue and full text archive of this journal is available on Emerald Insight at:

https://www.emerald.com/insight/1463-7154.htm

Received 15 November 2020 Revised 27 March 2021 Accepted 21 April 2021

Business Process Management Journal

Vol. 27 No. 5, 2021 pp. 1569-1589

© Emerald Publishing Limited 1463-7154

DOI 10.1108/BPMJ-11-2020-0493

adaptation for both sides (Gopal and Koka, 2010). Most companies agree that the key to meet such expectations is a collaborative and proactive partnership with the vendor (Roels et al., 2010), and they need to develop capabilities in vendor management. Deloitte Global Outsourcing Survey (Deloitte, 2020, p. 4) highlights that “clients need to invest more in building their supplier management capabilities to manage the new normal and achieve maximum value from their service provider ecosystem” in the post COVID-19 era.

The current study focuses on a specific type of vender management – contract management, which lays out the foundation for the client to control and coordinate with the vendor (Poppo and Zenger, 2002) and is vital for outsourcing success (Benaroch et al., 2016; Gopal and Koka, 2010; Kern and Willcocks, 2002; Mani et al., 2012; Wei et al., 2021). While empirical studies focus on comparing the effectiveness of fixed-price (FP) and time and material (T&M) contracts in outsourcing projects (e.g. Gopal and Koka, 2010; Mani et al., 2012), this study explores the drivers and mechanisms underlying the decision of contract choice. Understanding the decision of contract choice could contribute to the alignments between business process characteristics and contract types, which ultimately speaks to outsourcing success.

How to determine the appropriate contractual structure for an outsourcing relationship has been a major theme in BPO research (e.g. Chen and Bharadwaj, 2009). Transaction cost economics (TCE) approach has dominated the study of contract (Williamson, 2008a), which argues that transaction attributes influence governance decision and views contract as a mechanism to safeguard against transaction hazards such as opportunism (Schepker et al., 2014). Research on contract in the BPO context reveals that asset specificity and project/task complexity, which would incur ex post adaptation (e.g. contract renegotiation and adjustment) and opportunistic behavior, affect contract structure (e.g. Banerjee and Duflo, 2000; Chen and Bharadwaj, 2009; Gopal et al., 2003, Susarla et al., 2010; Mani et al., 2012). In general, more flexible contracts are preferred when more expected adaptation is needed (e.g. Gopal et al., 2003). Moreover, empirical evidence from both BPO and organizational studies suggest that anticipated coordination costs – expected costs associated with linking and integrating resources and activities across organizational boundaries (Gulati and Singh, 1998; Dibbern et al., 2008) – also play an important role in design of contracts (Schepker et al., 2014). Coordination costs often are associated with task scope (i.e. reflected by the number of different functional areas involved) (Susarla et al., 2010) and task interdependence.

Control and coordination are major concerns in managing interorganizational relationships (Dibbern et al., 2008; Wei et al., 2021). Although the extant literature tends to suggest that both coordination costs and adaptation costs affect contract design (Benaroch et al., 2016), there is an assumption that these mediating mechanisms are unobservable and can only be inferred by certain exchange attributes (Godfrey and Hill, 1995). One exceptional work is Schilling and Steensma’s (2002) research, which explicitly demonstrates the intermediate mechanisms of managers’ perceptions (i.e. threat of opportunism and potential for sustainable advantage) underlying the relationship between attributes of technology to be sourced on governance mode (i.e. licensing vs acquisition).

This study aims to explicitly examine how attributes of business process to be sourced influence anticipated adaptation and coordination costs, which further affects contract choice. Moreover, there may be intracontractual tension between alleviating adaptation and coordination costs. That is, to facilitate easy adaptation, the contract should feature adequate flexibility and remain less specific on project requirements, performance and processes, whereas to facilitate coordination may require detailed specifications. Such tension may create dynamics between the impacts of adaptation and coordination costs on contract choice. We contend that the contract choice needs to achieve the optimal balance of mitigating the two types of anticipated ex post costs. To understand the interaction between them, we introduce explicit measurement of managers’ anticipated coordination and adaptation costs.

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This study offers a fine-grained understanding of contract choice process by revealing the role of anticipated ex post costs, which differ from ex ante contract cost (i.e. search and evaluation exchange partner) and contracting cost (i.e. negotiating the clauses). The findings reveal that modular design characteristics and the underlying IT infrastructure have different impacts on the extent to which adaptation and coordination costs are incurred. Furthermore, anticipated adaptation and coordination costs differently impact contract choice among FP, T&M and hybrid structures [1]. These findings extend the literature on outsourcing contract design and success (Benaroch et al., 2016; Choudhury and Sabherwal, 2003; Handley and Benton, 2013).

2. Theoretical background 2.1 Adaptation costs, coordination costs and their antecedents There are two types of costs that are pervasive in BPO relationship: adaptation costs and coordination costs. These ex post transaction costs affect firms’ choice of specific contract structure: first, adaptation costs are incurred when unforeseen changes happen, and exchange parties need to engage in costly renegotiation and bargaining. As transaction specific investments limit the possibility to switch to other firms, the investing party is under the threat of appropriation due to the other party’s opportunistic renegotiation and expropriation (Williamson, 2008b). The incomplete contract leaves discretion for the other party to use its bargaining power to exploit the investing party. Even if the parties do not behave opportunistically, maladaptation occurs in unforeseen situations in ex post implementation. Bargaining over the changes is time-consuming and wastes resources. Furthermore, due to information asymmetry, for instance, the vendor’s cost structure and efforts are largely private information (Jain et al., 2020; Zhang et al., 2018); transaction parties may fail to reach an efficient agreement. Thus, knowledge intensive BPO relationships often incur substantial ex post adaptation.

Empirical studies on adaptation costs and governance forms have identified the relationship between some antecedents of adaptation costs and governance choices. For instance, asset specificity, which entails project complexity and generates uncertainty, have been proven to have significant impact on the choice of governance forms such as outsourcing arrangements (e.g. Rindfleisch and Heide, 1997) or contract choices (e.g. Gopal et al., 2003; Chen and Bharadwaj, 2009; Susarla et al., 2010; Mani et al., 2012).

In addition to adaptation costs, firms have to take coordination costs into consideration in BPO arrangements. The concern of high coordination costs is as critical as TCE-based transaction costs for firms when selecting governance forms (De Rond and Bouchikhi, 2004; White and Siu-Yun Lui, 2005). Coordination costs refer to the costs of coordinating activities across organizational boundaries (Dibbern et al., 2008). Even if both parties are perfectly cooperative with each other, and there is no concern of opportunistic behavior, they still need to coordinate to divide labor and manage the interface of activities between them (Gulati and Singh, 1998). When there lacks predefined hierarchy in a contractual relationship, coordination is costly for both sides as they have to establish procedures, structures and systems across organizational boundaries. Similar to adaptation costs’ studies, researchers have identified coordination costs and related characteristics such as interdependence (e.g. Gulati and Singh, 1998), task complexity and scope (e.g. Chen and Bharadwaj, 2009).

A contract works as a major incentive and monitoring instrument for the relationship between the client and the vendor (Wei et al., 2021). The literature differentiates two main types of contracts in BPO arrangements based on compensation scheme: FP and T&M (e.g. Banerjee and Duflo, 2000; Chen and Bharadwaj, 2009; Ethiraj et al., 2005; Gopal et al., 2003; Gopal and Sivaramakrishnan, 2008). They differ in their methods of payment and in dealing with overruns that cannot be specified in the contract ex ante. FP contracts pay a

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fixed price, and the vendor bears all overruns, if any. Such arrangements place technological and financial risks on the vendor when uncertainties arise. T&M contracts work the other way around: the risks are on the client because they pay for every person-hour of effort that is required to finish the job at the end of the project or pre-scribed periodic intervals of project milestones. There might also be contracts which fall in between FP and T&M contracts, i.e. hybrid contracts, in which the client and the vendor share overruns and thus the risks. It consists of a T&M contract but with a cap (Benaroch et al., 2016; Kalnins and Mayer, 2004).

The difference between the two types of contracts lies not only in the fee and payment schedule but in other features associated with buyer/vendor inputs (Roels et al., 2010), profitability potentials and risk allocation (Gopal and Sivaramakrishnan, 2008; Hoermann et al., 2015; Schermann et al., 2016). First, in terms of contract completeness or extensiveness, FP contracts provide strong incentives for the vendor to reveal all relevant information when drafting a contract as completely as possible ex ante and to achieve exactly what is specified in the contract ex post to avoid any extra costs. Thus, the vendor is committed to establish a framework with operational details, performance specifications and contingency plans, etc. (Chen and Bharadwaj, 2009). Within this framework, they are protected from uncertain risks and have room to pursue cost-savings. With T&M contracts, on the other hand, the vendor does not have strong incentives to foresee the complete picture and put them in a contract as they are compensated for all costs, even if conditions or circumstances change.

Second, T&M contracts is more behavior-based and thus involves more monitoring than FP contracts do (e.g. Chen and Bharadwaj, 2009; Gopal and Sivaramakrishnan, 2008). FP contracts provide no financial incentives for the client to closely monitor the vendor’s operations as monitoring is costly and the contracts usually involve penalties in cases of delays or defects in service delivery; the vendor, on the other hand, have incentives to improve efficiency for higher margins (Ethiraj et al., 2005). Under T&M contracts, by contrast, the vendor lacks incentives to execute more efficiently (Ethiraj et al., 2005). To control overrun and possible opportunistic behavior, the client needs to maintain a close watch over the vendor. Recent empirical findings demonstrate that T&M contracts tend to be associated with more detailed provisions that specify monitoring and dispute resolution (Chen and Bharadwaj, 2009).

Third, T&M contracts are more flexible and cause less frictions in possible renegotiation (Bajari and Tadelis, 2001; Banerjee and Duflo, 2000). FP contracts, however, give the vendor an incentive to focus on delivering product/services as described since the vendor’s profitability may not vary significantly if changes or adaptations are needed ex post. Moreover, the FP mode is difficult to re-negotiate. Therefore, there is less tension between the vendor and the client under T&M contracts since the vendor is not under as much as pressure for cost savings or delivery as pre- specified.

2.2 The choice of contract types in BPO We contend that firms choose appropriate contract types to mitigate adaptation or coordination costs in a BPO relationship. It is challenging to describe and analyze a business process at the outset of the contract negotiation as the product (e.g. software application) is not prototypic or standardized (Banerjee and Duflo, 2000). Firms usually need to put together a cross-functional team to develop a comprehensive contract (Ranganathan and Balaji, 2007). Second, business processes are not static; they evolve over time with learning and changes in the environment. When processes evolve, they are subject to frequent changes and learning (Adner and Levinthal, 2001).We followTanriverdi et al.’s (2007) framework and examine four major causes of adaptation and coordination costs: human capital specificity, maturity, modularity and IT detachability.

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Specifically, human capital specificity and maturity are associated with adaptation costs. The TCE literature has established the impact of asset specificity as the major antecedent factor of opportunistic behaviors. We focus on human asset specificity because human resources are fundamental to most organizational processes (Katzenstein and Lerch, 2000) and constitute the primary investment in BPO relationships (Tate and Ellram, 2009). When a business process requires significant specific investment in human capital, it is subject to the significant ex post hassle of renegotiation if one party leverages their power to “hold up” the other (Susarla and Mukhopadhyay, 2019). Maturity level of a business process, on the other hand, affects the level of potential uncertainties. Immature business process entails high levels of uncertainty because operational rules and procedures and interfaces with other business processes are not defined well and are still evolving. Employees are learning about and becoming familiar with the process. Run-time exceptions and problems are common. By contrast, a matured process is characterized by well-established procedures, routine operations and self-sufficient management. There is little need for changes and ex post adaptation. Thus, business processes with high maturity incur lower adaptation costs.

Modularity and IT detachability are associated with coordination costs. Interdependence has long been recognized as the major cause of coordination costs (Gulati and Singh, 1998). Factors that increase the needs for information processing make communication more difficult or complicate the decision-making process between the partners will incur higher coordination costs. This concept has been operationalized as task complexity, scope and duration, among others. Consistent with Tanriverdi et al. (2007), we contend that modularity and IT detachability capture the essence of interdependence between business process activities. Modular business processes can be disaggregated and recombined into new configurations with little loss of functionality (Schilling and Steensma, 2001). Modularity makes it possible to operate and change a business process without affecting other business processes or functions because the interfaces between one process and other processes are standardized.

IT detachability defines how well the business process can be separated from firm’s underlying IT infrastructure and executed on another IT systemwithout loss of functionality (Tanriverdi et al., 2007). Business processes and their underlying IT support infrastructures complement and mutually influence each other. As information processing, communication and operation flows of a process are all dependent on the IT platform, intensive interaction between the process and the IT infrastructure should be expected on a daily basis. Processes that are highly detachable from the infrastructure, as currently promoted in the trend toward Software as a service (Saas) and cloud computing, are “encapsulated” with standard interfaces and are interchangeable across various IT platforms. Either transplanting the process onto another platform or working with the current one does not generate much need for communication and coordination. Thus, we contend that high level of modularity and IT detachability lead to lower coordination costs.

H1a. Maturity of the business process to be sourced will be negatively related to the anticipated adaptation costs.

H1b. Human capital specificity of the business process to be sourced will be positively related to anticipated adaptation costs.

H1c. Modularity of the business process to be sourced will be negatively related to the anticipated coordination costs.

H1d. IT detachability of the business process to be sourced will be negatively related to the anticipated coordination costs.

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ABPO contract can be a lengthy document that specifies all legal, financial, operational and procedural details. It often features a service-level agreement (SLA), with layout performance metrics, measurement scheme, review schedule, required level of services and penalties for over-and-under performance (Fehrenbacher andWiener, 2019; Goo, 2010). BPO with high anticipated adaptation costs should choose contracts that offer flexibility and monitoring capabilities. As discussed above, adaptation costs are mainly caused by ex post hassles of renegotiation, change adaptation and efficiency loss due to opportunistic bargaining when unexpected situations rise. When a process requires specific investments and is still not mature, the client expects the vendor to be more cooperative and willing to adapt when contingencies unfold. Yet FP contracts are constrained by a fee schedule, and thus the vendor is incentivized to reduce costs rather than incur extra costs to make changes, leading to underinvestment and maladaptation hazards (Susarla, 2012). Second, the fixed payment makes it a zero-sum game between the vendor and the client. Third, FP tends to have detailed specifications and requirements. When uncertainties realize, renegotiation has to go over the same process in great detail, thus incurring high adaptation costs.

T&M contracts are not stringently structured in the initial setup of the contract because the client’s willingness to pay for overruns eases the pressure on the vendor. They can lower ex post maladaptation and control ex post nonperformance (Benaroch et al., 2016). The literature has shown that T&M contracts perform better in mitigating high adaptation costs because they have greater flexibility due to the coarse-grained specifications (Bajari and Tadelis, 2001; Benaroch et al., 2016). Thus, when uncertainties arise and adaptation is needed, T&M contracts entail lower contracting costs during renegotiation. Moreover, as the vendor does not have the incentive to conceal information and seek leverage, friction incurred by adaptation is reduced. Therefore, we propose:

H2a. The anticipated adaptation costswill increase the likelihood of using amore flexible contract.

We argue that BPO clients would like to implement FP contracts for transactions with higher anticipated coordination costs (e.g. frequent meeting and communication) primarily because FP contracts inherently specify and contain coordination provisions. Coordination expectations derive from interdependence between the client and vendor, in terms of resources, monitoring and performance measurement (Mani et al., 2013).

Firms can use FP contracts to facilitate modularization processes and reduce coordination costs. First, FP contracts demand a highly extensive design because the vendor would rely on detailed specification of tasks and expectations to avoid unexpected changes. Hence, the vendor is incentivized to fully document the process execution and performance requirements (Gopal and Sivaramakrishnan, 2008). Popular SLA in BPO practices is an example of detailed contract description. Second, the vendor signing FP contracts also has an incentive to standardize the process to improve efficiency (e.g. assigning highly trained staff to FP-based projects) (Gopal and Sivaramakrishnan, 2008). By clarifying well-defined inputs, as well as output and performance specifications in the initial design effort, the vendor can expect fewer uncertainties with its payment in the future. The contractual coordination specifications also could minimize execution frictions by enabling communication (Willcocks and Feeny, 2006). Also, to save costs of communication and information sharing, the vendor tends to standardize the interfaces between other processes.

Therefore, we propose:

H2b. The anticipated coordination costs will increase the likelihood of using a less flexible contract.

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2.3 The interaction between the two costs Coordination costs and adaptation costs could not only independently but also jointly affect the choice of contract types. As shown above, the demand for coordination versus adaptation could be in conflict. Coordination cost concerns are better alleviated with FP contracts (with higher level of completeness, contingencies specified and provisions enabling monitoring), while adaptation cost concerns lead to contracts with more flexibility. In a BPO relationship with both types of concerns, the firm has to choose a contract that balances coordination and flexibility.

We argue that coordination costs weaken the impact of adaptation costs on the tendency of choosing a more flexible contract. Adaptation requires the parties to cooperate ex post when contingencies unfold. As discussed in the last section, anticipating high coordination costs, the parties are likely to clarify interfaces, processes and procedures of interaction during the process of contracting, creating an ex ante framework for the parties to communicate, share information and collaborate. A contract with strong coordination governance leads to more cooperative negotiation strategy (Lumineau and Henderson, 2012). When high coordination costs give the parties incentives to specify their coordination plans in the future, the foundation for more cooperative adaptation in the future is anticipated. Moreover, some researchers argue that relational benefits come from frequent communication and information sharing (White and Siu-Yun Lui, 2005). Over time, the parties may developmutual understanding and trust in a cooperative relationship. As such, adaptation becomes easier when there is more coordination between the two parties. Thus, in anticipation of more coordination in the future, the need for a highly flexible contract decreases. Therefore, we propose:

H3. Anticipated coordination costs reduce the impact of anticipated adaptation costs on the tendency to select a more flexible contract.

Figure 1 presents our conceptual model and hypotheses.

3. Methodology 3.1 Sample and data We tested our hypotheses using survey data from medium and large US firms. The survey design was validated and pre-tested with academic colleagues, executives and MBA students. The data collection process includes two stages. For the first stage, we selected 2,000 firms from a general directory as well as a targeted sample of 592 firms based on news search and alumni reference. The surveys were sent to senior executives of the functional areas. The final valid survey responses are 88 firms. After about a year, we started a new round of data collection to gain a larger sample size. We approached 5,000 members of Institute for Supply Management (ISM) through email. Most of them are professionals who are interested in supply chain management from various industries (excluding 27 respondents from universities). Their titles range from buyer to supply chain manager to chief operations officer to president. We excluded buyer and other lower-level contacts, resulting in a list of 3,742. After about four months, we received 104 responses, which was a response rate of 2.8%. Excluding one record that has high data missing rate, we obtained a sample of 103 cases. Combining the 88 cases from the first stage, we had a total of 191 data points. After eliminating missing data and firms that did not report information of contract choices, we used a final sample of 171 US companies [2]. We test the respondents’ eligibility based on their tenure (N 5 153, average tenure 5 7.9 years) and experience in outsourcing (N 5 156, average 5 5.1 years). The sample firms reported an average revenue of over 26,000m dollars (N5 114). The firms were mainly from the following industries (2-digit SIC code, N 5 134): manufacturing (42%), services (25%), transportation and public utilities (18%), finance, insurance and real estate (9%), and others.

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To be comfortable combining the sample from the two stages, we perform two tests for differences between the two samples. First, independent t-test showed that there is no significant difference in average revenues (t 5 0.72, p > 0.1), indicating average sizes of companies in the two stages converge. Second, t-tests indicated differences to some extent in business characteristics in two stages (maturity (t 5 0.38, p > 0.1), modularity (t 5 1.91, p > 0.05), human capital specificity (t 5 3.76, p < 0.01) and IT detachability (t 5 1.84, p > 0.05)). We conjectured that process type may be the cause as there were obviously more supply chain/procurement management processes in the second stage. After we controlled for the effect of process type (first regressing characteristic variables on process type – supply chain/procure vs others and then performing t-test for the residuals), there is no significant difference in the business process characteristic variables between the two stages (human capital specificity (t 5 1.23, p > 0.1), modularity (t 5 0.37, p > 0.1) and IT detachability (t 5 0.42, p > 0.1)). Thus, we are confident in performing analysis on the combined sample.

3.2 Variables We use established measures from prior studies. The dependent variable is the choice of contract types, an ordinal variable containing three categories: FP, hybrid and T&M contracts. We measure anticipated adaptation costs as the difficulty of haggling related to negotiation and cooperation for detailed description of requirements when changes occur. The measurement items were adapted from Artz and Brush (2000) and Simester and Knez (2002). Anticipated coordination costs measure the costs of information sharing, task coordination and shared decision-making between the client and the vendor. The measurement items were adapted from Keller (1994) and Ang and Straub (1998).

We control for firms’ strategic intentswhen choosing to outsource the process as theymay affect or even override the cost-benefit analysis of different types of contracts. The first

Maturity

Human capital

specificity

Modularity

IT

detachability

Perceived

adaptation cost

Perceived

coordination cost

Contract type

choice

(flexibility)

H1a (–)

H1b (+)

H1c (–)

H1d (–)

H2a (+)

H2b (–)

H3 (–)

Note(s): * The interaction term between adaptation cost and coordination cost

Figure 1. Conceptual model

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common intent is to reduce cost versus to improve quality. Cost-saving incentives may decrease firms’ incentive to improve quality (Holmstrom andMilgrom, 1991). Thus, the extent to which firms are eager to save costs or improve quality may impact firms’ contract choice. We also control for firms’ strategic intents such as entry into new markets, access to technologies and skilled personnel, and reduction of T&M of products (DiRomauldo and Gurbaxani, 1998) when considering outsourcing. These intents may shape firms’ preference for a certain type of contract.We use dummy variables to capture and control for the strategic intent of firms. In addition, we use dummy variables to control whether a firm has prior experience with domestic outsourcing (0 5 No; 1 5 Yes) and with offshore outsourcing (0 5 No; 1 5 Yes).

To examine the relationship between business process characteristics and the two types of cost, we use measures for process characteristics from Tanriverdi et al. (2007). Table 1 summarizes definitions and measurement items.

3.3 Measurement properties of constructs Confirmatory factor analysis (CFA) was used to assess convergent and discriminant validity of the multi-item constructs. Table 2 reports purified measurement items, factor loadings, AVE (average variance extracted) and reliabilities (Cronbach alpha and composite reliability) of the multi-item constructs of this study. Cronbach’s alpha values of all constructs are above the recommended threshold level of 0.70 (Nunnally, 1978), indicating sufficient reliability. The AVEs (except “maturity”) are above the threshold of 0.50 and the CRs (composite reliability) are above the recommended level of 0.60 (Fornell and Larcker, 1981).

3.4 Descriptive statistics and correlations Table 3 presents descriptive statistics and correlations of the variables. In line with our theoretical analysis, business process characteristics are correlated with coordination and negotiation costs.

4. Results We first examine the relationship between business process characteristics and adaptation and coordination costs (Table 4) to validate our argument that the two types of costs are theoretically and empirically distinct, and they have different impacts on contract choice. The results show that maturity is negatively associated with anticipated adaptation costs (β_mat5�0.279, p < 0.05), but has no significant influence on anticipated coordination costs, while modularity and IT detachability are negatively related to anticipated coordination costs (β_mod 5 �0.146, p < 0.05; β_IT 5 �0.093, p < 0.10). Human capital specificity significantly affects both adaptation and coordination costs (β_coordination 5 0.145, p < 0.05; β_adaptation 5 0.218, p < 0.05). In general, the results are in accordance with H1: adaptation costs occurwhen uncertainties are high, and the companies need to bemore cooperative in the process of adaptation and renegotiation; coordination costs are more about managing the interdependence of the process for higher efficiency.

Next, we examine the main effect of adaptation costs and coordination costs on the choice of contract types. As the dependent variable is inherently ordered in terms of contract flexibility, we used an ordered probit model.We also take the adjustedmean of the variables to address potential multicollinearity between the interaction term and the main variables. The results are presented in Table 5 (model 1 and model 2 with control variables). Then, we controlled sample selection bias with the two-step method (model 3 and 4). Since the contract choice can only be observed after firms decide to outsource, the factors that determine the contract choice may also affect the choice of whether or not to outsource. Thus, the selected

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Constructs and definitions Items Supporting literatures

Perceived coordination costs (PCC)a

PCC1 We have (or expect to have) significant amount of communication between the vendor (offshore subsidiary) and us

Keller (1994), Ang and Straub (1998)

The perceived cost of communicating, coordinating and mutual decision-making with the vendor

PCC2 We have (or expect to have) frequent interactions with the vendor (offshore subsidiary) in day-to-day operations of this business process

PCC3 We have (or expect to have) constant monitoring of the vendor to ensure smooth execution of this business process

Perceived adaptation costs (PNC)a PNC1 We have difficulty in reaching agreement with the vendor (offshore subsidiary) when problems arise

Artz and Brush (2000), Simester and Knez (2002)

The perceived cost of potential contractual risks such as hold-up and maladaptation problems from the vendor

PNC2 We have difficulty in negotiating with the vendor (offshore subsidiary) when there are any changes

PNC3 We have difficulty in locating, accessing and transferring information when needed from the vendor (offshore subsidiary)

Human capital specificity (HCS)a HCS1 To run this business process effectively, workers have to spend a lot of time and effort learning the ins and outs of our firm

Anderson (1985), Anderson and Schmittlein (1984)

The extent to which the human capital associated with the process transferable to other uses or users

HCS2 There is a need for significant firm-specific training for a new employee to effectively execute this business process, even when s/he has general experience in our industry

HCS3 Workers need a deeper understanding of our firm and customers to be effective in executing this business process

HCS4 Effective execution of this business process generally requires tacit knowledge acquired through experience in our firm

(continued )

Table 1. Construct definitions, measurement items, and supporting literatures

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Constructs and definitions Items Supporting literatures

Maturity (MAT)a MAT1 Employees find no ambiguity in executing this business process

Anderson and Zeithaml (1984), Benner and Tushman (2002), CMMI (2002), Harter et al. (2000)

The extent to which a business process has well-defined operational rules and procedures, stable underlying technologies, and experience few run-time exceptions

MAT2 The technologies, rules and procedures of this business process are stable

MAT3 There are many exceptions regarding the rules and procedures of this business process

MAT4 There is seldom any change to this business process

MAT5 Our managers are frequently involved in resolving process- related issues. (Dropped after item purification process)

Modularity (MOD)a MOD1 This business process has very well-defined interfaces with our other processes. (Dropped after item purification process)

Baldwin and Clark (1998, 2000), Baldwin (2007)

The extent to which a business process has well-defined inputs, outputs, and interfaces with other business processes and can be easily detached from a system, changed, and combined or recombined with other processes

MOD2 Changing this business process does not affect our other processes

MOD3 It is very easy to detach this business process from our other processes

MOD4 We can easily assess the performance of this business process independent of the performance of our other processes

MOD5 It is very easy to combine or recombine this business process with other processes

IT detachability (ITD)a ITD1 The interface between this business process and supporting IT infrastructure is well-defined. (Dropped after item purification process)

Mitchell and Zmud (1999), Orton and Weick (1990)

The extent to which the supporting IT infrastructure can be separated from the execution of the business process

ITD2 The supporting IT infrastructure is highly customized to the needs of this business process

ITD3 This business process and the supporting IT infrastructure are tightly coupled

ITD4 This business process can be easily transferred and implemented across IT platforms of outsourcing vendors. (Dropped after item purification process)

(continued ) Table 1.

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contract choice may be biased. We correct the selection bias with a two-step method: first estimate the choice of sourcing mechanisms and then use predicted probability to estimate the choice of contract types (Bourguignon et al., 2007).

It appears that the coefficient values are larger after controlling for the sample selection, suggesting that the impact was biased downward with the sample selection problem. The positive impact of adaptation costs on contract choice indicates that the firm would be more likely to choose a flexible contract (i.e. T&M)when adaptation costs are high, supporting H2a. However, the anticipated coordination costs do not have a significant direct impact on contract choice (i.e. H2b is not supported) but affects the choice mainly through negatively moderating the impact of adaptation costs. When anticipated adaptation costs are held constant, a higher level of anticipated coordination costs would lower the probability of using more flexible contracts. Thus, H3 is supported.

5. Discussion and conclusion 5.1 Theoretical implication This study examines firms’ contract choice in the context of BPO. We propose and empirically test how coordination and adaptation costs impact contract choice by considering three types of contracts: FP, CP and T&M, which differ in their levels of comprehensiveness of contract design and flexibility for renegotiation. The findings reveal that both anticipated coordination and adaptation costs affect the choice of contract types. While adaptation costs have a direct impact on the choice of contract type, the impact of coordination costs is mainly manifested through moderating the relationship between adaptation costs and contract choice. To address high anticipated adaptation costs, firms would choose more flexible contracts. However, the strength of this relationship would be significantly weakened when anticipated coordination costs are high. Thus, firms need to balance the needs to address ex post adaptation costs and coordination costs.

Constructs and definitions Items Supporting literatures

Strategic intent (SI)b SI1 Cost reduction intent: Reduce the total cost of executing this process

Ang and Straub (1998), DiRomauldo and Gurbaxani (1998), Quinn (1999)The extent to which the following

objectives motivate the firm to change (or consider to change) its sourcing mechanism for a given business process

SI2 Quality improvement intent: Improve the quality of existing service

SI3 Entry into a new market SI4 Access to technologies and

skilled personnel SI5 Reduce time to market of our

products Experience in domestic outsourcingc

Doe Your firm’s experience with the domestic outsourcing mechanism

Leiblein and Miller (2003)

Experience in offshore outsourcingc

OOE Your firm’s experience with the offshore outsourcing mechanism

Type of Process (0:non-IT; 1:IT) IT Coded based on the process name reported by the informants

Note(s): aScale: 1 5 Strongly disagree. . .4 5 Neutral. . .7 5 Strongly Agree; bScale: 1 5 Extremely low. . .4 5 Moderate. . .7 5 Extremely high; cScale: 1 5 Very poor. . .4 5 Good. . .7 5 Exceptional; Items marked as “dropped” in Table 1 are eliminated either because they failed to converge on the factor they intended to measure, or they were highly noisy and reduced the overall reliability of the corresponding scaleTable 1.

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C on st ru ct s

F ac to r lo ad in g s

C ro n b ac h

al p h a

A V E

C R

It em

s H u m an

ca p it al

sp ec if ic it y

M at u ri ty

M od u la ri ty

IT d et ac h ab il it y

P er ce iv ed

co or d in at io n co st

P er ce iv ed

n eg ot ia ti on

co st

H u m an

ca p it al

sp ec if ic it y

0. 89 2

0. 70 9

0. 90 7

H C S 1

0 .8 0 7

�0 .1 13

�0 .0 40

�0 .0 51

0. 13 9

0. 10 7

H C S 2

0 .7 9 1

�0 .0 59

�0 .1 54

0. 10 3

0. 14 6

0. 06 2

H C S 3

0 .8 9 4

�0 .0 68

�0 .1 55

�0 .0 26

0. 01 2

0. 05 2

H C S 4

0 .8 7 2

�0 .0 09

�0 .0 80

�0 .0 65

0. 04 5

0. 16 9

M at u ri ty

0. 66 6

0. 46 0

0. 77 1

M A T 1

0. 05 1

0 .7 2 1

0. 06 3

0. 05 7

0. 05 2

�0 .1 01

M A T 2

�0 .1 11

0 .7 8 1

0. 20 8

0. 09 5

�0 .1 44

�0 .1 26

M A T 3

�0 .2 98

0 .5 7 3

0. 09 3

�0 .0 14

�0 .1 26

0. 03 5

M A T 4

0. 01 0

0 .6 1 9

0. 14 2

�0 .0 78

0. 01 2

�0 .1 52

M od u la ri ty

0. 78 0

0. 54 7

0. 82 5

M O D 2

�0 .1 76

0. 10 1

0 .8 2 6

�0 .0 70

�0 .1 33

0. 08 2

M O D 3

�0 .1 19

0. 06 7

0 .8 3 7

�0 .0 50

�0 .1 49

�0 .1 58

M O D 4

�0 .1 30

0. 31 1

0 .5 6 7

0. 33 5

0. 02 6

�0 .0 14

M O D 5

�0 .0 50

0. 21 6

0 .6 9 6

�0 .0 49

�0 .0 81

�0 .1 87

IT d et ac h ab il it y

0. 80 2

0. 79 8

0. 88 8

IT D 2

0. 42 0

�0 .0 88

�0 .0 44

0 .8 8 2

0. 10 3

�0 .0 23

IT D 3

�0 .0 59

0. 11 4

0. 00 5

0 .9 0 5

0. 04 6

�0 .0 32

P er ce iv ed

co or d in at io n co st

0. 87 2

0. 75 7

0. 90 3

P C C 1

0. 07 7

0. 02 8

�0 .0 65

0. 03 0

0 .8 8 8

�0 .0 06

P C C 2

0. 15 9

�0 .0 83

�0 .1 77

0. 05 9

0 .8 6 1

0. 08 5

P C C 3

0. 08 5

�0 .0 97

�0 .0 85

0. 09 0

0 .8 6 0

0. 18 1

P er ce iv ed

ad ap ta ti on

co st

0. 90 8

0. 79 6

0. 92 1

P N C 1

0. 18 0

�0 .1 19

�0 .0 79

�0 .0 01

0. 09 0

0 .8 8 5

P N C 2

0. 10 3

�0 .1 56

�0 .1 05

�0 .0 17

0. 05 4

0 .9 2 6

P N C 3

0. 07 7

�0 .0 91

�0 .0 91

�0 .0 46

0. 10 3

0 .8 6 5

N o te (s ): T ot al v ar ia n ce

ex p la in ed

b y th e 6 fa ct or s 71 .9 % ;A

V E 5

av er ag e v ar ia n ce

ex tr ac te d ,C

R 5

co m p os it e re li ab il it y

Table 2. Measurement properties of constructs

Contract types in BPO

1581

1 2

3 4

5 6

7 8

9 10

11 12

13 14

1 P er ce iv ed

co or d in at io n co st s

2 P er ce iv ed

ad ap ta ti on

co st s

0. 20 4*

3 B u si n es s p ro ce ss

h u m an

ca p it al

sp ec if ic it y

0. 24 2*

* 0. 25 6*

*

4 B u si n es s p ro ce ss

m at u ri ty

�0 .1 56

�0 .2 84

* * �0

.2 32

* *

5 B u si n es s p ro ce ss

m od u la ri ty

�0 .2 60

* * �0

.2 41

* * �0

.2 97

* *

0. 41 4*

*

6 B u si n es s p ro ce ss

IT d et ac h ab il it y

�0 .1 24

0. 04 6

0. 00 6

�0 .0 47

�0 .0 09

7 T y p e of

p ro ce ss

– IT

0. 08 9

0. 19 6*

�0 .0 55

0. 02 4

�0 .0 24

�0 .1 86

*

8 In te n t to

re d u ce

co st

0. 02 0

�0 .1 06

�0 .1 69

�0 .0 85

0. 16 1*

�0 .0 58

�0 .1 25

9 In te n t to

im p ro v e q u al it y

�0 .0 50

�0 .2 44

* * �0

.1 41

�0 .0 08

0. 14 2

�0 .0 85

�0 .0 31

0. 29 1*

10 In te n t to

en te r n ew

m ar k et

0. 03 8

0. 05 8

0. 13 6

�0 .0 47

0. 01 1

�0 .0 56

�0 .0 50

0. 19 1*

0. 15 7

11 In te n t to

ac ce ss

te ch n ol og ie s an d

sk ill ed

p er so n n el

�0 .0 19

�0 .2 04

* �0

.0 17

0. 07 4

0. 08 7

0. 02 5

0. 00 5

0. 24 8*

* 0. 51 6*

* 0. 19 9*

12 In te n t to

re d u ce

ti m e to

m ar k et

�0 .0 38

�0 .0 91

�0 .0 05

�0 .0 30

0. 13 0

�0 .0 72

�0 .0 26

0. 30 0*

* 0. 37 9*

* 0. 38 3*

* 0. 35 6*

*

13 E x p er ie n ce in d om

es ti c ou ts ou rc in g

�0 .0 05

�0 .0 48

�0 .0 30

0. 07 9

0. 15 2

�0 .0 71

�0 .0 83

0. 20 0*

0. 06 5

0. 19 9*

0. 11 4

0. 25 3*

*

14 E x p er ie n ce

in of fs h or e ou ts ou rc in g

0. 07 0

0. 07 7

�0 .0 50

�0 .0 40

0. 05 8

0. 07 8

0. 10 9

0. 11 8

0. 05 4

0. 17 0*

0. 03 0

0. 02 1

0. 24 8*

*

M ea n

5. 98 3

3. 51 1

4. 49 1

4. 07 3

3. 99 9

3. 44 5

0. 36 0

0. 72 0

0. 63 0

0. 31 0

0. 64 0

0. 48 0

0. 72 0

0. 43

S ta n d ar d d ev ia ti on

1. 17 8

1. 64 7

1. 45 9

1. 21 1

1. 40 9

1. 63 4

0. 48 0

0. 44 9

0. 48 4

0. 46 4

0. 48 0

0. 50 1

0. 45 2

0. 49 6

N o te (s ): yp

< 0. 1; *p

< 0. 05 ;* *p

< 0. 01 ;* ** p < 0. 00 1; N 5

15 2

Table 3. Descriptive statistics and correlations

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This research makes contributions to the following aspects of BPO research. First, we explicate the different impacts of coordination and adaptation costs on governance choices in BPO relationships. Coordination costs mainly derive from process interdependence, whereas adaptation costs are anticipated by risks of ex post renegotiation between the client and the vendor. Both types of costs are found to affect the contract choice. The extant literature has established the link between transaction characteristics and contract choice based on TCE and organizational theories, but it has seldom considered how different anticipated costsmay affect the governance choice differently. The seminal work of Gulati and Singh (1998) builds the theoretical foundation for differentiating coordination and adaptation costs and proposes that coordination costs are better addressed with hierarchical governance forms because hierarchical controls such as command structure, authority systems and standard operating procedures better facilitate decision-making procedures and resolving disputes. Following researchers have highlighted that contracts could multiple functions such as coordination and adaptation in addition to safeguarding (e.g. Barth�elemy and Qu�elin, 2006; Benaroch et al., 2016; Schepker et al., 2014). In line with this strand of the contract literature, we propose that anticipated transaction costs may place different or even conflicting demands on contract type choice. Specifically, coordination costs may be better managed with contractual instruments that clearly define obligations, procedures and command structure, etc. However, such features of contracts are in conflict with the flexibility required to address adaptation costs. The results reveal the tension between contractual design requirements of coordination and adaptation costs. The finding that anticipated coordination costs only work through moderating adaptation costs suggests that contracts are more important instruments for safeguarding against opportunistic behavior than facilitating coordination, which nevertheless cannot be ignored.

Second, we improve the understanding of coordination and adaptation costs in terms of both antecedents and consequences by explicitly measuring the two conceptual constructs. The prior literature contains abundant evidence of the link between transaction characteristics and governance forms, implicitly supporting theories on coordination or adaptation costs. Due to the conceptual convenience of the term “transaction costs”, all types of costs associated with outsourcing relationships are often discussed under this umbrella

Explanatory variables

Dependent variable: coordination cost

Dependent variable: coordination cost

Dependent variable: adaptation cost

Dependent variable: adaptation cost

Model 1 Model 2 Model 3 Model 4

Intercept 6.506*** (0.577) 6.375*** (0.592) 4.082*** (0.796) 3.558*** (0.796)

Busines process characteristics Human capital specificity

0.141* (0.066) 0.145* (0.066) 0.202* (0.091) 0.218* (0.089)

Maturity �0.052 (0.084) �0.053 (0.084) �0.273* (0.115) �0.279* (0.112) Modularity �0.150* (0.084) �0.146* (0.073) �0.119 (0.101) �0.106 (0.098) IT detachability

�0.104y (0.056) �0.093y (0.057) 0.031 (0.077) 0.074 (0.076)

Business process types IT 0.193 (0.195) 0.770** (0.262)

Model statistics Adjusted R2 0.090 0.090 0.105 0.149 Number of observations

152 153 125 153

Note(s): 1. One-sided tests were used for directional hypotheses; yp < 0.1; *p < 0.05; **p < 0.01; ***p < 0.001

Table 4. Effect of BP

characteristics on coordination and adaptation costs

Contract types in BPO

1583

concept. As interorganizational transactions become more complicated than sourcing parts for a car or assigning members of a sales force, new issues or concerns are emerging from complicated relationships. Thus, we need to theorize new transaction characteristics of BPO, identify their impact on coordination and adaptation costs and differentiate their impacts. In line with Tanriverdi et al. (2007)’s theorization, we found that modular design features: process modularity and IT detachability significantly reduce anticipated coordination costs, but not adaptation costs. Process maturity, which implies the probability of exceptions and changes in operations of the process, is negatively associated with adaptation costs, but not significantly associated with coordination costs. By demonstrating that different types of costs are associated with a tendency for different contract types, we establish a more comprehensive framework to analyze interorganizational transactions.

Third, we find that when everything else remains the same, the less modular a process (higher coordination costs), the more likely the firm is to choose a FP contract. This finding deviates from what Gulati and Singh (1998) suggested, i.e. more hierarchical controls (T&M contracts) should be adopted to alleviate coordination problems. We argue that the new IT- enabled modularization trend of organizational design may have motivated firms to take advantage of FP features (Schermann et al., 2016). The vendor has the incentive to define and

Explanatory variables Model 1 Model 2 Model 3 Model 4

Threshold 1 0.455 (1.474) 0.290 (1.609) 1.667 (1.847) �9.539y (5.400) Threshold 2 2.855y (1.505) 2.684y (1.633) 4.145* (1.900) �6.814 (5.347)

Perceived costs Perceived coordination costs �0.153 (0.233) �0.049 (0.262) �0.087 (0.240) 0.029 (0.271) Perceived adaptation costs 0.347* (0.170) 0.414* (0.189) 0.365* (0.175) 0.548** (0.207) Perceived coordination costs3 perceived adaptation costs

�0.571** (0.207) �0.602** (0.220) �0.555** (0.211) �0.855*** (0.269)

Control variables Intent to reduce cost (05 No; 1 5 Yes)

�1.362y (0.742) �5.745* (2.410)

Intent to improve quality (0 5 No; 1 5 Yes)

�0.658 (0.571) �0.641 (0.577)

Intent to enter new market (0 5 No; 1 5 Yes)

�0.910y (0.540) �0.034 (0.703)

Intent to access technologies and skilled personnel (0 5 No; 1 5 Yes)

1.370* (0.609) 1.002 (0.725)

Intent to reduce time to market (0 5 No; 1 5 Yes)

�0.548 (0.515) �1.869* (0.882)

Selection correction Correction for domestic outsourcing

0.044 ’(0.556) �3.361y (1.786)

Correction for offshore outsourcing

0.573y (0.350) �2.061y (1.197)

Model statistics –2Log-Likelihood 131.451 142.041 153.983 140.213 X2 12.329** 25.381*** 15.636** 29.407*** Pseudo R2 0.119 0.230 0.149 0.262 Number of observations 97 97 152 152

Note(s): One-sided tests were used for directional hypotheses; yp < 0.1; *p < 0.05; **p < 0.01; ***p < 0.001

Table 5. Effect of coordination and adaptation costs on contract choice

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clarify the process to achieve complete, detailed initial description of the process. This effort provides the client with the chance to introduce new changes that may be difficult to start internally. Also, the fixed fee schedule motivates the vendor to seek methods to minimize costs of communication and information sharing (Banerjee and Duflo, 2000; Ethiraj et al., 2005).

5.2 Managerial implications Our results also offer practical implications. First, contracts with over-specifications are not only costly but may inhibit firms’ ability to respond to changes. Thus, firms need to take a more comprehensive view and need to incorporate expectations for changes when they craft the contract. In addition, the results show that less modular design characteristics lead to higher coordination costs. The solution, however, may not be the conventional thinking to increase control and monitoring of the relationship but to adopt high-powered incentive contracts to motivate the vendor to reduce coordination costs by possibly modularizing the process rather than simply to cope with it. This approach may provide firms with opportunities to keep hands off “the mess” of internal organizational changes and achieve better results of process modularization. New approach to contract has been emerging in business practices (Frydlinger et al., 2019). In particular, formal relational contracting, which is featured by joint goals, mutual expectations and aligned interests, and long-term orientation, is more desirable (Hakansson and Axelsson, 2020).

5.3 Limitations and future research direction We acknowledge the following limitations of our study. The main limitation of the study is that we only utilize information about contract types in terms of their payment arrangements with no detailed contractual clauses. Although the literature has provided evidence that payment structures are associated with governance features of coordination and adaptation, it would be ideal if we could measure the actual dimensions, such as the level of documentation, flexibility clauses, etc. Second, as our data are survey-based with a single informant, the study is prone to common method bias. Although the data passed the Harman’s single factor test (the variance explained by a single factor is 25.74%), it would be much more convincing if the research could be better designed to address this problem a priori. Third, there is the issue of endogeneity, in the sense that unobservable factors that affect the coordination and adaptation costs also affect their choice of contract types (e.g. the firm’s capability of managing costs). Although our first stage analysis of coordination and adaptation costs is similar to using business process type as an instrument variable, it would be preferable to find other instrument variables.

Notes

1. Since hybrid contract lies in between fixed-price (FP) and time and-material (TM) in terms of flexibility, we treat contract type choices as an ordinal variable containing three categories.

2. The sample from the first wave of data collection (N5 88) has been used and published in Tanriverdi et al. (2007). In hypothesis testing, we excluded cases of offshore insourcing because this outsourcing mode

does not apply to the current research question. Thus, the number of cases in the analysis is 153. Due to missing values, the numbers of observations vary across models.

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About the authors Ling Ge is Assistant Professor at Department of Information Technology & Decision Science, G. Brint Ryan College of Business, University of North Texas, USA. Her research areas focus on IT outsourcing and crowdfunding. She has published in Journal of Marketing, Information System Research.

Xiaoyan Wang is Assistant Professor at Business School, Shandong University at Weihai (China). She received her Ph.D. in Marketing from City University of Hong Kong. Her research interests focus on marketing strategies, business-to-business relationships, and sales management. She has published in International Marketing Review and Industrial Marketing Management. Xiaoyan Wang is the corresponding author and can be contacted at: [email protected]

Zhilin Yang is Professor at Department of Marketing, College of Business, City University of Hong Kong. He received his Ph.D. in Marketing from New Mexico State University. Professor Yang’s main research areas are governance strategies in marketing channels, institutional theory, business network analysis, and online service marketing. He has published in Journal of Marketing, Journal of Marketing Research, Journal of International Business Studies, Journal of Operations Management, International Business Review, International Marketing Review, Journal of Advertising Research, Journal of Business Research, and Psychology and Marketing.

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