Contracting for Innovation in Information Technology Outsourcing

Abstract

The scope for innovations through outsourcing of information technology (IT), and more broadly, the challenges of sourcing innovations across firm boundaries has been an understudied area of literature. We study under what conditions certain contractual arrangements foster specific types of innovations in client organizations from IT outsourcing. We conceptualize two dimensions of innovation through outsourcing: process innovation and product innovations. Given the inherent uncertainty of innovative tasks, two distinct sets of contracting challenges could preclude firms from realizing business value through innovations. The ex ante problem is that of providing the vendor incentives for innovative services that raise the issue of appropriability of the gains from the innovation. The ex post challenge is the threat of holdup where the vendor, for example, is less willing to engage in the iterative collaboration needed for innovative tasks. We suggest two complementary solutions that simultaneously address both ex ante and ex post contractual problems: (i) credible commitments by outsourcing firms (clients) that act as reciprocal pledges, and (ii) contingent control rights that confer control contingent upon observed performance. We find that credible commitments are more important with process transformations while contingent control rights are more important with product innovations. We also find that the two contractual provisions are complementary. The impact of contractual provisions on post contract innovation performance is complicated by endogeneity. We employ methods from multi-valued treatment effects literature to deal with this issue. Our study suggests that portfolios of complementary contractual provisions need to simultaneously address ex ante and ex post hazards through contract design in the outsourcing of innovative tasks. Implications for practitioners and researchers are discussed.