Contracting for Knowledge Intensive Services: An Empirical Investigation of IT Sourcing Arrangements

Abstract

This paper focuses on contractual provisions in external sourcing of innovative services. Such agreements require protection of key knowledge assets, whilst simultaneously providing incentives for heuristic search to enable problem solving and knowledge transfer. We conceptualize two distinct dimensions of knowledge in the inter-organizational context: problem solving complexity and the need for synthesis of knowledge bases across organizational boundaries. Integrating explanations from transaction cost economics, incomplete contracting theory and knowledge-based research, we analyze a sample of IT outsourcing contracts to investigate the role of three contractual provisions: joint decision making rights, intellectual property safeguards, as well as the intensity of the incentives. Contracts for bilateral agreements that involve high problem solving complexity contain stronger and more clearly elucidated joint decision rights, which rely less on measurable outcomes, in conjunction with strong IP safeguards and low powered incentives. When prior experience of the vendor is critical for fulfillment of the contracted task, contracts include joint decision rights. Exchanges characterized by complementarity in knowledge bases across firms are more likely to be governed by high powered incentives contracts while exchanges characterized by co-specialization are governed by contracting arrangements involving joint decision rights in conjunction with low powered incentives.