Formal and relational incentives in BPO relationship management

Abstract

This paper studies the formal contract and relational contract in business process outsourcing. If some outcomes or outsourcing performance is unverifiable, then the contracts have to satisfy the self-enforcing condition. We characterise the optimal contract in terms of the discount rate, the level of the unverifiable outcomes and the divergence between the high service value and low service value provided by the vendor. The results suggest that, as the discount rate increases, the incentive to verifiable outcome (formal incentive) decreases while the incentive to the unverifiable outcome (relational incentive) increases. On the other hand, as the level of the unverifiable outcomes increase, the incentive to formal contract decreases while the incentive to relational contract becomes increase. As the divergence between the high service value and low service value provided by the vendor, the relational contract becomes more effective.