Vendor Selection, Contract Efficiency, and Performance Measurement in Service Outsourcing

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This study compares the efficacy of some commonly observed vendor selection and contracting mechanisms with respect to two key challenges in service outsourcing: vendor selection and contract efficiency. We show that competitive bidding yields good selection but contract inefficiency (positive information rent paid by the client); in this process, the winning vendor's bid constitutes the terms of the contract between client and vendor. We then show that if instead the client establishes the contract terms then the menu it designs yields contract efficiency but poor selection. In one particular case - namely, when the client establishes the contract terms and may work with a previously nonselected vendor if the first vendor reneges - it is possible to attain good selection and contract efficiency. We also highlight the implications of performance-based contracts in services.