Abstract:

The proliferation of outsourcing facilitates the clients to access to technological expertise and cost efficiency of the service venders. However， purposes of outsourcing are not always met. Firstly， the investment of outsourcing is irreversible. When the clients select outsourcing， there will be a payment for service vendors via contracting and a considerable management cost due to supervising outsourcing process. Moreover， there will be a switching cost as a result of switching form insourcing to outsourcing. Once the outsourcing fails， these expenses will not be able to recovered. Secondly， the service requirements are changing and uncertain resulting from the turbulent information technology environments and business change， increasing the difficulty of outsourcing relationship management and the probability of outsourcing failure. The aforementioned considerations motivate the clients to reserve the outsourcing flexibility. Specifically， the clients can exercise outsourcing immediately when the environment is favorable or choose insourcing when facing unfavorable conditions or postpone outsourcing until the conditions become favorable， that is， the clients owns the outsourcing option. In addition， contracts are pivotal tools to manage outsourcing operations， in which the incentive and flexibility associated with outsourcing timing is different. For instance， fixed-price contract can incentive the service vendors to reduce costs through process innovation but lacks flexibility， while cost-plus contract has no incentive for the service vendors to cut cost but has high flexibility. Uncertainty may make it necessary for the clients to have more flexibility in an outsourcing. However， the lack of incentive in the contract may bring opposite influence. Considering the risks of demand uncertainty and irreversible investment of IT outsourcing， an analytical framework with real options theory is developed to address issues of outsourcing timing. The results show that for low-skill process the probability of outsourcing is decreasing in volatility of demand and waiting time of outsourcing is increasing in volatility of demand for both the cost-plus contract and fixed-price contract， for high-skill process the probability of outsourcing is decreasing in volatility of demand and waiting time of outsourcing is increasing in volatility of demand for fixed-price contract， however， the results are opposite for cost-plus contract. High fixed cost of insourcing， low fixed cost of outsourcing and switching cost favor outsourcing under both contracts. For low-skill process high variable cost favors outsourcing with both cost-plus contract and fixed-price contract， for high-skill process high variable cost favors outsourcing when adopting the fixed-price contract but favors insourcing when adopting the cost-plus contract. The cost advantage of the service provider is beneficial for outsourcing when adopting cost-plus contract， but has no effect on the outsourcing timing when adopting the fixed-price contract.

Key words: IT outsourcing, contract type, outsourcing timing, real options theory