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Abstract
The central management's decision to outsource an organization's information processing to an external supplier is studied. The internal computing resource is represented by a queuing model; its manager has private information about the department's cost and has objectives that may differ from those of the organization. Outsourcing decision rules are derived for both the cost center and profit center organizational forms for the internal department. With a cost center, the IS manager must report on the department's cost parameter, which models his or her private information, in order for the central management to make its decision; a mechanism design approach is used to ensure truthful reporting. The decision is shown to be quite complex, depending in part on the shape of the long‐run marginal cost function for the internal department, thus requiring considerable knowledge on the part of the central management. Full and no outsourcing are the most frequent outcomes, but partial outsourcing is optimal in one case. Various other implications are discussed, including the distortion of the decision caused by the information asymmetry and the beneficial effects of even the threat of outsourcing on the internal department's efficiency. In contrast, the decision rule for a profit center is very simple: The internal department should be retained as long as it can at least break even in the face of the external competition. Thus, very limited communication between the IS manager and central management suffices in this case. Again, full, partial, and no outsourcing are all possible as the optimal decision. The efficiency of the profit center can also be expected to be improved by the presence of the external source as the result of a reduction in its monopoly power.
