The Impact of Firm Learning on Value Creation in Strategic Outsourcing Relationships

Abstract

Information technology (IT) is central to the process execution and management of an ongoing relationship in outsourcing, both of which are fraught with challenges, and often lead to poor business outcomes. Thus, it is important for IT groups in organizations to understand how to deal with such difficulties for improved outsourcing performance. We study whether firms learn over time to deal with these two related but distinct issues in IT and business process outsourcing. Does such learning affect financial value appropriation through outsourcing? We build on the literature in information systems and strategy to investigate whether value creation in outsourcing depends on relational learning that results from prior association with the vendor, and procedural learning that results from prior experience in managing interfirm relationships. We estimate value in terms of long-term abnormal stock returns to the client relative to an industry, size, and book-to-market matched sample of control firms following the implementation of the outsourcing contract. We also analyze announcement period returns and allied wealth effects. Using data from the hundred largest outsourcing deals between 1996 and 2005, we find that whereas relational learning influences value creation in both simple and complex outsourcing engagements, procedural learning impacts value only in complex initiatives. Financial markets are slow to price the value of learning. The results suggest that caution should be exercised when firms without the experience of managing interfirm relationships externalize complex tasks to vendors they have not worked with in the past. Furthermore, IT groups can help improve learning-based outcomes by developing processes and systems that enable a firm to improve outsourcing procedures in a cumulative manner and also to coordinate and collaborate with the vendor.

Key words and phrases:

• abnormal returns
• business process outsourcing
• contracts
• financial value
• market efficiency
• organizational learning
• outsourcing

We gratefully acknowledge the helpful comments and suggestions provided by three anonymous reviewers and Vladimir Zwass during various stages of the review process. An early version of this article appeared in the Proceedings of the 30^th International Conference on Information Systems.

Notes

1. Firms’ contract choices are categorized as either fixed price or variable price, which differ in risks and incentives. Fixed (variable) prices involve higher (lower) levels of completeness and a lower (higher) probability that adaptations are needed ex post. When the outsourced task and relational environments are characterized by greater complexity and uncertainty, variable price contracts are preferred to fixed price contracts [56]. Thus there is greater ambiguity, complexity, and uncertainty in variable price outsourcing contracts than in fixed price deals.

^2. The presence of long-term abnormal returns is indicative of market inefficiency [44]. Such inefficiency can result from the acquisition and processing costs associated with intangible information on an event, which is not found in financial statements of the focal firm. In such cases, announcement period returns may not accurately reflect the market value of the event. This issue has been addressed extensively in recent research in the context of IT outsourcing [57], and is not the focus of this study.

^3. Sobrero and Schrader [76] refer to these processes that enable mutual exchange of information as procedural coordination. Procedural coordination might be structurally identified by the contractual form or governed by the contract but is realized through the actual day-to-day interactions and communication between participant firms that implement the contract.

^4. Estes [20] suggests that “learning to learn” may be a misnomer because prior experience does not necessarily help individuals with how to learn by forming new associations but rather with enabling the individual to leverage accumulated knowledge so that he or she needs to learn less to attain a given level of performance.

^5. We eliminated any contracts that were implemented in tranches because it is difficult to accurately estimate the long-term value of the outsourcing event in such cases. Different tranches may have different governance structures, coordination processes, and technological capabilities—for example, one of the contracts for customer service outsourcing in our sample involved three subcontracts for billing, helpdesk, and analytics, each of which was governed by a different type of contract and varied in complexity. If we estimated long-term value for the three-year period commencing the month after the implementation of the first contract, the returns would be confounded by the other two tranches also implemented in the same year. In order to reduce such confounding effects introduced by multiple contracts implemented in the same year, we eliminated them from our analysis. These contracts were less than 5 percent of our sample.

^6. Managers in the outsourcing firm noted that combination contracts start largely as time and materials compensation and may progress to fixed price compensation after the provider has acquired a more sound understanding of the outsourced task requirements. Thus, in the three-year period following the implementation of the contract, we group combination contracts with time and materials contracts.

Additional information

Notes on contributors

Deepa Mani

Deepa Mani is an assistant professor in the Information Systems group at the Indian School of Business (ISB). She also serves as the joint executive director of the Srini Raju Center for Technology and the Networked Economy at ISB. Her research interests are at the intersection of technology, organization, and society. She is interested in studying the impact of technology on the organization of economic activity, including firm boundary decisions, and the impact of such organization on firm value and economic productivity. Her research articles have been published in many journals including MIS Quarterly, Information Systems Research, Sloan Management Review, and MIS Quarterly Executive. Her articles have also appeared in refereed conference proceedings and as chapters in edited books, and have been featured in popular media outlets such as Forbes, CIO Magazine, LiveMint, Yahoo Finance, and The Street.

Anitesh Barua

Anitesh Barua is the William F. Wright Centennial Professor of Information Technology in the Department of Information, Risk and Operations Management at the McCombs School of Business, University of Texas at Austin. His research interests are in the areas of economics of information systems, outsourcing governance, and social media. He has published over seventy five articles in academic journals and refereed conference proceedings. He has served as associate editor of Management Science and Information Systems Research, and senior editor of Information Systems Research. He serves on the editorial board of Journal of Management Information Systems and International Journal of Electronic Commerce.