Pricing Your Outsourcing Contract in UncertaintyBy
A study examines the impact that volatility and ambiguity can have on whether a fixed-price or cost-plus contract provides greater benefit in strategic outsourcing agreements.
Companies in a global economy are increasingly involved in strategic outsourcing contracts that require joint efforts by vendors and clients. These agreements often involve uncertainty that creates contracting challenges. We conducted a study (“Uncertainty and Compensation Design in Strategic Interfirm Contracts,” Contemporary Accounting Research, Spring 2020, pp. 542-574, bit.ly/2J61IwV) to examine two types of uncertainty—volatility and ambiguity—and their effect on the choice of contract type. The results can help companies develop accounting systems that improve the design of strategic outsourcing contracts.
AN OUTSOURCING EXAMPLE
GE Aviation contracted with Accenture in 2012 to provide airlines with intelligent operations services to predict, prevent, and recover from operational disruptions. The project required technology assets and operational expertise from both GE Aviation and Accenture, although GE Aviation paid for and owned the final product. A fundamental question is: What price should GE Aviation pay Accenture for its product and services?
GE Aviation and Accenture could use either a cost-plus contract or a fixed-price contract. In a cost-plus contract, GE Aviation reimburses Accenture for the cost incurred. In a fixed-price contract, GE Aviation and Accenture settle on a price before implementation.
For Accenture, a cost-plus contract is attractive because the risk of future cost overruns shifts to GE Aviation. Accenture has minimal incentive to look for efficiencies in execution because all its costs are reimbursed. For GE Aviation, a cost-plus contract is unattractive because of the cost risk from future contingencies it has to bear (the risk-sharing problem) and the risk that Accenture will insufficiently invest in cost control (the moral-hazard problem).
In a fixed-price contract, the risk-sharing problem rests squarely on Accenture because it bears the risk of cost overruns. Accenture also has incentives to invest in cost control, which mitigates the moral-hazard problem. While this might sound like a perfect solution for GE Aviation, a fixed-price contract is a very specific contract based on the information that the parties have at the time the contract is signed. It assumes that both parties have a clear idea of the nature of the product or service, the expectations with respect to quality and timeliness of the project deliverables, the future contingencies that could arise, and how to resolve these contingencies.
In strategic outsourcing contracts, companies rarely have a complete understanding of what they’re setting out to achieve from the project. The two parties could have plans for some contingencies but may face entirely unexpected situations after signing the contract.
Therefore, while fixed-price contracts theoretically provide strong incentives for the vendor to be cost-efficient, changes in circumstances that require adjustments to designs or performance specifications necessitate costly contract renegotiations. Cost-plus contracts create weak incentives for cost efficiency but provide flexibility to modify designs, deliverables, and performance parameters to respond to unexpected exigencies. Uncertainty about future contingencies influences the trade-off between flexibility and cost efficiency.
We focused on two types of uncertainty: volatility and ambiguity. Volatility refers to known unknowns, whereas ambiguity refers to unknown unknowns. Contracting situations have volatility when the parties involved can agree on probability distribution of potential future states. For example, there’s uncertainty about the rate of inflation that could occur in the next decade, but statistical models can help build a confidence interval around this uncertainty. These confidence intervals can be incorporated into the contract such that parties don’t need to modify the contract if inflation is within the interval. GE Aviation and Accenture can incorporate automatic inflation adjustment clauses in the contract.
Given that fixed-price contracts require consensus on contract terms (e.g., price, quality, schedules, and redistribution of surplus under various potential outcome scenarios), increased volatility (i.e., a larger range of possible outcomes) reduces the likelihood of fixed-price contracts. Similarly, causal indeterminacy and uncertain outcomes associated with increased ambiguity lead to differences of opinion among contracting parties about the effect of changes in the environment on the project and the appropriate actions required. This reduced ability to specify contingent contract terms increases the likelihood of more flexible cost-plus contracts.
For example, volatility in the aggregate performance measures of GE Aviation (the client) should reflect uncertainty in the implementation environment, which increases project risk to Accenture (the vendor). Ambiguity in GE Aviation’s performance measures suggests difficulties in predicting the long-term consequences from GE Aviation’s managerial choices. This limits the parties’ ability to price the outsourcing contract appropriately. Therefore, volatility and ambiguity in the client’s performance measures increase contract incompleteness and affect contract design and probability of renegotiations.
While it’s easy to visualize a link between project-specific uncertainty and the contract choice, a major impediment to testing this link is a lack of reliable measures of project uncertainty. We analyzed data for 455 strategic outsourcing contracts, with an average contract value of $356 million, to determine whether company and market-level accounting measures can capture underlying project-level uncertainties.
We identified company-level revenue-, earnings-, and equity-based measures of volatility and constructed an overall measure of volatility. Our measures of ambiguity were the correlation between market value of the client and its book income, and variance in abnormal returns surrounding earnings announcements. We controlled for other factors that can influence contracts, such as project-specific investments, contract size and complexity, bidding process, prior experience with alliances, and macro-level uncertainty.
Statistical estimations indicate that increases in volatility and ambiguity reduce the probability of fixed-price contracts and increase the probability of renegotiations. A one-standard-deviation increase in volatility reduces the odds of implementing a fixed-price contract by about 61% to 90%. A one-standard-deviation increase in volatility increases the odds of renegotiating of a fixed-price contract by nearly 40%. Similarly, a one-standard-deviation increase in ambiguity decreases the odds of observing a fixed-price contract by 36%.
Accounting measures provide useful information for contract design and choice in strategic outsourcing contracts. They can also help predict potential contract renegotiations. Our study has implications for the design of accounting systems that can help in assessing volatility and ambiguity and improve the design of strategic outsourcing contracts. Finally, we determined that pricing of strategic outsourcing contracts depends on the volatility and ambiguity faced by the contracting parties.