Firms increasingly outsource their information technology (IT) provisions to save money, improve the quality of their services and get access to scarce resources. Revenue from outsourcing in the U.S. is well over $700 billion, but transactions are not as simple as handing over a difficult job to an expert. When firms seek vendors for strategic or transformational IT initiatives, a lot of uncertainties hang in the air. How can these be translated into contract terms?

While some researchers have suggested companies pursue a "tight" contract that locks in as many outcomes and variables as possible, Anjana Susarla, Ramanath Subramanyam and Prasanna Karhade argue that even with such contracts, it is not possible to foresee everything. Therefore, they argue, another approach may be better, particularly with complex, transformational initiatives.

They look at contract terms and find that building non-price incentives into the contract, such as an option to extend, can help to discourage unwanted behaviour that may arise from uncertainties.

These uncertainties concern chiefly two problems. One is underinvestment by the vendor, which may lower the value of outsourcing to the firm. The other is inefficient bargaining, where either the firm or the vendor finds itself locked into a situation where they have little bargaining power. For example, the firm's hands could be tied if the vendor demands higher rates because it is too expensive to switch to another vendor midway through a project, or the vendor may come under pressure from the firm to lower its rates after investing in the firm's project.

"The fundamental challenge is that one party can take advantage of contractual incompleteness to extract rents from the other, leading to the potential for underinvestment or inefficient bargaining, collectively referred to as the holdup problem," the authors say.

"Prior research has examined the role of pricing or compensation to overcome this, but we highlight the fact that contracts are fundamentally incomplete and that nonprice provisions can play a strategic role in contracts structuring. Our argument is that parties are motivated by payoffs from repeated interaction to undertake specific investments and to reduce the likelihood of inefficient bargaining."

The nonprice provisions they look at include contract extensiveness, contract duration, and contract extendibility. These are examined in 103 outsourcing contracts in the US between 1992 and 2005 with a focus on both the scope and the complexity of the task, as the authors consider these to be important determinants to contract terms.

They find that nonprice provisions can indeed help to overcome the holdup problem and this is particularly true for complex tasks.

Such tasks are more likely to be dealt with in shorter term contracts because greater task complexity means greater unpredictability, but they are also associated with contract extendibility. By dangling a carrot of future possible pay-offs, firms are able to encourage investment by vendors and reduce the threat of inefficient bargaining.

The authors also find contracts with extendibility clauses are more likely to be renewed than those without, and that extensively detailed contracts are more likely to be renewed.

"With extendibility options, firms can achieve success in IT outsourcing by offering the promise of future business payoffs, without either party having to invest in extensive contractual safeguards or in incurring the costs of detailing extensive contracts," they say.

"Our results underscore the importance of deliberate and well-planned contract design choices, and in particular the strategic role of decision rights such extendibility provisions to limit opportunistic bargaining and solve the underinvestment problem."