Design of incentive contracting mechanisms for outsourced project coordination


Student thesis: Doctoral Thesis

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  • Qin ZHU


Awarding Institution
Award date15 Jul 2014


Under intense competition in the emerging global economy, an increasing number of manufacturing firms are choosing to outsource part of their business processes to external organizations with the aim of leveraging resources, dispersing risks, and concentrating on critical processes to facilitate future growth. When managing an outsourced project wherein the behavior of the contractor cannot be observed and completion time is uncertain, conflicts of interest may arise between the outsourcing firm and the contractor, thus leading to actions that may result in low profits for both parties. An incentive contract can serve as an effective tool to align the interest of the contractor with that of the outsourcing firm and to consequently achieve a "win-win" situation. The aim of this thesis is to design an incentive contracting mechanism to coordinate outsourced projects such that the cost, time and performance requirements are balanced to achieve an optimal target. The proposed mechanisms are designed for three types of contracts, namely, incentive contracts for quality improvement, incentive contracts for intellectual capital development, and incentive contracts for just-in-time delivery. The first part of this thesis focuses on the design of incentive contracting mechanisms in completely outsourced projects, where the contractor works completely on behalf of the outsourcing firm. Product quality and intellectual capital are selected as key performance indicators that aim at improving the profits for both the outsourcing firm and contractor. The reason of choosing these two performance measures is that products with high quality are believed to gain high profit while investment on intellectual capital brings return in the future. Principal-agent theory is used to model the problem in which the outsourcing firm is regarded as the principal, and the contractor is referred to as the agent. As the actions of the agent are unobservable to the principal, the reward scheme normally depends on the realized output based on the performance measure. Whereas output in terms of financial profits can be expressed as a stochastic function of the productive effort determined by probability, output in terms of intellectual capital is not readily verifiable for contracting purposes. A noisy key performance indicator is instead used to reflect the intellectual capital deployed. An optimal incentive mechanism is obtained using the first-order approach such that the incentive scheme chosen by the principal and the inputs chosen by the contractor: either the productive effort in quality improvement contracts or the investment in intellectual capital in intellectual capital development contracts, are in Pareto optimality. Numerical experiments are used to verify the proposed optimal contracting mechanism in both the two scenarios. A benchmark situation is analyzed in intellectual capital development contracts. The second part of this thesis emphasizes the design of just-in-time delivery contracts to coordinate the delivery activities of the contractor and to consequently achieve an expected on-time delivery rate at the lowest possible cost. This case is applied in partially outsourced projects, where the outsourcing firm controls the final assembly of the products. An analytic model for just-in-time delivery is built based on standard inventory management theory and decision-making techniques. A Stackelberg leader-follower game is used to formulate the interactions of the outsourcing firm and the contractor. As the leader, the outsourcing firm moves first to offer a bonus for just-in-time delivery and penalties for tardiness. As the follower, the contractor chooses a delivery guarantee based on the incentive scheme; this delivery guarantee determines the timeliness of delivery. The outsourcing firm considers the cost-minimizing response of the contractor in choosing bonuses and penalties. The task variability of the contractor, the inventory cost, the expected cost of tardiness, and the probability of on-time delivery are analyzed. Stackelberg equilibrium is gained when both parties achieve minimal cost. Simulation is used to verify the findings in the analytical model. The major contribution of this research lies in five aspects: First, performance-based incentive contracts are used to coordinate the outsourced projects. Incentives are crucial since a simple fixed-price contract is not enough to guarantee the required performance. In addition, performance-based contracts allow the outsourcing firm to focus on what is important by specifying the performance indicators in different projects. Second, this research fills the gap by investigating how to manage outsourced projects through agency and game theories; while existing theories such as transaction cost, resource-based and organizational structure theories focuses on studying why, what, and where to outsource. Third, analytically tractable models are developed so that the proposed optimal compensation scheme motivates the contractors to adopt actions that would either maximize the expected profits or minimize the total costs. Fourth, this research seeks to develop an improved understanding on how contractors react to incentive contracts that are economically equivalent but framed differently. The role of risk aversion in such reactions is analyzed. The findings highlight the importance for the outsourcing firms to identify various factors that affect the behaviors of their contractors, such as revenue sharing intensity, their attitudes toward risk, and the performance measurement errors. Finally, this research provides a possible solution for the difficulties that are caused by non-contractible outcomes, in which performance such as intellectual capital cannot be accurately measured. A noisy performance indicator has been proven effective in directing the compensation payment.

    Research areas

  • Contracting out, Incentives in industry