Mitigating Outsourcing Risk through Relational Contract

This paper analyzed the risk management under the uncertain outsourcing environment and put forward a relational contract model. Applying agency theory and cooperative game theory, a relational contract model with incentive bonus was explored for outsourcing in a double-moral-hazard setting. Vendors are often a major risk factor of outsourcing. Firms usually resort to incentive contracts against vendor's moral hazard and imperfect commitment Relational contract involving discretionary bonus based on combination of objective and subjective performance could reduce the distorted incentives that would be created by the contract only based on objective performance. According to repeated game theory, the relational contracts must be self-enforcing when the value of the future relationship must be sufficiently large that neither party wishes to renege and vendor would choose optimal action improving the outsourcing profits. The results showed that the validity of relational incentive contracts correlated with the discount rate of the contractors. Finally, the range of available bonus for outsourcing vendors was calculated. This analysis may help firms deciding adequate incentive bonus without excessive cost.