Success of IT Outsourcing contracts: Effects of the Complexity of the Activity, Relational Governance and Structure of Incentives

Transcription

1 Success of IT Outsourcing contracts: Effects of the Complexity of the Activity, Relational Governance and Structure of Incentives Completed Research Paper Otavio P. Sanchez EAESP-FGV 474, Itapeva St - 9 th floor SP-Brazil otavio.sanchez@fgv.br Marcelo A. Cruz EAESP-FGV 474, Itapeva St - 9 th floor SP-Brazil marcelo.cruz@metodista.br Paulo B. Goes University of Arizona McClelland Hall 430 Tucson AZ pgoes@ .arizona.edu Abstract The outsourcing of Information Technology (IT) services is a practice generally regulated by contracts. Since contracts are inevitably incomplete, buyer-supplier relationships are usually managed by additional mechanisms of incentives and governance, which results in a variety of success levels. Buyer perceived volatility and ambiguity of the future relationship are argued to be keys in defining the balance of contract design. A model to predict supplier behavior and perceived contract success is proposed by interrelating outsourced activity complexity, relational governance and structure of formal incentives. Results of empirical data show the proposed variables are good predictors of supplier s behavior and expectation of success of the contracts. This research makes a contribution by clarifying how to better design contracts and how relationships between buyer and supplier can be managed to achieve higher levels of success. Keywords: Contracting, Outsourcing, IT governance Thirty Fifth International Conference on Information Systems, Auckland

2 IS Governance Introduction The outsourcing of Information Technology (IT) is a widespread practice between organizations. The motivation for outsourcing a specific IT service or activity frequently is associated with a number of strategic possibilities such as cost reductions, access to new technologies, acquisition of capabilities and improving focus on the core activities, among others. The process of outsourcing is usually regulated by contracts between the parties. However, contracts are considered incomplete in their power to guide behaviors, because of the difficulty to anticipate all contingencies that can arise during the relationship along with the inability of the parties to continuously monitor and control mutual behaviors. Because of contracts incompleteness, contracting parties usually feel the need to employ additional mechanisms to implement the relationship, such as conducting the relationship governance in a more relational fashion and incorporating special designed structure of incentives into the contracts. While using formal contracts to support inter-organizational relationships is a widely established practice covering almost all activities from basic, standardized IT services such as printing, to more complex activities such as strategic applications development, it is expected that a wide spectrum of combinations of formal contractual clauses with mechanisms of incentives and relational governance can be applied. The ability of the contracting party to combine these management instruments to govern relationships with suppliers may contribute to successful contracts. The complexity of the contracted service, the intensity of the applied relational governance and the type of structure of contractual incentives are supposed to be factors that affect the success of contracts. In a recent study, Weber and Mayer present theoretical propositions about the possible effects of the structure of incentives upon the relational governance, and of relational governance constructs upon the suppliers behavior and the contract success expectation (Weber and Mayer 2011). As those propositions have not yet been empirically tested in the context of outsourcing services of IT, this article aims to refine and empirically extend prior research by (1) proposing a nomological network and operationalization of the constructs involved, (2) analyzing the relationship between structure of incentives and relational governance, and (3) evaluating the effects of the level of complexity, intensity of relational governance and types of structure of incentives on the supplier behavior and expectation of success of IT contracts, from the perspective of the contracting party. Literature review Formal contracts are seen in economics as instrumental to align behaviors in relationships between agents. However, the reliability and good intentions which can be inserted into contractual relations are highly fragile aspects, since agents prefer to seek their own interests afterwards (Williamson 1985). Without the limits of control and monitoring, the emphasis of pursuing of self interest can lead to behaviors that contravene the contract obtectives. The lack of parties capabilities for monitoring and control creates the possibility of the interest of one party prevailing over the other, causing a suboptimal economic equilibrium (Williamson 2003; Williamson 2008). Additionally, it is argued that formal contracts built on control provision clauses can actually undermine trust and thereby encourage the opportunistic behavior they are designed to discourage (Malhotra and Lumineau 2011; Poppo and Zenger 2002; Rai et al. 2012). Moreover, the formalization of contracts consists of an insufficient attempt to avoid the counterpart opportunistic behavior (Milgrom and Roberts 1992), thus requiring additional mechanisms such as relational governance and contractual incentives. Relational governance is the social mechanism (Rai et al. 2009) characterized by a combination of communication, interaction and cooperation used between agents for conducting activities, solving problems and sharing the objectives of the relationship (Poppo et al. 2008). In the economic literature, 2 Thirty Fifth International Conference on Information Systems, Auckland 2014

3 Short Title up to 8 words relational governance is considered part of the relational contract, which is a tacit agreement between the parties. While in a formal contract specifications of expected behaviors are written, in the relational contract the parties interact to share a common understanding of what is agreed upon, thus relying heavily on social mechanisms during the relationship that foster trust (Malhotra and Lumineau 2011). The extent by which the intensity of relational governance interacts with contractual elements promoting a successful agreement is a topic that has generated academy interest (Goo et al. 2009). There is no consensus in the literature about relational governance and contract formalization being substitutes or complements (Huber et al. 2013; Poppo and Zenger 2002) or both (Huber et al. 2013; Tiwana 2010). However, as the relational governance involves communication, interaction and cooperation, which creates a positive and reciprocal support between the parties, it may be seen as a refinement of the formalization of contracts. One interpretation is that relational governance can be understood as a complement of the formal contract (Poppo and Zenger 2002) and, in line with most of economic literature, a preferable way to conducted contracts, when formal contracts - the lower cost alternative - couldn't be applied (Gulati 1995). However, besides relational governance, there is another way for dealing with the inability to predict all future contingencies in the elaboration of contracts: formalizing clauses that represent a structure of incentives which leads to the reduction of the contract control provision and improvement of the coordination provision (Malhotra and Lumineau 2011). A coordination structure consists on clauses more focused on the desired results rather than on specific controls of behaviors. Together, they intend to encourage the alignment of agents interests with the final objectives of the contract, promoting cooperation and reducing the possibility of distrust in the contractual relationship (Vanneste and Puranam 2010). Similarly, a structure of incentives is characterized in the organization literature as showing a promotional or preventive design (Weber and Mayer 2011) or frame (Higgins 1998). These two different and opposite types of incentive structures establish different motivations for the agents, ranging from the stimulation of high creative and risk adoption behaviors to conformity and risk avoidance behaviors. In the context of a contract, the promotional frame provides incentives aimed at expanding high goals aspiration and acceptance of risk by the supplier, while the preventive frame provides incentives for supplier conformity and risk avoidance. Table 1 shows the role of the contractual clauses in shaping preventive and promotional contractual designs. Contractual Clauses Preventive Role Promotional Role Payment for performance Penalty Bonus Performance milestones Specific, detailed Higher level, general Duration Early termination Extendability Price adjustment Increase with negative events Decrease with positive events Table 1 Role of the contractual clauses Based on (Weber and Mayer 2011). The preventive structure of incentives favors buyers with aversion of potential losses in a contractual relationship to satisfy the need for safety. Thus, as far as preventive structure of incentives is concerned, the completion of the contracted objectives is expected to be characterized by the attainment of a minimum level of objective, something that is little challenging or represents an easy ideal to be achieved, usually with low-complexity (Weber and Mayer 2011). As consequence of the expectations associated with the fulfillment of a contract with limited goals and low risks, the perception of value is asymmetric in case of success or failure. Preventive structures are seen by buyers as projecting net economic results that are low-positive in case of final contract success and high-negative in case of final contract failure Thirty Fifth International Conference on Information Systems, Auckland

4 IS Governance (Tversky and Kahneman 1991). Agents who intend to use a preventive structure of incentives rely on highly formalized contracts and on provisions of control and power. Typically, contracts with preventive structure are detailed in an attempt and contain penalty clauses to increase the guarantees. Conversely, promotional structure of incentives is based on a perspective of aiming high rewards combined with low risk aversion, as the object of the contract is considered by agents as challenging and the process of achieving it stimulating (Weber and Mayer 2011). The structures of incentives with promotional character are seen by buyers as projecting net economic results that are high-positive in case of final contract success and low-negative in case of final contract failure (Tversky and Kahneman 1991). Under promotional structure of incentives, the agents' behaviors are shaped by an emphasis on communication, interaction and cooperation aiming at realizing the potential positive outcome. From the buyer s point of view, the focus of the contract is to stimulate the achievement of the most challenging objectives possible. As consequence of the positive expectations associated with the fulfillment of a contract, the perception of value is also asymmetric in case of success or failure. The feelings associated with this structure show high positive levels of intensity when the objectives are met and little frustration when objectives are not met. Again, we see here a correspondence with the feelings of pleasure and pain that individuals perceive when exposed to situations of incremental gains or losses while departing from a given level of previous considered assured position of gain and loss, that means, when considering a situation change from a different domain (Tversky and Kahneman 1991). Contracts of IT outsourcing The outsourcing of IT services is a well established practice in organizations and is defined as the delegation of IT activities to outside companies, for planning, management and operation. In a more strategic level, it can be understood as an organizational decision to search for resources to accomplish its objectives (Loh and Venkatraman 1992; Willcocks and Lacity 1998). Aside the traditional motivation of achieving a cost reduction, IT outsourcing is recognized as capable to allow access to new features and capabilities, release attention to focus on core business, increase the flexibility of business process, reduce the delivery time, and provide access to new markets (Griffiths and Remenyi 2008). Typically, in the context of management of contracts of outsourced IT services, the structure of incentives interacts with relational governance mechanisms (Rai et al. 2012) in a way that as contracted activities show varying levels of complexity, varying levels of cooperation arise between the parties that influences the levels of success. Adopting the view of the contracting party, the complexity of the outsourced service the object of the contract depends on the perception of their own competence in performing the service internally (Williamson 2008). Thus, the occasional lack of some critical resource to perform the service or the inexperience in running it leads to a perception of greater complexity of the service. The uncertainty of the activity is central in how the contracting party defines the structure of incentives (Carson et al. 2006) and in the intensity of relational governance (Huber et al. 2013). In this paper, we consider the complexity of the activity outsourced to be a primary source of buyer s perceived volatility and ambiguity, which can lead to the perception that only certain suppliers can meet the required technical competence, under certain confidence levels. This situation can reduce the number of possible suppliers to be considered and conduct to a buyer self-imposed imprisonment with a particular supplier due to the perception that changing is risky (Gulati 1995). Because relational governance is based on communication, interaction and collaboration that ultimately can reinforce mutual trust, it has the means to solve conflicting situations that are not predicted in the contract (Poppo et al. 2008). This aspect is present in both the literature of contracts in general and specific literature related to IT services (Gopal and Koka 2012). Aside from the debate if contract formalization and relational governance are complements or substitutes (Goo et al. 2009; Poppo and Zenger 2002) or even a process that can conduct to combinations or sequential replacement of both mechanisms (Huber et al. 2013), the simultaneous use of both mechanisms is described as a particular 4 Thirty Fifth International Conference on Information Systems, Auckland 2014

5 Short Title up to 8 words condition because control provisions induced by highly formalized contracts tend to foster distrust between agents (Poppo et al. 2008). As the various types of services outsourced vary on complexity, it is expected that different combinations of contracts and relational governance are observed (Gulati 1995; Poppo and Zenger 2002; Zaheer and Venkatraman 1995). Research model The research model is illustrated in Figure 1. We argue that the complexity of the contracted activity influences the design of the structure of incentives. If tasks are considered of low complexity, the most effective structure of incentives possibly chosen is the preventive, as presumably simple tasks will render low value with simple objectives, low risks associated. As a consequence, the foreseeable low complex activity allows the contract to include more control provisions, a lower cost mechanism than relational governance. Analogously, more complex activities are seen as having the potential to bring risks to the relationship due the control and monitoring limitations. In this situation, contracts are written with a higher level of incompleteness because the difficulty to predict all contingencies and, as consequence, the buyer is likely to employ promotional structure of incentives. We thus formulate the following two hypotheses: Hypothesis 1a Complex outsourced activities are associated with contracts with promotional structure of incentives Hypothesis 1b Simple outsourced activities are associated with contracts with preventive structure of incentives The level of complexity is supposed to influence the level of the relational governance in the course of the contract. Likewise, contracts with more complex and more challenging activities require greater cooperation, interaction and more communication between the agents during the contract period, due to the difficulty in controlling and monitoring the activities that are hardly predictable (Weber and Mayer 2011). Moreover, as contracts tend to be less than complete, the inability to predict all possible contingencies in the course of the contract makes necessary additional actions associated with relational governance. Thus, we propose: Hypothesis 2: Complex outsourced activities are associated with higher intensity of relational governance As relational governance is a mechanism that has the potential to solve contingencies not predicted in the contract, it may be seen as replacing contractual clauses (Williamson 2002) or complementing them (Poppo and Zenger 2002). However, contracts with a structure of incentives based on the preventive frame are those that emphasize safety and, as consequence, require monitoring and control that can be performed as long as the contract contains clauses establishing penalties for the non-achievement of the objectives. Accordingly, preventive contracts will require a lower level of relational governance since the expected guidelines for the fulfillment of what was contracted are explicit in the contractual clauses. In contrast, promotional contracts require a higher level of relational governance since they are associated with activities of greater complexity and therefore it is not possible to anticipate in their clauses all the situations that may occur over the contract. Consequently, it is necessary to improve collaboration, interaction and communication between the parties to meet the objectives. Additionally, the ambitious objectives usually present in promotional contracts may induce rewards for general results that are of mutual interest. As a result: Hypothesis 3a The more preventive the structure of incentives, the lower is the intensity of relational governance; Hypothesis 3b The more promotional the structure of incentives, the higher is the intensity of relational governance. Thirty Fifth International Conference on Information Systems, Auckland

6 IS Governance Structures of incentives are supposed to affect the suppliers behavior, since they encourage the contracted party to adopt a behavior that meets the demands of the contract. In a preventive contract, demands are focused on specific and predictable objectives. Consequently, the contracted party recognizes the demand for something specific and adopts a vigilant behavior in the relationship during the contract period. Usually, preventive contracts include clauses of penalties in case of non achievement of the objectives, which lead to the rise of the supplier s risk perception. Thus, as the matrix of incentives becomes asymmetric, the buyer tends to minimize his exposure to less predictable situations. Conversely, contracts with promotional structure of incentives are associated with activities of greater complexity in which rewarding clauses are usually included. The possibility of gaining a bonus on the progress of the contract, for example, stimulates a buyer behavior with more flexibility, cooperation and creativity, to achieve the objectives or expand them. During these contracts, the contracted party tends to adopt a proactive behavior, and unpredicted circumstances are regarded as opportunities with acceptable levels of risk, in view of possible awards, which stimulates greater achievements. Thus: Hypothesis 4a The more preventive the structure of incentives, less proactive will be the contracted party s behavior; Hypothesis 4b The more promotional the structure of incentives, more proactive will be the contracted party s behavior. Figure 1 - Research Model The relational governance is associated with higher levels of cooperation and trust between agents, which can contribute to address the incompleteness of the contract. Consequently, a higher level of governance implies that suppliers can adopt a more proactive behavior, since trust and communication reduces the perception of risk from which the contracted party sees the relationship. Thus, as aversion to risk is reduced, contracted party assumes a more propositional role. Analogously, greater communication between the parties allows greater interaction and collaboration between agents, which makes the contracted party assume a more proactive behavior during the contract period. The close proximity between agents creates an environment and the conditions for actions with more flexibility, creativity, cooperation (Poppo et al. 2008). Therefore: Hypothesis 5 The greater the intensity of relational governance, the more proactive is the contracted party s behavior The success of the contract is associated with the perception of accomplishment of the objectives and the satisfaction of the buyer regarding the relationship developed (Lee and Kim 1999; Willcocks and Lacity 6 Thirty Fifth International Conference on Information Systems, Auckland 2014

7 Short Title up to 8 words 1999). A greater level of communication and interaction between the buyer and supplier reduces the perception of risk between them because it makes less asymmetric the information available on the course of the contract. A higher level of communication and interaction creates the conditions for the supplier to get a better understanding of the objectives of the buyer, which allows a more participative and proactive behavior that tends to positively influence the achievement of objectives. On the other hand, a lower level of communication and interaction between the parties may result in inefficient procedures that may jeopardize the accomplishment of the objectives outlined in the contract and the consequent expectation of success. Thus, a relationship with great interaction, collaboration and communication between both parties may not only make the objectives of the contract to be met, but also can make the buyer to achieve a higher level of satisfaction, which is anticipated as perception of success of the contract. Thus: Hypothesis 6a The higher the level of relational governance, the greater is the buyer expectation of contract success Hypothesis 6b: The lower the level of relational governance, the lower is the buyer expectation of contract success The perception of success in contracts with promotional structure of incentives is greater than the perception of success in contracts with preventive structure of incentives, because it is based on the achievement of riskier ambitious objectives and is opposed to the minimum objectives given as certain. Thus, the promotional structure of incentives is associated with a perception of success in the field of gains, whereas preventive structure of incentives is associated with the perception of success supported in the field of losses. Thus: Hypothesis 7 Contracts with promotional structure of incentives have greater perception of success than contracts with preventive structure of incentives The supplier s behavior is supposed to influence the expectation of contract success because contingencies can be easily solved if suppliers react collaboratively. It is expected that a more proactive (flexible, creative and cooperative) behavior of the supplier increases the expectation of success of the contract by the contracting party. Therefore: Hypothesis 8 The more flexible, cooperative and creative the supplier, the higher is the expectation of success of contract Methodology The data were collected based on a sample consisting of companies of varying industries and sizes. The respondents were CEOs and IT professionals at different hierarchical levels, directors, managers and analysts responsible for contracting services from third parties. They were accessed through an invitation ed from an initial database of 6300 companies in Sao Paulo, Brazil. Thereafter, the list was expanded by the technique of "snowball", through which the respondents could recommend others from their list of contacts and from social networks, who they considered involved in the activity of outsourcing and able to answer the questionnaire. These additional respondents were assessed regarding redundancy and the appropriateness considering the objectives of the study. The questionnaire became available for 6 weeks at Surveymonkey platform, which respondents could access based on a login and password sent via . We had no previous information about the size of the effects to expect in the model. So we perform a power analysis with GPower (Faul et al. 2009) in order to obtain the minimum sample size consistent with the detection of an effect as small as (Grissom and Kim 2012). This considers a worst case scenario in which we could at least find a correlation of 0.2 between each predictor and the outcome, and Thirty Fifth International Conference on Information Systems, Auckland

8 IS Governance 0.2 correlation between predictors, for the construct with higher number of predictors in the model. Considering the Structure of Incentives construct, which has 5 formative indicators (Cenfetelli and Bassellier 2009) and 1 exogenous path as predictors, a power of 0.85, and a Type I error of 0.05, the minimum sample size resulted 107. Overall, data of 207 respondents were collected, out of which because of missing data, only 119 valid respondents were considered, which is consistent to the power required. No bias was identified in this portion of respondents showing incomplete answers. The relative high number of incomplete data is possibly associated with the fact that the questionnaire was relatively long, since it was part of a larger survey, with a total of 70 questions, presented in 7 screens of the collection program. Construct Definition Indicators Code Based on Structure of Incentives (formative) Activity Complexity (reflexive) Relational Governance (reflexive) Extent towhich the contracting party sees the contract providing control of the relationship and power Extent to which the contracting party perceives the object of the contract as a complex activity Extent to which the contracting party perceives its ability to effectively employ socialenforcement governance mechanisms The contract has clauses of penalties in case the supplier does not fulfill the contract object (yes/no) The contract has bonus provision clauses for supplier in case of achieving specific goals (yes/no) The contract has early termination clauses in case of problems or disagreement (yes/no) The contract states the conditions for its renovation (yes/no) The contract received extensive juridical analysis before to be signed (yes/no) I consider the object of the contract a simple/complex activity It is required many stages to the contracted service to be accomplished It is needed effort, involvement and knowledge to the contracted service to be accomplished The contract requires close interaction with the supplier It is fundamental that the parties collaborate to conduct the contract The progress of the service contract requires lots of communication Prev_1 (reverse) Prev_2 Prev_3 (reverse) Prev_4 Prev_5 (reverse) Cativ_1 Cativ_2 Cativ_3 Govre_1 Govre_2 Govre_3 (Weber and Mayer 2011) (Mani et al. 2012) (Weber and Mayer 2011) (Poppo and Zenger 2002) (Weber and Mayer 2011) Supplier's Behavior (reflexive) Expectation of Success (reflexive) Extent to which the contracting party perceives the supplier behavior as collaborative Extent to which the contracting party perceives the contract as having the potential of yield positive results The supplier is flexible when we need The supplier cooperates when we need The supplier reacts with creativity when necessary During the contract the supplier has offered suggestions, alternatives and solutions that are beneficial We believe the contract will meet the expectations We expect the contract will be successfully accomplished Our expectation is that the contract will yield good results Comfo_1 Comfo_2 Comfo_3 Comfo_4 Expsu_1 Expsu_2 Expsu_3 (Weber and Mayer 2011) (Poppo and Zenger 2002) (Mani et al. 2012) (Rai et al. 2012) Table 2 Constructs definitions and operationalization 8 Thirty Fifth International Conference on Information Systems, Auckland 2014

9 Short Title up to 8 words In order to operationalize the constructs, some concepts related to the management of contracts of IT outsourcing were initially identified in the literature. We then conducted a qualitative study based on interviews with CEOs, directors and managers from different branches of activities, in order to assess the content validity of the concepts. Subsequently, a preliminary questionnaire was proposed based on the definitions of each construct and on the relevant literature, as well as on the knowledge of this field. Afterwards, the questionnaire was reviewed by two researchers, separately, followed by 4 joint review cycles. Additionally, the resultant questionnaire was submitted to IT professionals assessment, in order to refine the understanding of the issues. The final questions were asked to respondents involved in ongoing contracts of IT outsourcing services. Constructs definitions and operationalization are shown in Table 2. Results and analysis Demographic data show a concentration of respondents in the service sector (68.7%), and the type of outsourcing service predominant is ERP development, with a percentage of 21.8% of the sample. Hosting services, in the second place, represents 20.2% of the sample. As far as the size of the suppliers in the sample, there is a considerable variation among the various groups, with a slight predominance of small contracting parties, with annual revenues (2012) in the range between US$ 180,000 and US$ 1.8 million. The demographic information of the sample is presented in Table 3. Item Net revenue (2012) Sector Types of Outsourcing Description Standard Contract Customized Contract Customized Contract with SLA. Informal (without Contract) ERP development Hosting Maintenance Network Acquisition of Applications Development Print Website Other Services Industry Trade Uninformed From U$ 0.00 to U$ 180, From U$ 180,000 to U$ 1,800, From U$ 1,800,000 to U$ 9,000, From U$ 9,000,000 to U$ 45,000, From U$ 45,000,000 to U$ 150,000, Over U$ 150,000, Unknown Uninformed N % Table 3 Sample Demographics n % Thirty Fifth International Conference on Information Systems, Auckland

10 IS Governance We use PLS-SEM technique (Ringle et al. 2005; Wetzels et al. 2009) because it can easily deal with both reflexive and formative measurements and works efficiently with small sample sizes (Hair et al. 2014). Although CB-SEM can also handle formative constructs, it requires the construct include both formative and reflexive indicators (Diamantopoulos 2011) and usually higher power than PLS-SEM. Quality of measurement model The coefficient of Composite Reliability indicates that each construct converges toward measuring the intended construct. Table 4 shows Composite Reliability values above 0.87 for all variables, which indicates good reliability in the measurement model and below 0.95, that could represent a threat to content validity (Hair et al. 2014). Composite Reliability Cronbach's Alpha Activity complexity Structure of incentives (formative) (formative) Relational governance Supplier s behavior Expectation of success Table 4 Internal Consistency Reliability The convergent validity in reflexive constructs is assessed by the coefficients of Average Variance Extracted (AVE) of each latent variable whose coefficient must be greater than 0.5 for each latent variable, implying that the variance shared between the construct and its indicators, on average, is larger than the measurement error variance (Hair et al. 2014). Table 5 shows that the indicators of the questionnaire measure the latent variable appropriately as the least value of AVE is We use a second criterion, referred to the weight of each indicator in the intended latent variable, which should be higher than 0.71 (the square root of 0.5), demonstrating that the indicator contributes at least half of its variance to composition of this latent variable. As seen in Table 5, the loadings of all intended latent variable indicators are higher than for reflexive constructs. Note that Cativ_1 was dropped, as its value was close to the limit of 0.4 where a indicator must be deleted from a scale (Hair et al. 2011). Although the construct Activity Complexity is left with only two indicators, we found the elimination didn't represent a serious content validity problem, as the Cativ_1 is worded in an integrative way, which content is already covered by Cativ_2 and Cativ_3. The Discriminant Validity is assessed by two measures. The first, comparing the cross loadings of the latent variables indicators. The loading values should be higher (we adopt at least 0.2) in the construct in which the indicator is intended to measure, than in others. Table 5 shows loadings that differ between constructs by no more than 0.23, which is considered adequate. The second measure, the Fornell-Larker s criterion (Fornell and Larcker 1981), is considered more conservative than the previous (Hair et al. 2011) and compares the square root of AVE of a latent variable with its correlations with other latent variables, showing that the indicators that measure one of the latent variables are not confused with other, by explaining a higher portion of the variance in the desired construct than they show of correlation with other constructs in the model (Hair et al. 2014). (Table 6) shows that all the reflexive constructs present diagonal values (square root of AVE) higher than correlations between other constructs. The formative construct (Structure of Incentives) was assessed against possible multicollinearity problems by means of the calculation of Variance Inflation Factors (VIF) of each indicator in the construct, resulting values ranging from 1.07 to 1.18 which were considered adequate (Wright et al. 2012). The Structure of Incentives indicators relevance was assessed based on the values of their weights and loadings. As shown in Table 5, Prev_4 and Prev_5 present weights superior to 0.5, which represents a 10 Thirty Fifth International Conference on Information Systems, Auckland 2014

11 Short Title up to 8 words good contribution to the construct. On the other hand, once running the PLS algorithm and analyzing the loadings of the remaining indicators, Prev_1 and Prev_3 show respectively values of and Construct Activity Structure of Relational Supplier s Expectation complexity incentives governance behavior of success AVE (formative) Cativ_ Cativ_ Prev_ Prev_ Prev_ Prev_ Prev_ Govre_ Govre_ Govre_ Comfo_ Comfo_ Comfo_ Comfo_ Expsu_ Expsu_ Expsu_ Table 5 Indicator Reliability Additionally, the significance of the indicators was assessed by means of a non-parametric bootstrap procedure (Hair et al. 2014) with 5,000 subsamples. Respectively, t statistics for Prev_1 to Prev_5 result 1.911, 0.150, 2.662, and Consequently, the data offer marginal empirical evidence to keep Prev_1 and Prev_3 in the construct but, as there is strong theoretical support for the related content validity (Weber and Mayer 2011), we decide to keep those indicators. However, Prev_2 shows no empirical evidence to be kept in the model but, theoretically, bonus provision clauses are important elements to differentiate a promotional structure of incentives from a preventive one (Weber and Mayer 2011) and we consider this argument to also keep Prev_2 in the model. Activity complexity Structure of incentives Relational governance Supplier s behavior Expectation of success Activity complexity Structure of incentives (formative) Relational governance Supplier s behavior Expectation of success Table 6 - Discriminant Validity (1) (1) The square root of Average Variance Extracted is diagonally represented. Thirty Fifth International Conference on Information Systems, Auckland

12 IS Governance Quality of the structural model We analyze the structural model with respect to collinearity issues. For all the predicted constructs, indicators or path coefficients show no concern about multicollinearity as VIF ranged from 1.4 to 2.3 (Wright et al. 2012). The effects in the model are indicated by the coefficients shown in Table 7 and Figure 2 whose significance was estimated using the bootstrap technique with 5,000 subsamples, with replacement (Hair et al. 2014). Table 7 shows direct and indirect effects while Figure 2 shows path coefficients (direct effects) and the respective level of significance. Analysis results show substantial predictive accuracy for Relational Governance, and moderate predictive accuracy for Supplier's Behavior and Expectation of Success and weak predictive accuracy for Structure of Incentives. Activity Complexity has a negative influence on preventive Structure of Incentives (-0.46, p<0.001), indicating, by contrast, that contracts in which the activity is seen as more complex are associated with promotional contractual structures. In turn, the complexity of the activity shows a positive relationship with the level of Relational Governance (+0.51, p<0.001), indicating that the more complex is the activity, the more intense is the need for communication, interaction and collaboration to conduct the contract. Besides, Activity Complexity presents a mediated effect on supplier s behavior (+0.38, p<0.01), which means that activities considered more complex involve supplier s more flexible, creative and cooperative behavior. This behavior is stimulated by higher levels of relational governance (+0.42, p<0.001) accompanied by minor intensity of preventive structure of contractual incentives (-0.22, p<0.05). The preventive structure of contractual incentives also reduces the intensity of relational governance (-0.32, p<0.001), which means that the more the contract is formalized in order to specify the desired action and restrict the supplier s autonomy, the lower is the need for relational governance. The expectation of the contracting party about the successful management of the contract is greater in the case in which the supplier's behavior is more flexible, creative and collaborative (+0.25, p<0.01). Equally, higher levels of intensity of relational governance are associated with higher levels of expectation of success by the contracting party (+0.31, p<0.01). Furthermore, the activities that are considered more complex are seen by the contracting parties as involved in contracts with the greatest potential for success shows a moderate mediated effect (+0.34, p<0.01). Relational Structure of Expectation Supplier s behavior governance Incentives of success direct mediated direct mediated direct mediated Activity complexity 0.51*** 0.15*** -0.46*** 0.38** 0.34** Supplier s behavior 0.18* Relational governance 0.42*** 0.31** 0.08** Structure of incentives -0.32*** -0.22* -0.13** -0.16ns -0.16** Coefficient of 50.6 % 21.5 % 32.5 % 29.7 % determination (R 2 ) Table 7 Total Effects on the Structural Model and Significances (1) (*) p< 0.05; (**) p< 0.01; (***) p< 0.001; (ns) not significant (2) Bootstrap estimation with 5,000 subsamples, with replacement (1) (2) The complexity of the task and preventive structure of contractual incentives are good predictors of the intensity of relational governance, with explanatory power of 50.6%, whereas the supplier's behavior may be explained in 32.5% of the variability of the intensity of the effects of the relational governance and of the preventive structure of contractual incentives. In turn, the preventive structure of contractual 12 Thirty Fifth International Conference on Information Systems, Auckland 2014

13 Short Title up to 8 words incentives may be explained by 21.5% of its variability while the expectation of success, 29.7%. Figure 2 illustrates the main effects in the model. Figure 2 Figure 2 - Results of the Analysis (*) p< 0.05; (**) p< 0.01; (***) p< 0.001; (ns) not significant Discussion and theoretical implications Of all hypotheses, eleven of them were supported, and just one was not. The results of the study show support for hypotheses H1a and H1b, meaning that the more complex the activities that are outsourced, the less preventive is the structure of incentives, while the less complex contracts tend to have a preventive structure of contractual incentives. This result conforms to the Weber and Mayer s theoretical proposition, in which complex activities are characterized as situations which are difficult to be anticipated and for this reason, they are seen as riskier by the agents, requiring the buyer to create the conditions so that the supplier is motivated to engage in the relationship. This is done through incentives that align the behaviors. In turn, less complex activities are more predictable, and therefore are seen as less risky, being susceptible to being incorporated into formal contractual structures that effectively govern the relationship. As the formal structure has a lower cost of being conducted, the contracting party tends to opt for a preventive structure of contractual incentives to signal the desired behaviors. Similarly, hypothesis H2 was supported by the results. Although complexity can be seen as enhancing the difficulty of making outsourcing decisions, there are not known works in which complexity effects have been analyzed simultaneously in a nomological network structure involving structures of formal contractual incentives and relational governance. In this context, facing a condition in which there is greater complexity in the contracted activity, the buyer will tend to govern the relationship through greater communication, interaction and collaboration with the supplier. The mechanisms of relational governance create the conditions to have the contingencies supplanted, replacing the contractual formalization. Conversely, activities considered simple make contingencies predictable, and thus are easily incorporated in contractual clauses, making relational governance unnecessary. The structure of contractual incentives and relational governance are substitutes, according to the survey results, which introduces support for both hypotheses, H3a and H3b. Previous research works have reported mixed results indicating that the contractual formalization is complementary to relational Thirty Fifth International Conference on Information Systems, Auckland

14 IS Governance governance, substitute, and both. From the buyer s perspective, there are different forms of control over the progress of activities. It is possible to opt for either formalization of contractual clauses, when the activity is simple or relational mechanisms, when with higher complexity of the activity, or by combinations of both. Additionally, it was observed that in cases where the costs of implementing contracts were considered high, which usually happened within small and less structured organizations, they adopted standard contracts, a one-size-fits- all approach, apparently due to the aversion of risking a relationship without any formal basis. The data also provided support to hypotheses H4a and H4B, indicating that the structure of contractual incentives put into practice by the buyer has an effect on the supplier s behavior in terms of flexibility, creativity and collaboration. Although preventive structure of contractual incentives can be seen as desirable to formalize the relationship and clearly signal the desired behavior, it may have a negative effect if contingencies occur that could lead to the need for adaptations and flexibility. Confirming Weber and Mayer s proposition, a preventive contractual structure of incentives tends to raise the supplier perception of risk and consequently induces a defensive position and a vigilant behavior in reaction to signs that buyer emits while including penalties through contractual clauses. Likewise, a promotional structure of contractual incentives signals that the contracting party intends to adopt a collaborative attitude in which occasional contingencies will not become losses for the supplier. This stimulates the supplier to a lower perception of risk that leads to a more cooperative, creative and flexible attitude. The relational governance also has the property of reducing the contracting party s perception of risk. Thus, the intensity of interaction, communication and collaboration with which the contracting party governs the relationship shows to the supplier that there are established and legitimate channels for renegotiations, in the case any occasional situations of loss due to the occurrence of unpredicted contingencies. This is the argument that provides support found in hypothesis H5. The results also support hypotheses H6a and H6b. Higher levels of intensity of relational governance are associated with higher expectations of success by the contracting party. Higher levels of relational intensity are associated with greater communication and interaction, which are necessary to reduce the buyers' perception of risk in the course of the contract. The reduction of the perception of risk makes more modest results to be admissible as matrix of payments, which increases the expectation of success. In contrast, a low level of relational intensity, under a rational choice premise, corresponds to a predictable structure of contractual incentives whose rewards, if successful, are taken as certain. If this gain does not occur in an asymmetric matrix of gain, which is taken as almost certain, the associated falls in the region of losses, which results in high negative emotional loads. When the buyer has a perception of gain in an asymmetric matrix in which gaining is considered unlikely, the expectation of success is greater than the one in the domain of losses, resulting in higher positive emotional loadings. The score indicating that the promotional structure of incentives has a greater perception of success than contracts with preventative structures was not significant. This shows no support for the hypothesis H7. According to Weber and Mayer, as promotional structure of incentives is associated with the most challenging situations, it should present superior expectation of success. However, the results did not clearly indicate support for this proposition. Finally, the results support hypothesis H8, indicating that the more creative, cooperative and flexible is the supplier s behavior, the greater is the expectation of success in the view of the buyer. Practical implications With this study, both buyers and suppliers of IT services can find support to better structure their relationships to reduce the problems that can arise from the incompleteness of contracts. Depending on the complexity of the outsourced service, agents can properly choose different structures of incentives in contracts and choose to operate with the appropriate level of relational governance, in a way to maximize 14 Thirty Fifth International Conference on Information Systems, Auckland 2014

15 Short Title up to 8 words the chance of success in the relationship. Besides, the level of governance adequately defined may induce the supplier s behaviors during the contract period in the desired way, with a positive effect on the expectation of success. It is also possible to develop less incomplete contracts, reducing possible damages to agents. Additionally, for companies that provide IT services, understanding the buyers' visions towards contracts of outsourcing may be useful to improve their business strategies. Limitations and suggestions for future research The present study has limitations regarding the size of the sample, primarily due to the difficulty in obtaining data in Brazil. A possible extension of this study could be collect data in a different cultural context to assess how those aspects are seen, such as the formalization of contracts and relational governance. For example, the perception that Brazilians tend to first consider the informality of relationships, even in the corporate context, is rather folkloric, but may have influenced the results. Similarly, increasing the number of respondents can also contribute to make the results more robust, even in the Brazilian context. Some variables were operationalized dichotomously, making us believe that the model can extend its explanatory power if these constructs are operationalized through continuous scales. Another limitation is associated with the possible generalization from this study, since the non-probability sampling limits the ability to extrapolate the study itself. Other possibilities for future studies involve: the analysis of the suppliers vision; carrying out studies segmented per region or per particular business sector; or even focus on the research of certain types of outsourced services. References Carson, S.J., Madhok, A., and Wu, T "Uncertainty, Opportunism, and Governance: The Effects of Volatility and Ambiguity on Formal and Relational Contracting," Academy of Management Journal (49:5), pp Cenfetelli, R.T., and Bassellier, G "Interpretation of Formative Measurement in Information Systems Research," MIS Quarterly (33:4), pp Diamantopoulos, A "Incorporating Formative Measures into Covariance-Based Structural Equation Models," MIS Quarterly (35:2), pp. 335-A335. Faul, F., Erdfelder, E., Buchner, A., and Lang, A.-G "Statistical power analyses using GPower 3.1: Tests for correlation and regression analyses," Behavior Research Methods (41:4), pp Fornell, C., and Larcker, D.F "Evaluating Structural Equation Models with Unobservable Variables and Measurement Error," Journal of Marketing Research (18:1), pp Goo, J., Kishore, R., and Rao, H.R "The Role of Service Level Agreements in Relational Management of Information Technology Outsourcing: An Empirical Study," MIS Quarterly (33:1), pp Gopal, A., and Koka, B.R "The Asymmetric Benefits of Relational Flexibility: Evidence from Software Development Outsourcing," MIS Quarterly (36:2), pp Griffiths, P.D.R., and Remenyi, D "The burning question in ICT: What and how should we outsource?," in Outsourcing de TI: Impactos, dilemas, discussões e casos reais, A.L. Albertin and O.P. Sanchez (eds.). Brazil: Editora FGV, pp Grissom, R.J., and Kim, J.J Effect sizes for research: Univariate and multivariate applications (2nd ed.). New York: Routledge. Gulati, R "Does Familiarity Breed Trust? The Implications of Repeated Ties for Contractual Choices in Alliances," Academy of Management Journal (38:1), pp Hair, J.F., Hult, G.T.M., Ringle, C.M., and Sarstedt, M A Primer on Partial Least Squares Structural Equation Modeling (PLS-SEM). Thousand Oaks, California: Sage. Hair, J.F., Ringle, C.M., and Sarstedt, M "PLS-SEM: Indeed a Silver Bullet," Journal of Marketing Theory and Practice (19:2), pp Higgins, E.T "Promotion and Prevention Regulatory Focus as a motivational principle," Advances in Experimental Social Psychology (30), pp Thirty Fifth International Conference on Information Systems, Auckland

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