Outsourcing Contracts in Service Industries

Once limited to the purchase of simple commodity parts, now outsourced components represent more than half the cost of some automobiles. Most recently, outsourcing has made the leap from manufacturing into service industries such as call centers and order fulfillment operations. However, service firms present a different set of challenges for outsourcing clients and providers: whereas manufacturers contract for specific numbers of outsourced components, service firms and the outsourcers they engage must deal with uncertainties in their contract negotiations. Although neither party knows the volume of work the contract will entail, the service provider must invest in personnel and working space before the contract starts.

A study by Martin Lariviere and Barış Ata, respectively professor and associate professor of managerial economics and decision sciences at the Kellogg School of Management, provides a possible solution to that problem. They conclude that a two-part tariff, in which clients pay a fixed fee up front and a constant price per unit of service, represents the most effective pricing scheme for access services. “The main message of our model is that some fairly simple contracts are very effective in assuring efficient outcomes when a service provider contracts with a client, even if the client has better information,” Lariviere says. “That such simple contracts work well is rather surprising.”

Lariviere, Ata, and Mustafa Akan of Carnegie Mellon University’s Tepper School of Business, who contributed to the project when a PhD candidate at Kellogg, summarize their conclusion in the paper reporting their study: “Adopting a mechanism design approach, we prove that a menu of two-part tariffs achieves the full-information solution.”

Different Types of Outsourcing
The study reflects the fact that the process of outsourcing services differs from outsourcing physical goods in two particular ways. “With services it is natural to consider rapid adjustments to capacity,” Lariviere says. “Call centers adjust their staffing levels on a much more frequent time scale than a buyer chooses a new call center partner. That puts an emphasis on having the supplier act on the observed arrival rate as opposed to just the average arrival rate forecast. That is one of the features that drives the results of the paper.

“A second consideration is that service processes naturally exhibit economies of scale,” he continues. “For a desired service level it is cheaper on a per-transaction basis to provide that service if the arrival rate is high. That is a basic feature that we emphasize. Most of the work on supply chain contracting assumes linear costs, so if the manufacturer produces twice as much, it costs twice as much. Here, if the demand rate is twice as high costs will not double, assuming that the same service level is targeted.”

The researchers began by modeling call centers, a particular interest of Ata’s. But to make their model more general, they then expanded the study to include fulfillment centers. In both cases the possible fee structures included hourly charges based on the number of agents working on a contract, per-minute fees whenever a provider interacted with a client, and charges per interaction.

The Key Issue
The key issue in negotiating service contracts stems from an asymmetry in information between the client and the service provider. “At a basic level, this means the firm that will buy the service—the originator—knows a piece of information that would be useful to the service provider,” Lariviere explains. “What makes this interesting is that if the service provider could easily see the originator’s information it would treat the originator in a particular way. The important part is that an originator with low demand would benefit from being taken for one with high demand. The challenge for the service provider, then, is to come up with a way to tell different kinds of originators apart.”

To set up its model of service outsourcing, the team used a mechanism design approach. This standard analytical framework indicates how a decision maker sets the rules for the way in which any particular transaction, such as a contract between client and provider, will take place. “We assumed that the service provider gets to set the rules,” Lariviere explains. “This presupposes that the service provider is in some sense in a stronger position than the originator.”

The model yielded a definitive result. “Our analysis validates the use of two-part tariffs and proposes that any new such contracts between the call center and inventory managers should take these forms,” the researchers write. “They can achieve perfect price discrimination by simply offering the originator the choice to select his payment from a menu that consists of bundles of fixed payments and linear payment schedules.”

Two Surprises
The result surprised the team in two ways. First, it is remarkably simple. “The best mechanism is often relatively complicated,” Lariviere notes. In addition, the model shows that the two-part tariff solution negates the asymmetry between client and service provider. Both call centers and fulfillment operations obtain the same service they would have received if their service providers had had access to the clients’ private information.

Lariviere notes that the study is strictly a theoretical exercise. However, he sees practical indications that confirm its validity. “A lot of firms running call centers that serve primarily small businesses have pricing per minute like cell phone services; you’ll pay a lower permanent rate and lower penalty rate the more minutes you sign up for,” he explains.

“That starts to look very much like the contract that we propose. Clients expecting low demand commit to fewer minutes per month and have a relatively high per-minute charge. Clients expecting a lot of demand, on the other hand, commit to a larger number of minutes per month and thus pay a large amount up front.”

“Small firms benefit for outsourcing services that have economies of scale,” Lariviere summarizes. “Working with relatively simple contracts is very effective from the perspective of the outsourcer. You can tell the high- and low-volume clients; you don’t need to leave a lot of money on the table.”

Related reading on Kellogg Insight

Firm Size and Service Level: When is it advantageous for a service-oriented firm to differentiate itself along service quality dimensions?

Supply Chain Coordination with Revenue-Sharing Contracts: A missed opportunity?