Agency Theory

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Contents 1 Agency Theory 2 Goal Congruence 3 Information Asymmetries 4 Agency Theory Overview 5 References

Agency Theory

The third major theory that informs the outsourcing process and arguably the most important extends and is complementary to Williamson’s (1985) ^[1] concept of opportunism we discussed under Transaction Cost Economics is that of Agency Theory. An Agency relation comes into existence when one party engages another party to perform some aspect of work for a consideration and a contractual arrangement is needed to manage the relation between the parties. Overall this is a quite general economic approach and agency theory has been applied to all sorts of economic relations but for this Outsource Wiki the main focus will be the formation of a agency relationship in the context of a client contracting an outsource vendor for the provision of services.

Goal Congruence

Agency Theory (AT) attempts to explain what occurs in the situation when two cooperating parties in a venture share differing objectives and goals. In particular the question arises as to extent that the agent acts to ensure the achievement of the principal’s goals and how the relationship is managed to achieve this. The theory looks at how two key aspects of this type of relationship can be resolved: 1) in what ways the desires or goals of the principal and agent differ and, 2) the difficulty that the principal has in confirming how the agent has performed (Eisenhardt 1989)^[2]

The core idea is that each agent in a relationship has a tendency to place their own interest above that of the joint objectives or task. There is goal incongruence between a vendor of a service and the client such as we see in the purchase and supply of the outsource services. Put simplistically (as an example) the delivery of a service is measured within the vendor organisation based on long term margin evolution whilst the client organisation is more concerned with services delivered at an effective cost thus at a fundamental level the parties seem to pursue different objectives from the same contract. The point of the lack of assurance that the principal’s goals are not maximised is central to the theory as is the differing perspective on risk. Briefly whilst the principal may be more or less neutral to the exchange the Agent on the other hand are assumed to be more risk adverse in its decisions towards the client firm due to the risk to personal wealth (or profit) resulting from the performance of the work.

Indeed as one of the key drivers of the outsourcing decision still tends to be concerned with delivering cost savings as the prime driver this sort of distinction is still very important. The issue as far as managing this situation is in the nature of the measurement problem (verification and information asymmetries) and the differing risk appetites of the parties. What the approach (Agency Theory) is concerned with is the monitoring and control processes that need to be in place, specifically contracting, and searching for the most (cost) efficient mechanisms that can be structured to control the relationship given assumptions about people behaviour (bounded rationality, opportunism etc.) in order to perform to the clients requirement and organisation. It is these two points that we now briefly consider.

Information Asymmetries

Overall one of the core problems for client managers is to overcome the information asymmetries that occur between the actual delivery performance of the vendor and the desired service requirement. For example when delivering software we may assume or even place into the contract that specific control and quality assurance processes need to be in place. What we cannot know is whether the vendor has an appropriate process in place that works or even whether the vendor actually carried out any appropriate QA at all to reduce errors. To some extent all the client has to go on is the delivered software quality and faults that emerge during testing (although as no software QA process is 100% effective it is very difficult to apportion blame) and of course trust. Unless the client actually strictly monitors the software development process remotely and relies on the test and integration test to weed out errors. What these two client side processes do is add cost to the client ex contract as integrated testing processes have to be put into place and the vendor monitored as to their own working processes. Thus typically complex monitoring and checking processes need to be in place that act to increase client side cost ex post and reduce cost benefit of the outsource contract. This second aspect of the management of output can be seen in the creation of detailed evaluation matrices to check work produced or contract clauses such as service credits in an SLA agreement all to ensure service and outcome meet contractual requirement and all adding to post contract cost.

Measurement is a critical characteristic of the principal agent relationship and boils down to the problem of objectively measuring outcomes and agreeing processes that allow the work to continue whilst ensuring performance is monitored and rewards linked to performance. Measurement however key it is actually difficult to arrange and is potentially a source of conflict in the outsourcing relationship and there is some evidence that this in fact occurs at least in the early days of the contract where there are constant discussions over relative cost savings and contractual disputes. These erupt as aspects of the service demanded that are not covered in the contract (say) and extra charges may be challenged and become an area of intense conflict.

If we reflect back on the discussion on contracting outsourcing services and the nature of asset specificity when asset specificity low and the service is broadly generic market based contracts are favoured. And it is relatively easy to specify the requirement as the service outcome is fairly easy to define. As asset specificity rises thus as services become more specific to the relationship then more complex contractual arrangements are required that reflect the greater degree of uncertainty in the service provision and governance. In such circumstances difficulties in measurement of performance and the governance structure emerge. There are mediations that can be put in place to obviate this, for example if visibility of the vendors becomes important collocation or frequent delivery (or shorter project stages) and other close monitoring procedures are to be expected. These aspects, particularly during the early stages of the contract need to be planned in and a cost determined and is another area of ‘hidden’ cost in the outsourcing contract. Overall then returning to the theory the focus in a normative sense for Principals is the creation of a contractual relationship that minimise cost (ex ante and ex post), whilst assuring performance of the agency relationship is optimal.

Agency Theory Overview

Table One - Eisenhardt (1989) page 59

Key idea	• Principal-agent relationships should reflect efficient organization of information and risk-bearing costs
Unit of analysis	• Contract between principal and agent
Human assumptions	• Self-interest • Bounded rationality • Risk aversion
Organizational assumptions	• Partial goal conflict among participants • Efficiency as the effectiveness criterion Information asymmetry between principal and agent
Information assumption	• Information as a purchasable commodity
Contracting problems	• Agency (moral hazard and adverse selection)• Risk sharing
Problem domain	• Relationships in which the principal and agent have partly differing goals and risk preferences (e.g., compensation, regulation, leadership, impression management, whistle-blowing, vertical integration, transfer pricing)

References

1. ↑ Williamson, O., E.,(1985) 'The Economic Institutions of Capitalism', Free Press New York
2. ↑ Eisenhardt, K., M. (1989), Agency Theory: An Assessment and Review, Academy of Management Review, Volume 14 No. 1