Agency theory

Focus, aim, unit of analysis. Agency theory has broadened the risk-sharing literature to include the agency problem that occurs when cooperating parties have different goals and division of labor. The cooperating parties are en-gaged in an agency relationship defined as a contract under which one or more persons (the principal(s)) engage another person (agent) to perform some service on their behalf which involves delegating some decision mak-ing authority to the agent (Jensen & Mecklmak-ing, 1976). Agency theory de-scribes the relationship between the two parties using the metaphor of a con-tract. In an IT outsourcing relationship this is a client-vendor relationship and an outsourcing contract.

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According to Eisenhardt (1985), agency theory is concerned with resolving two problems that can occur in agency relationships. The first is the agency problem that arises when the desires or goals of the principal and agent con-flict and it is difficult or expensive for the principal to verify what the agent is actually doing. The second is the problem of risk sharing that arises when the principal and agent have different risk preferences. These problems are well known in IT outsourcing. An example might be that the client organiza-tion wants to reduce its IT costs, while the vendor organizaorganiza-tion wants to maximize profits. The agency problem arises when the two parties do not share productivity gains. The risk-sharing problem might be the result of different attitudes towards the use of new technologies. Because the unit of analysis is the contract governing the relationship between the two parties, the focus of the theory is on determining the most efficient contract govern-ing the principal-agent relationship given assumptions about people (e.g., self-interest, bounded rationality, risk aversion), organizations (e.g., goal conflict of members), and information (e.g., information is a commodity which can be purchased). Thus the question becomes: Is a behavior-oriented contract more efficient than an outcome-oriented contract? Outsourcing con-tracts are to a great extent tied up to service level agreements, where the outcome of the service is the focal point.

The agency theory is applicable when describing client-vendor relationships in IT outsourcing arrangements. Typically, the client organization (principal) transfers property rights to the vendor organization (agent). In the context of IT, assets transferred might be infrastructure, systems and documentation, and employees. For a certain amount of money, the vendor organization provides services to the client organization. This implies a change in legal relationships, and IT services are carried out using a more formal transaction process. The status of personal relationships also changes, from that of a manager and a subordinate, to that of a client-manager and a vendor. Ac-cording to agency theory, control mechanisms also change, from that of be-havioral control, to that of outcome-based control. If both parties to the rela-tionship are trying to maximize their utility, there is good reason to believe that the vendor organization will not always act in the best interests of the client. Monitoring and bonding activities in reducing agency costs include auditing, formal control systems, budget restrictions, and the establishment of incentive compensation systems which serve to more closely identify the manager’s interests with those of the outside equity holder.

Contribution to the understanding of IT outsourcing. The original impetus for the development of agency theory was large corporations' separation of control from ownership. Thus, its focus was never on organizational bounda-ries, as with transaction cost theory. Agency theory's primary interest is not the decision to source via the hierarchy or via the market. Although all

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tractual arrangements contain important elements of agency, agency theory is essentially concerned with the delegation of work by the principal to the agent via a contract, whether or not they are both within the same organiza-tion. However, agency and transaction cost theories share several concepts, such as opportunism, uncertainty and bounded rationality, and there is a rough correspondence between transaction cost economics' hierarchies and markets and agency theory's behavior-based contracts and outcome-based contracts. The technological and business complexity of IT means that there may be a critical success factor for the principal in choosing a suitable agent and in monitoring the agent's work. Only the agent knows how hard he is working, and that can be especially important in multilateral contracting where one agent acts for several principals. This is often the case in IT out-sourcing because of the market dominance of one (or a few) large firm(s).

Given the difficulties of behavior-based contracts suggested by agency the-ory, it is reasonable to assume that the overwhelming majority of clients would insist on outcome-based contracts when acquiring IT products and services. Such a strategy can only succeed if the client can confidently spec-ify current and future requirements. But accurate predictions by the client may not always be in the vendor's interests, since vendor account managers often are rewarded according to contract profitability, which is principally achieved through charging the client extra for anything that is not in the con-tract.

According to Hancox and Hackney (2000), the choice of contract type de-pends on the agency costs, which include the principal's effort in assessing the agent's performance and the agent's efforts in assuring the principal of his commitment. Agency theory holds that human beings act through self-interest and therefore, as contracting parties, they may have divergent goals.

An important aspect of the theory is that both principal and agent wish to avoid risk when dealing with each other. The principal may prefer to place risk with the agent via an outcome-based contract, whereas the agent may prefer to avoid risk by having a behavior-based contract. Outcome-based contracts are claimed to reduce agent opportunism because the rewards of both agent and principal depend on the same actions. Behavior-based con-tracts need the principal to have sufficient information to identify two possi-ble dangers: first, whether there is adverse selection (the agent does not pos-sess the skills he claims); second, moral hazard — the agent is shirking.

Sourcing via the hierarchy may reduce the overall risk, but agency costs also exist in hierarchies. Problems between agents and principals are greater in complex organizations with many managerial layers.

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