Sandra Slaughter Donald E. Harter Soon Ang Jonathan Whitaker

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Contract Choice and Product Quality Outcomes in Outsourcing: Empirical Evidence from Software Development. Sandra Slaughter Donald E. Harter Soon Ang Jonathan Whitaker. Software Quality. Problem - PowerPoint PPT Presentation

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  • Contract Choice and Product Quality Outcomes in Outsourcing:Empirical Evidence from Software DevelopmentSandra SlaughterDonald E. HarterSoon AngJonathan Whitaker

    American University

  • Software QualityProblemIn April, a software glitch resulted in the loss of thousands of dollars for US Airways Group Inc. when some tickets were mistakenly priced at $1.86. (ComputerWorld 7/25/05)A software bug apparently caused the largest power outage in North America, the Northeast blackout of August 2003, which threw millions of people into darkness (ComputerWorld 7/25/05)Flawed software cost the U.S. economy $60 billion in 2002 (NIST 2002)

    American University

  • Research MotivationSolutionsProcess maturity is key to higher quality, lower costs, shorter development timeHarter, Krishnan, Slaughter, Management Science 2000

    Questions remain:How to encourage higher quality?

    Research questionCan contract selection be a vehicle to encourage software quality?If so, what factors drive contract selection?

    American University

  • Contract SelectionContract theory & agency theoryChoice of contract structure is crucial to ensure that agents goals are aligned with principal (Crocker & Reynolds, 1993; Grossman & Hart, 1983; Milgrom & Roberts, 1992)Issues:Hidden information leads to adverse selectionInformation asymmetry leads to moral hazardType of contract can serve as an effective governance mechanism

    American University

  • Information AsymmetrySources of information asymmetryuncertainty in product specifications and uncertainty about the vendors ability to develop quality productsArtz and Norman 2002Stump and Heide 1996Kalnins and Mayer 2004High uncertainty increases costs of writing specific contract terms

    American University

  • Research ModelContract ChoiceTime & Material, Hybrid, Fixed PriceUncertainty of Product Specifications:Uncertainty of Vendor Quality:Verification &Validation QualityH1, H2H3, H4H5a, H5b

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  • Product UncertaintyIssuesClient requirements can be ambiguous (Nidumolu 1995)Software products are innovations and innovations embody uncertainties (Ang & Beath 1993)Software development is frequently exploratory (MacCormack 2001)Client understanding is evolutionary (Richmond 1992)HypothesisH1: Time & Materials contracts more likely when specification uncertainty is high

    American University

  • Product ComplexityIssuesComplex designs are more difficult to develop (Brooks 1995)Effort required for testing complex designs is highly variable (Banker 2002)Higher software complexity increases technical risk (Barki 1993)Development cost estimation is more uncertainHypothesisH2: Time & Materials contracts more likely when design complexity is high

    American University

  • Vendor UncertaintyIssuesInability to determine vendor quality can create problems of adverse selection and moral hazard (Artz & Norman 2002)Repeated interaction and long-term relationships mitigate adverse selection and moral hazard (Baker 1994)Repeated transactions provide incentives that decrease likelihood of opportunism (MacNeil 1978; Granovetter 1985)Corts & Singh (2004)Repeated interactions reduce contracting costs, leading to fixed priceInteraction reduces opportunism, leading to time & materialVariance of these costs affects contract choice (Kalnins & Mayer 2004)HypothesisH3: Hybrid contracts more likely when contracting experience between vendor and client is low

    American University

  • Vendor UncertaintyIssuesAdverse selection can be addressed using signals designed to reveal private information (Milgrom & Roberts 1992; Mishra 1998)Qualification process can identify vendors with necessary skills (Stump & Heide 1996)Process maturity can be used to signal quality (Arora & Asundi 1999)HypothesisH4: Fixed price contracts more likely when software process maturity is high

    American University

  • Effect of Contract Choiceon Quality OutcomesIssuesOpportunity for ex post opportunism by both parties (Williamson 1979)Vendor has financial incentive to freeze the specification in fixed price contractIncentives are to develop the software right the first time, according to the specificationClients may change are articulate new requirements as they discover what they truly needVendor profits from new requirements under Time & Materials, and may accommodate clients requirementsHypothesesH5a: Fixed price contracts have higher development and production verification qualityH5b: Time & Materials contracts have higher acceptance validation quality

    American University

  • Research Site &Data CollectionData collected on software projects developed from 1987 to 200478 contracts were negotiated26 time and material38 fixed price14 hybrid

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  • Contract TypesTime & MaterialVendor reimbursed through hourly rateTechnical and financial risks on clientFixed PriceVendor agrees to fixed contract valueTechnical and financial risks on vendorCostly to negotiate requires detailed specifications ex anteHybridAgreement on cost estimate, but client pays all costs; profit based on initial estimate and performanceFinancial risk primarily on client

    American University

  • MeasuresContract choiceCategorical variables1-T&M, 2-hybrid, 3-Fixed priceQualityVerification (development & production) technical issues of whether the software has been developed correctly and performs correctlyValidation (acceptance) whether the right software has been developed that satisfies the usersAntecedents of contract choiceSpecification uncertaintyDesign complexityPrior contracting experienceSoftware process maturityControlsProduct size

    American University

  • Regression Models: ChoiceStage 1: Contract Choicemultinomial regression using Newton-Raphson maximum likelihood estimationProb(yi=j) = e jXi / e kXiCorrectionsNon-independence of disturbances across different contract segmentsHuber (1967)/White (1982) sandwich estimatorResultsAntecedents significant in predicting choice (p
  • Uncertainty & ComplexityLikelihood of Contract ChoiceGiven Levels of Specification UncertaintyLikelihood of Contract ChoiceGiven Levels of Design Complexity

    American University

  • Hypotheses SummaryH1: Time & Materials preferred over fixed price for higher levels of specification uncertainty66% likelihood for high specification uncertainty10% likelihood for low specification uncertaintyH2: Time & Materials preferred over fixed price and hybrid when there is higher design complexity71% likelihood for high design complexity8% likelihood for low design complexity

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  • Experience & ProcessLikelihood of Contract ChoiceGiven Levels of Prior Contracting ExperienceLikelihood of Contract ChoiceGiven Levels of Software Process Maturity

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  • Hypotheses SummaryH3: hybrid contracts preferred over fixed price when prior contracting experience is lower84% likelihood of hybrid for low experience88% likelihood of fixed price for high experienceH4: fixed price preferred for higher levels of process maturity

    American University

  • Regression Models: QualityStage 2: Quality Outcomes of Contract ChoiceMultivariate general linear modeling (GLM)Two-step multinomial selection bias correction method of Lee (1983)ModelsDevelopment Verification Quality = f(Contract-Choice, Specification-Uncertainty, Design-Complexity, Prior-Contracting-Experience, Software-Process-Maturity, Product-Size)

    Production Verification Quality = f(Contract-Choice, Specification-Uncertainty, Design-Complexity, Prior-Contracting-Experience, Software-Process-Maturity, Product-Size)

    Acceptance Validation Quality = f(Contract-Choice, Specification-Uncertainty, Design-Complexity, Prior-Contracting-Experience, Software-Process-Maturity, Product-Size)ResultsHotellings T2 test of contract choice significant (p

  • Quality Outcomes

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  • DiscussionInformation asymmetry arising from product uncertainties (specification uncertainty and design complexity) shifts contract choice to Time & MaterialUncertainty of vendor quality is a strong motivator of contract choiceVendor quality (30.2%) explains eight times the variance of product uncertainty (3.7%)

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  • DiscussionPrior contracting experience is a critical mitigator of information asymmetryHybrid contracts more likely when experience between client and vendor is lowReducing contracting and shirking costsVendor quality certification explains highest variance in contract choice (20%)Quality certification engenders greater confidence in the vendors abilities to estimate and deliver software products to specifications

    American University

  • Thank You!Questions?

    American University