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This study provides evidence on the determinants of contract terms between professional services firms and their clients. Because professional services are typically characterized by a high degree of transactional uncertainty and a double moral hazard risk, contracts can be essential for the creation of incentives to control the behavior of those involved in the service encounter. Based on both agency and organizational theory, hypotheses on the determinants of implementing a specific type of cost contract are developed and tested empirically with respect to management consulting firms. Our results indicate that (1) service characteristics exert a significant impact on the chosen contract type, (2) performance-based contracts may not be optimal, even if service output is measurable and verifiable, and (3) experience-based trust and reputation impact on the choice of controls used in short-term contracts. These results contribute to the field of management accounting by providing insights into the design of management control systems in service organizations.

Because co-production by service employees and clients is at the heart of many services (Larsson and Bowen, 1989 and Solomon et al., 1985), clients themselves often exert a considerable impact on both the cost of the service process and its output (Glückler and Armbrüster, 2003, p. 277). Despite this insight, there is little research on how service organizations actually design management control systems to govern transactions at the organization–client interface (Chenhall, 2003, Hopwood, 1996, Modell, 1996, Otley, 1994 and Shields, 1997). In this paper, we focus on professional services, in particular management consulting services, and examine the determinants of contract terms between management consulting firms and their clients. Contracts are formal mechanisms of management control (Anderson and Dekker, 2005 and Kirsch et al., 2002) and the analysis of contract terms yields insights into how transactions between both contracting parties are governed. Contractual relationships between management consulting firms and their clients have several relevant and important characteristics. First, consulting services are often complex and involve a high level of both transactional uncertainty and risk for the client, as he does not purchase a ready-made product (Glückler and Armbrüster, 2003, p. 269; Mitchell, 1994). Second, because of the interdependent and interactive character of co-production between consultants and clients in service delivery, both contracting parties can behave opportunistically, which results in a double moral hazard risk that needs to be considered in the design of a contract. Third, these contractual relationships are generally rather short-term in nature. It has been established that, in long-term inter-organizational relationships such as international joint-ventures (Groot and Merchant, 2000), outsourcing relationships (Anderson et al., 2000, Langfield-Smith and Smith, 2003 and Van der Meer-Kooistra and Vosselman, 2000), strategic alliances (Dekker, 2004) and integrative buyer–supplier arrangements (Frances and Garnsey, 1996), the social context, i.e., trust and reputation, in which these business exchanges are embedded, is highly relevant as a means of mitigating potential opportunistic behavior. However, little is known on whether this effect is also relevant to short-term inter-organizational relationships, such as those between service organizations and their clients. In addition to defining the agreed-upon service, contracts also specify the monetary terms of the contract, that is, how the management consulting firm is to be remunerated. Contracts can be classified into two broad types, according to whether the remuneration of the consulting firm and therefore the cost to the client receiving the service, depend on the realized service output or not. Under a fixed-cost contract, the remuneration of the management consulting firm is invariant with regard to the realized service output, while under a variable-cost (performance-based) contract, it is contingent on the realized service output. The literature usually differentiates between two types of controls that can be used to direct the behavior of a contracting party: behavior-based and outcome-based controls (Eisenhardt, 1985 and Ouchi, 1979). Following Eisenhardt, we operationalize a control strategy based on the monetary terms in the contract, that is fixed-cost contracts are a form of behavior-based control, while variable-cost (performance-based) contracts constitute outcome-based control (Eisenhardt, 1985, p. 144). The purpose of this paper is to add to the limited body of knowledge on the design of management control systems in service organizations. Based on both agency and organizational theory, hypotheses on the determinants of implementing a specific type of cost contract are developed and tested empirically in the context of management consulting. This paper contributes to management accounting in several ways. First, we present empirical evidence with regard to the circumstances under which service companies use behavior- and outcome-based controls to govern transactions at the organization–client interface. Second, our results indicate that both the characteristics of the service and the characteristics of the contracting relationship exert a significant impact on the chosen contract type. This indicates that trust and reputation can be effective in the provision of incentives and the mitigation of moral hazard risks also in contractual relationships that are short-term in nature. Third, the paper provides evidence that in contracting situations characterized by a double moral hazard risk it might be, under specific conditions, optimal not to tie the remuneration of a service provider to actual performance. This adds to our knowledge of the cybernetic process of monitoring and rewarding performance in inter-organizational relationships. The remainder of the paper is organized as follows. In Section 2, the contracting problems specific to professional services are discussed with reference to management consulting. In Section 3, hypotheses on the determinants of implementing a specific type of cost contract in the presence of double moral hazard are developed, and tested empirically in Section 4. Section 5 concludes the study with a discussion of the results.

This study sought to develop a better understanding of the determinants of contract terms between professional services firms and their clients. The intention was to better understand the control mechanisms used to manage short-term inter-organizational exchanges characterized by a high level of transactional uncertainty and a double moral hazard risk. While we took care to address methodological concerns, several limitations of the study should be noted when considering the empirical evidence presented here. As with all cross-sectional surveys, the results do not constitute proof of the relationships. Rather, the evidence presented can only be said to be consistent with the theoretical position developed in the paper. The major problem is the low response rate which limits the generalization of our findings to larger populations of professional services firms. While a test for non-response bias did not indicate any problems, a higher response rate could yield more generalizable findings. Notwithstanding these limitations, the study does provide some useful empirical insights into formal controls used by service companies to govern transactions at the organization–customer interface. First, the empirical data indicate that service characteristics exert a significant impact on the chosen contract type. Consistent with prior empirical results, the use of outcome-based controls (i.e., variable-cost (performance-based) contracts) is positively related to services for which the output can be measured and verified, while the use of behavior-based controls (i.e., fixed-cost contracts) is positively related to the verifiability of service provider behavior (Eisenhardt, 1985 and Kirsch et al., 2002). The use of fixed-cost contracts that are time and materials-based, which can be considered a mix between behavior-based and outcome-based controls is positively related to services that are characterized by a high level of integrativity. This contract type has the advantage for clients of providing them with a high degree of flexibility in their decision on whether to continue an ongoing project or not. Management consulting firms therefore have an incentive to choose a high level of effort even in situations where neither their behavior nor the service output is verifiable, in order to avoid risking a project being terminated, because a customer feels he is not being treated professionally and appropriately. Second, variable-cost (performance-based) contracts might not be optimal, despite the verifiability of service output. For professional services characterized by a high level of integrativity, fixed-cost contracts can provide stronger incentives to all contracting parties than variable-cost (performance-based) contracts. The reason is that output sharing can weaken the incentives for all contracting parties, which can be circumvented, provided that the expected utility of future client relationships is high enough to prevent the service provider from engaging in opportunistic behavior. Finally, the results indicate that trust and reputation have an impact on the choice of controls used in short-term contracts. As markets and contractual relationships are usually not temporally limited nor anonymous, both contracting parties need to take into account that opportunism often only pays off in the short-term. This offers the possibility to control the behavior of those involved in the service encounter, despite difficulties in the verifiability of both effort and service output. Provided that a management consultancy wishes to remain in the market over the long-term, the prospects of either obtaining future assignments from an existing client or having valuable references for the acquisition of new clients can mitigate potential opportunistic behavior on their side. Behavioral controls can therefore also be applied effectively in situations where behavior is observable, but not verifiable. Our results contribute to the field of management accounting by providing insights on control mechanisms used to manage inter-organizational exchanges, in particular for service companies. Management accounting research on service organizations often focuses on measuring the service output in order to increase the efficiency of service encounters. This study indicates, however, that it might be as beneficial for both service organization and client to raise the level of transparency of the service process and, thereby, the observability (not necessarily the verifiability) of the behavior of the contracting parties. This is particularly true for services characterized by a high integrativity level and for contractual relationships characterized by a high expected utility of future client relationships. Various measures in the area of project management can be applied to achieve this. Examples are regular steering committee meetings or, for the client, the staffing of experienced client employees in a project team. It is important to note, however, that it cannot be concluded from the results, that the implementation of fixed-cost contracts that are independent of performance makes it unnecessary or even harmful for clients or consulting firms to measure and evaluate the service output. The service output should still be measured, but it may be ill-advised to attempt to provide an incentive to the service provider by making his remuneration contingent on this output.