Even though many studies have discussed outsourcing contracts from the client’s perspective, little research has been done from the vendor’s perspective. In this paper, we consider a vendor’s outsourcing contract decision-making process, during which the market price and the vendor’s operation cost are uncertain. This paper develops real option models to investigate whether a vendor firm should sign an outsourcing contract from its client or establish a joint venture with this client. Our results show that, while the feasibility of an outsourcing contract to the vendor increases with a higher contract price offered by the client, the feasibility of a joint venture depends on market conditions. We also find that there are loss-by-acceptance regions, in which either an outsourcing or a joint venture contract is currently feasible to start, but a vendor may sustain a loss by accepting such a contract.
Strategic alliance among different firms has been highlighted in both literature and practice. Cooperating with other firms can attain many benefits, such as ease of market access, cost reduction, operational efficiency, capacity pooling and access to external expertise or technology advantages. According to Hamel et al. (1989), even competitive collaboration between competitors can strengthen both firms against outsiders.
Inter-firm collaboration can be contracted in many different forms, such as joint-venture, outsourcing, product licensing and cooperative research. In this research, we are interested in two strategic alliances: outsourcing and joint venture. In an outsourcing contract, a client externalizes its previous in-house operational or technological activities to a vendor and then purchases the outsourcing service from this vendor. For example, to compete against Japanese companies Matsushita, Sanyo and Sharp in 1980s, GE contracted out the production of microwave ovens to Samsung in South Korea because this Korean vendor could perform the manufacturing operations at a lower cost (Domberger, 1998). To form a joint venture, the client and its vendor(s) proportionally share some of their resources, capabilities and profits. For example, US Steel and two Asian vendors, POSCO and SeAH Steel, established a joint venture with shares of 35%, 35% and 30% in 2008.
Thus far, most research has been mainly focused on the client’s side while overlooking the vendor’s standpoint (Levina and Ross, 2003 and Jiang et al., 2008a). Evaluating the feasibility of a contract is challenging for a vendor, because the vendor’s operation cost is not usually constant over the duration of a contract due to fluctuations in the exchange rate, labor wage policy changes and hyperinflation conditions (Austin, 2002, Li and Kouvelis, 1999 and Chopra and Sodhi, 2004). In addition, the market price keeps fluctuating over time. Under such an uncertain environment, different alliance strategies may result in different outputs to a vendor. This article develops valuation models incorporating cost and price uncertainties and compares different contracts from the vendor’s perspective.
This paper provides a model for evaluating an alliance contract under price and cost uncertainties from the vendor’s perspective. Even though many studies on different contracts have been well documented, little attention is paid to the vendor’s concerns. Since the vendor can determine whether or not to accept the client’s offer, it is reasonable to investigate such a managerial flexibility by using the real options theory.
First, we find that to the vendor, if a contract is evaluated by the NPV method, it will be more feasible than that evaluated by the ROT method. Second, our results show that, while the feasibility of a fixed-price outsourcing contract can be improved by increase in the contract price offered by the client, the feasibility of a joint venture contract depends only on market conditions (i.e., the exogenous market price and the vendor’s operation cost). The share ratio between both parties for a joint venture contract affects only how much the contract makes profits. In addition, we reveal that the NPV approach fails to address the relationship between uncertainty and timing decision, while the ROT method can explain such a relationship successfully. Finally, by comparing an outsourcing agreement and a joint venture contract, our real options framework provides two additional strategic scenarios, the outsourcing and the joint venture loss-by-acceptance regions, which cannot be explained by the traditional NPV method. This implies that the NPV method might lead to a wrong contract selection.
