Uncertainty and Compensation Design in Strategic Inter-Firm Contracts

Posted: 24 Jun 2019

See all articles by Ranjani Krishnan

Ranjani Krishnan

Michigan State University - Department of Accounting & Information Systems

Deepa Mani

Indian School of Business (ISB), Hyderabad

Date Written: February 5, 2019

Abstract

In strategic outsourcing contracts, a substantial portion of implementation occurs at the client’s premises and requires integration of effort between the vendor and the client. Compensation design in such contracts involves trade-offs between the higher (lower) incentive properties of fixed-price (cost-plus) contracts and their higher (lower) ex ante contracting and ex post adaptation costs. Uncertainty influences these trade-offs and affects compensation design. We explore the compensation implications of two types of uncertainty—volatility and ambiguity—which are reflected in the client’s accounting measures. Volatility reflects the unpredictability of changes in the future environment, which makes it difficult to contractually specify future contingencies. Ambiguity reflects lack of consensus about the nature, drivers, and value effects of uncertainty, which makes it difficult to contractually specify responses to contingencies if and when they occur. Volatility increases the likelihood of ex post adaptation costs while ambiguity increases ex ante contracting costs; therefore, volatility and ambiguity decrease the attractiveness of FP contracts. We use accounting and market measures to calibrate volatility and ambiguity and examine their implications for compensation design and ex post renegotiation. Analysis of archival data for 455 strategic outsourcing contracts valued over $15 million indicates that volatility and ambiguity influence contract compensation design and renegotiation likelihood. These results hold even after controlling for asset specificity, task complexity, and relational factors. We conclude that accounting measures can provide signals of volatility and ambiguity and thereby influence compensation design in strategic inter-firm contracts.

Keywords: uncertainty, outsourcing, transaction cost economics

Suggested Citation

Krishnan, Ranjani and Mani, Deepa, Uncertainty and Compensation Design in Strategic Inter-Firm Contracts (February 5, 2019). Contemporary Accounting Research, Forthcoming, Indian School of Business, Available at SSRN: https://ssrn.com/abstract=3406044

Ranjani Krishnan (Contact Author)

Michigan State University - Department of Accounting & Information Systems ( email )

270 North Business Complex
East Lansing, MI 48824-1034
United States
517-353-4687 (Phone)
517-432-1101 (Fax)

Deepa Mani

Indian School of Business (ISB), Hyderabad ( email )

Hyderabad, Gachibowli 500 019
India

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Abstract Views
572
PlumX Metrics