Outsourcing Contracts and Equity Prices

We investigate the impact of outsourcing on the long-term market performance of the firm. Outsourcing initiatives vary in terms of uncertainty in business requirements, complexity of coordination between the outsourcing firm and provider, and the consequent choice of the governing contract (fixed or variable price). Using theories from institutional economics, strategy, and information systems, we argue that firms pursuing large-scale, fixed price outsourcing, which are characterized by lower business uncertainty and simpler coordination requirements, will realize higher market returns relative to similar firms in the same industry who did not outsource. In contrast, variable price contracts that proxy for higher business uncertainty and coordination complexity may have a higher risk of failure and loss of shareholder value; however, prior outsourcing experience and prior association with the vendor may reduce uncertainty in the outsourcing relationship to help the outsourcing firm better manage challenges associated with complex, variable price engagements. We posit that financial markets are either not privy to or unlikely to accurately interpret such intangible information on the antecedents of outsourcing success during the announcement period. The delay in incorporation of this information in market prices results in positive long-term abnormal returns to fixed price contracts. Variable price contracts characterized by prior association between participant firms and greater outsourcing experience also realize positive long-term abnormal returns. Data on the hundred largest outsourcing initiatives implemented between 1996 and 2005 strongly support our hypotheses. The results imply that firms who retain simple functions and tasks in-house as well as those who outsource complex functions without pertinent experience or association with the vendor experience significant loss of shareholder value.