Applying the Real Option Approach to Vendor Selection in IT Outsourcing

Information technology (IT) outsourcing is one of the major issues facing organizations in today’s rapidly changing business environment. Due to its very nature of uncertainty, it is critical for companies to manage and mitigate the high risks associated with IT outsourcing practices including the task of vendor selection. In this study, we explore the two-stage vendor selection approach in IT outsourcing using real options analysis. In the first stage, the client engages a vendor for a pilot project and observes the outcome. Using this observation, the client decides either to continue the project to the second stage based upon pre-specified terms or to terminate the project. A case example of outsourcing the development of supply chain management information systems for a logistics firm is also presented in the paper. Our findings suggest that real options analysis is a viable project valuation technique for IT outsourcing. Outsourcing offers a firm flexibility. By purchasing specialized knowledge through outsourcing agreements, firms no longer have to deploy internal resources to solve an array of problems. As circumstances change, firms that outsource have the ability to adjust and pursue different opportunities rapidly. In essence, outsourcing is a real option the firm acquires and exercises as warranted. Information technology is in the forefront of the outsourcing phenomenon. For instance, Lacity and Willcocks report that IT outsourcing contracts alone were expected to reach US$ 156 billion by 2004.3 It is also estimated that more than 50% of companies in the United States outsourced their IT functions in 2006.