Strategic Outsourcing Contract Participation and Selection under Cost Uncertainty

Motivated by widespread outsourcing practices, this paper studies how a pre-outsourcing client facing uncertain operating costs selects an outsourcing contract between two contract types (the fixed-price contract and the cost-plus contract) proposed by two vendors, who offer contracts only if the expected profits of the contracts satisfy their reservation values. We propose a real options model to determine the optimal policy structure from both the client’s and the vendors’ perspectives, and we investigate comparative statics of the client’s or vendors’ optimal policy with respect to key system inputs. Our results help managers gain a better understanding of the closely intertwined relationship between the client’s contract selection policy and the vendors’ contract participation policies.