Agency Theory in Outsourcing

Economies of Scale

Since the Industrial Revolution, organizations have been questioning how to leverage their competitive advantage to expand their market share and profitability. The dominant model in the 19th and 20th centuries was the large integrated organization. In the 1950s and 1960s, companies broadened their bases to benefit from economies of scale.

The large integrated organization diversified its product range, and expansions required more management layers. Technological developments, such as the internet, forced organizations in the 1980s and 1990s to compete more globally. They were handicapped by a lack of flexibility due to bloated management structures. To increase agility, many large organizations developed a strategy focused on their core activities and core processes.

Principal-Agent Problem

The focus on core processes sparked a discussion about which processes were essential and crucial for business continuity and which could be outsourced to external service providers. Processes or functions lacking internal resources were outsourced to specialised agencies or providers. Consequently, the principal-agent problem evolved between the user organization and the service organization, and the principal-agent theory and related information asymmetry gained importance in line with the growth of outsourcing.

Information Asymmetry

The most common agency relationship in the financial domain occurs between investors (or shareholders) and the management of a company. The principal may be unaware of the agent’s activities or prohibited by the agent from obtaining information. The result is information asymmetry between the principal and the agent. For example, management might want to invest in emerging economies, while the principal’s risk tolerance is unfavourable. This management strategy might sacrifice short-term profitability and increase company risks, potentially leading to higher future revenues. Investors desiring high current capital income with low risks might not be aware of these management plans. If the consequence of this strategy is certain losses, management may be inclined not to disclose this information to shareholders. The development of the accounting profession was a crucial step in mitigating the agency problem globally. In 1992, the SAS 70 standard became relevant for outsourcing assurance, later replaced by the ISAE 3402 standard in 2011. Outsourcing assurance reduced information asymmetry and improved trust between the user (organizations outsourcing) and the service organization (organizations providing services to these organizations).

Agency Theory in Outsourcing

In general terms, agency theory concerns all relationships between two parties where one party is the principal and the other is the agent representing the principal in transactions with third parties. Agency relationships occur when principals hire agents to perform a service on behalf of the principals. Principals typically delegate decision-making authority to agents. Since contracts and decisions with third parties are made by the agent, affecting the principal, agency problems can arise.

In the situation where activities are outsourced by a user organization to a service organization, agency theory is relevant to all described aspects: information asymmetry, risk tolerance, and engaged resources. For instance, a financial institution outsources IT services to a managed services provider. The managed service provider may not be aware of the institution’s risk tolerance and might decide that a weekly backup is acceptable or that data storage outside the EU is permissible. The service provider might not inform the organization about certain server failures if the network issue is not identified by the financial institution. The service organization might also be inclined to minimise the resources performing activities while attempting to maximise received fees. A service organization may also have a different tolerance towards fraud or may commit fraud itself. In the pension sector, asset managers might profit from front-running pension fund transactions. This results in the principal-agent problem described above.

 Front running is also known as tailgating, is the prohibited practice of entering into trade to capitalize on advance, nonpublic knowledge of a large pending transaction that will influence the price of the underlying security.