Outsourcing throughout history

Economies of scale

Since the industrial revolution, organizations have pondered on leveraging their competitive advantage to expand markets and increase profits. The predominant model in the 19th and 20th centuries was the large integrated organization. In the 1950s and 1960s, businesses broadened their bases to capitalize on economies of scale.

The large integrated organization diversified its product range, requiring more layers of management for expansions. Technological advancements like the internet in the 1980s and 1990s forced organizations to globalize more and were hampered by inflexibility due to bloated management structures. To enhance agility, many large organizations developed a strategy focused on their core activities and core processes.

Principal-agent problem

The focus on core processes initiated discussions 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 specialized agencies or service providers. Consequently, the principal-agent problem evolved between user organizations and service organizations, and the principal-agent theory and related information asymmetry gained importance in line with outsourcing growth.

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 not be aware of the agent’s activities or may be prohibited by the agent from obtaining information. The result is an information asymmetry between the principal and the agent. For instance, management might want to invest in emerging economies while the principal’s risk tolerance is unfavorable. This management strategy might sacrifice short-term profitability, increase the company’s risks, and potentially lead to future higher returns. Investors seeking high current capital income with low risks may not be aware of these management plans. If the consequence of this management strategy results in certain losses, management may be inclined not to disclose this information to shareholders. The development of the accounting profession was a significant global development in mitigating the agency problem.

Risk and resource planning

As indicated above, situations may arise where the agent intends to allocate certain resources of the investors to high-risk investments. The agent is the decision-maker and bears little to no risk as all losses are borne by the principal. This situation may occur when shareholders contribute financial support to an entity that management uses at its discretion. The agent may have a different risk tolerance than the investors due to unequal risk distribution. Alternatively, employees may decide to invest their energy in a project that has no long-term benefits for the organization. Management is responsible for the organization’s financial situation and may be unaware of employees focusing on the wrong goals.

Financial consequences

If the principal is an investor or shareholder of an organization, the principal’s interests are focused on optimizing returns on investments. Returns from investments are distributed as dividends to investors in the short or long term. Principles are focused on optimizing (long-term) dividend yields. Paying high dividends to principals restricts investment opportunities or may cause cash flow problems for the organization’s management. Principals and agents have opposing financial interests in this regard.

The agency theory is also relevant in the management-employee relationship. Employees have an interest in increasing their personal salary and personal satisfaction with minimal effort. Management aims to optimize production or sales volumes at the lowest labor costs. In this context, information asymmetry also exists in the form of incomplete understanding of employees’ daily operations by management. Management is likely to implement budgeting mechanisms and controls to optimize employee activities for the organization’s purpose. The agency theory is also relevant in outsourcing situations.

Agency theory in outsourcing

In general terms, agency theory pertains to 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. Because contracts and decisions with third parties are made by the agent affecting the principal, agency problems may arise.

In the situation where activities are outsourced by a user organization to a service organization, agency theory is relevant to all aspects described; information asymmetry, risk tolerance, and committed resources. For example, a financial institution outsources IT services to a managed services provider. The managed service provider lacks insight into the institution’s risk tolerance and may decide that weekly backups are acceptable or that storing data outside the EU is acceptable. The service provider may not inform the organization about downtime of certain servers if this network outage is not identified by the financial institution. The service organization may also be inclined to minimize resources performing activities while attempting to increase fees received. A service organization may have a different tolerance for fraud or may engage in fraud itself. In the pension sector, asset managers can profit by front running transactions from pension funds. This results in the principal-agent problem described above.