Today's blog on principal-agent theory comes from Peter Allen, Partner and Managing Director, TPI.
Corporate executives immersed in sourcing decision-making constantly face information and interest asymmetry. Academics call this principal-agent theory, a framework for analysis of tension over alignment and power, but few executives pay close attention. The insightful people from academia I found myself in a conversation with this past week agree with me: that's gotta change.
Principal-agent theorists study the behavior of the employee or contractor (agent) vis-Ã -vis the principal (employer) when there's an information or interest gap between the two. They observe that in the absence of costly monitoring of agents the problem cannot be completely solved, which may undermine the premise of outsourcing.
But the outsourcing industry, oddly enough, hasn't yet adequately addressed the inherent concern over such misalignments.
Principal-agent theory highlights two important dimensions of sourcing decision-making. The first is cost-centric: When the goals of the principal and agent conflict, it is difficult and expensive for the principle to verify what the agent is actually doing. The second is risk-centric: The problem of risk sharing arises when the principal and agent have different risk tolerance levels which dictate behavior.
In the business process outsourcing (BPO) marketplace, avoiding the transition of informational power to the service provider means putting into play effort-based contracts (labor arbitrage agreements). The logic seems to follow this course:
- The more ambiguous the relation of means to ends, the greater the information advantage of the agent.
- The greater the agent's information advantage, the higher the information costs to the principal.
- The more risk-averse the agent, the more the agent will increase information costs to the principal.
- The higher the information costs, the more likely the contract will be specified in terms of agent efficiency rather than agent effectiveness.
So what's the solution? Unless there is thorough monitoring of the work performed the problem cannot be completely resolved. Tension over alignment and power will always exist, but continued professionalization of the service management disciplines within corporations to monitor the spectrum of attributes associated with their service relationships is key. So, too, is the avoidance of ambiguity in services contracting by focusing on defined outcomes.
I'd love to hear your thoughts on this perspective as it applies to buy-side and provider-side strategies for outsourcing.
