Tugas Review SPM

Management Accounting Research 14 (2003) 281307
Management control systems and trust in outsourcing relationships

Kim Langeld-Smith
, David Smith
Department of Accounting and Finance, Monash University, Vic. 3800, Australia
Received 16 June 2002; accepted 10 June 2003
Abstract
Outsourcing is a form of strategic alliance that has increased in popularity over the past decade. However, there
has been limited research that studies the design of management control systems (MCS) and the role of trust in
such inter-rm relationships. This paper draws on a model by van der Meer-Kooistra and Vosselman [Acc. Organ.
Society 25 (2001) 51] to examine howcontrol mechanisms and trust are used to achieve control in a single case study
of an electricity company and its outsourced IT operations. An analysis of the characteristics of the transaction,
environment and parties, indicated that the control strategy adopted appeared to be a trust based pattern of control,
rather than a market based or bureaucratic based pattern. Control was achieved through outcome controls and social
controls developing over time, and through the development of trust, particularly goodwill trust. This paper adds to
the growing knowledge of the design of control systems and trust in outsourcing relationships.
2003 Elsevier Ltd. All rights reserved.
Keywords: Outsourcing; Strategic alliance; Management control systems; Transaction cost economics; Trust
1. Introduction
With the advent of globalisation and enhanced levels of competition, many organisations have acknowl-
edged the difculties of developing and maintaining the range of expertise and skills necessary to compete
successfully. Various forms of cooperative ventures and strategic alliances provide ways of gaining access
to the specialised skills and competencies that are needed to compete effectively in a globalised market
place (Das and Teng, 2001a; Nooteboom et al., 1997). Strategic alliances are broad ranging relationships
and can encompass joint ventures, franchises, joint research and development, joint marketing ventures,
long-term supply arrangements, and outsourcing relationships. The outsourcing of core and non-core
activities are a form of strategic alliance (Nooteboom et al., 1997; van der Meer-Kooistra and Vosselman,
Corresponding author. Tel.: +61-3-9903-1472; fax: +61-3-9903-2577.

E-mail addresses: Kim.Langeld-Smith@buseco.monash.edu.au (K. Langeld-Smith), David.smith@buseco.monash.edu.au
(D. Smith).
1044-5005/$ see front matter 2003 Elsevier Ltd. All rights reserved.
doi:10.1016/S1044-5005(03)00046-5
282 K. Langeld-Smith, D. Smith / Management Accounting Research 14 (2003) 281307
2000; Das and Teng, 2001b), particularly when the outsourced activity is of key strategic importance to
the organisation.
Over the past decade, there has been increasing interest in the opportunities provided by strategic
alliances, and outsourcing in particular (Ring and Van de Ven, 1992; Nooteboom et al., 1997; Das
and Teng, 2001b). However, there is also a growing body of evidence of a high failure rate in such
arrangements. One cause of this is the high level of risk associated with alliances, compared to in-house
activities (Das and Teng, 2001a). Aspects that cause high risk include the difculties inherent in gaining
cooperation with partners who have different objectives, and the potential for opportunistic exploitation
of the dependence relationship that exists between partners. Appropriate governance structures, including
management control systems (MCS) and the development of trust, may work to reduce risk and decrease
failure (Das and Teng, 2001a; Spekl, 2001). However, there has been only limited attention to the form
of management control systems that are suited to strategic alliances, and we have only limited knowledge
of the role that trust plays in such relationships. There have been calls to extend the domain of MCS to
cover inter-rm relationships (Otley, 1994; Hopwood, 1996; Spekl, 2001), and research that considers
explicitly the design of MCS and trust in such situations has begun to appear (see, for example, Seal
and Vincent-Jones, 1997; Seal et al., 1999; Das and Teng, 2001a,b). In particular, some research focuses
on MCS design and outsourcing relationships (van der Meer-Kooistra and Vosselman, 2000; Mouritsen
et al., 2001; Chua and Mahama, 2002). The purpose of this paper is to build on this prior research, to add
to our knowledge of the design of MCS in outsourcing relationships.
Outsourcing is the contracting of any service or activity to a third party (Drtina, 1994; McHugh et al.,
1995). Since the early 1990s, there has been considerable growth in outsourcing, in both the public and
private sectors, with outsourcing being increasingly applied, not only to manufacturing activities, but
also to traditional in-house administrative and management functions. These include data processing and
IT operations, human resource management services, accounting functions, internal audit and marketing
(Chalos, 1995). The practice of outsourcing is an international phenomenon. In the USA, Digital has
outsourced its entire labour force and much of its production management to a labour hire rm. The
global clothing manufacturer Benetton is little more than a shell, having outsourced its product design,
manufacturing, and merchandising to contractors. In Australia, the Commonwealth Bank has outsourced
its information technology, printing, record centres, supply functions and mail operations (Long, 1998;
Syvret, 1998).
Much has been written about the criteria that should guide decisions to outsource, and both successes
and failures in outsourcing are reported in the media. The nancial press, in particular, tends to focus
on the size of the contract, and the identity of the successful bidder. Outsourcing success or failure is
often judged by whether the outsourcer achieves cost savings, or experiences cost over-runs. Few reports,
however, consider how the inter-rm MCS can be designed to suit the particular characteristics of the
outsourcing relationship.
There are several, well-established models or frameworks for studying the design of MCS (see, for
example, Ouchi, 1979; Flamholtz, 1983; Merchant, 1985; Simons, 1995). However, these frameworks
typically focus on control systems within an organization. Only a fewcomprehensive models consider the
design of MCS in outsourcing relationships. For example, Spekl (2001) developed a model of control
archetypes, based on transaction cost economics (TCE), and Das and Teng (2001a) modelled the rela-
tionships between MCS, trust and risk in various types of inter-rm relationships. van der Meer-Kooistra
and Vosselman (2000) developed a comprehensive model of management control, which was based on
principles of TCE, but which integrated the role of trust. These models will be drawn on in this paper.
K. Langeld-Smith, D. Smith / Management Accounting Research 14 (2003) 281307 283
The paper is organised as follows. Section 2 provides a review of the literature on the design of MCS
and the role of trust in outsourcing relationships. In particular, the models of van der Meer-Kooistra and
Vosselman (2000), and to a lesser extent Spekl (2001), are drawn on to develop expectations of the
form of controls and trust that are suited in particular transactional situations. Section 3 contains a case
study of an electricity company that outsourced its information technology activities to a single specialist
outsourcer. The fourth section analyses the case study to determine the form of control pattern in place,
the nature of the control mechanisms and the role of trust in establishing close cooperative relationships.
The nal section concludes with a discussion of directions for further research.
2. Theoretical development
It is only recently that researchers have begun to consider the design of MCS, or governance structures,
in situations that span traditional organisational boundaries, including strategic alliances with suppliers,
or outsourcing. These alliances are usually characterised as partnerships or relationships and may involve
the sharing of joint decision making in areas such as strategic planning, and new product and process
development. They may also entail joint investments in relation-specic assets. Compared to arms-length
relationships, which are often well dened and contractually based, outsourcing relationships may en-
compass a great deal of uncertainty or risk for both parties. The nature of the contract between the two
parties can be complex and cover many areas of interest that extend beyond the mere actions of supply
and receipt of goods and services. It has been argued that the complexity of such arrangements may
preclude the complete ex ante specication of detailed contracts (Heide, 1994). In addition, the need for
exibility and adaptation in those partnerships may imply that control systems rely less on formal mech-
anisms (Gietzmann, 1996; Ittner et al., 1999). However, in some outsourcing situations the institution
of a formal control system may enable greater control and transparency, which may not only impact on
the interorganisational relationship, but may have implications for strengthening control and increasing
insights within the outsourcing rm (Mouritsen et al., 2001).
A useful starting point in studying control systems in outsourcing relationships is to consider how
control systems within a single rm have been conceptualised.
2.1. Within-rm control systems
Control systems have been conceptualised and categorised in various ways: formal versus informal
controls, behaviour versus outcome controls; mechanistic versus organic controls; bureaucratic versus clan
controls. However, these typications are not distinct and there is some agreement that all organisational
control systems consist of formal, explicitly designed controls, as well as the unwritten informal or social
controls that cannot be designed directly. Within formal designed controls, some researchers distinguish
between outcome controls and behaviour controls (Ouchi, 1979; Eisenhardt, 1985). Outcome controls
measure and monitor the outputs of operations or behaviours, using techniques such as performance
measurement. Behaviour controls, such as rules and standard operating procedures, specify and monitor
individuals behaviours.
Clan or social controls are present in all organisations to varying degrees (Ouchi, 1979). Social controls
may develop from shared norms, values and beliefs, and may rely on the internalisation of goals, which
leads to organisationally desired behaviours. These controls cannot be designed explicitly, but can be
shaped and inuenced by activities such as frequent interactions, meetings, negotiation of disputes, codes
of conduct, senior management attitudes and style, and rituals. There is some evidence that social controls
are also relevant in inter-rm relationships (Gietzmann, 1996; Nooteboom et al., 1997).
Ouchi (1979) highlighted the relationships between the mode of control, and the information char-
acteristics of the task: the degree of output measurability and task programmability. Outcome controls
were said to be suitable in situations of high output measurability and low task programmability, whereas
behaviour controls suit situations of lowoutput measurability and high task programmability. Where both
output measurability and task programmability are high, either behaviour or outcome controls may be
used. Social controls emerge when both output measurability and task programmability are low.
2.2. Trust and control systems
Merchant (1985, p. 39) noted that almost every control system involves some degree of trust that the
individuals of concern will do what is best for the organization without any, or with only incomplete,
monitoring of actions or results. However, it is only relatively recently that researchers have begun to
study the specic relationships between trust and the MCS design, but there are inconsistencies. Some
researchers claimthat control mechanisms and trust can be pursued simultaneously, or are complementary
(Zaheer and Venkatraman, 1995; Goold and Campbell, 1987; Das and Teng, 1998), while others argue
that control mechanisms are detrimental to trust (see, for example, Lorange and Roos, 1992). However,
researchers have not always considered how specic forms of trust and specic types of controls relate
or interact.
Several researchers have focused on the role of trust in governance relationships (see, for example,
Zaheer and Venkatraman, 1995; Chiles and McMackin, 1996; Gietzmann, 1996; Nooteboom et al., 1997;
Seal and Vincent-Jones, 1997). Trust may develop over time through processes of learning and adaptation,
which are essential to the strengthening of the relationship between partners, making the relationship
more durable in the face of conict and encouraging interactions between partners involving knowledge
exchange and promotion of each others interests (Johanson and Mattsson, 1987). Close relationships with
suppliers may involve the sharing of information, joint product and process development and joint cost
improvement activities, and trust allows such alliances to ourish. It has been argued that certain minimum
levels of trust are essential in inter-rm relationships, as trust reduces the possibility of opportunistic
behaviour (Axelrod, 1984; Bradach and Eccles, 1989; Birnberg, 1998). In addition, trust may increase
the predictability of mutual behaviour through each party honouring commitments and allowing partners
to deal with unforeseen contingencies in mutually acceptable ways (Sako, 1992, p. 37).
Trust is a difcult concept to study as it has been dened and classied in many ways. Most denitions
of trust focus on exposing oneself to vulnerability. Asimple denition is that trust is having condence that
ones expectations will be realised (Luhmann, 1979). Other denitions suggest that trust entails positive
expectations regarding the other in a risky situation (Gambetta, 1988), and includes adopting a belief,
without having full information to conrm that belief (Tomkins, 2001). Several researchers have noted
the link between trust and information requirements (see, for example, Luhmann, 1979; Creed and Miles,
1996; Wicks et al., 1999; Tomkins, 2001). Trust is characterised as an alternative uncertainty absorption
mechanism to providing increased information. This has led some researchers to suggest that there is an
inverse relationship between willingness to trust and the need for information (see, for example, Wicks
et al., 1999), while others see the trade-off as more complex (see, for example, Seal and Vincent-Jones,
1997; Tomkins, 2001). The provision of information, such as cost reports or performance information,
is a component of MCS, and is certainly important in outsourcing relationships, where the sharing of
information and the generation of performance information is common.
It has been argued that trust is particularly relevant to inter-rm relationships, as trust is only important
in situations where there is risk (Luhmann, 1979; Coleman, 1990; Sako, 1992), and risk management
is a critical aspect of these relationships (Ring and Van de Ven, 1992; Das and Teng, 2001b). Three
denitions of trust relevant to managing outsourcing are contractual trust, competence trust and goodwill
trust (Sako, 1992). Contractual trust is based on the moral standard of honesty, and rests on an assumption
that the other party will honour the agreement, whether the agreement is in writing or not (Sako, 1992;
van der Meer-Kooistra and Vosselman, 2000). The higher the level of contractual trust that a rm has in
an outsourcer, the less need there is to gather information to prevent or reduce opportunistic behaviour.
Competence trust focuses on perceptions of ability and expertise, and is the expectation of technically
competent role performance (Barber, 1983, p. 14). In inter-rm relationships, competence trust relates
to a partners ability to perform according to the specied agreement or contract (Nooteboom, 1996). In
contrast, goodwill trust can be dened as perceptions of a partners intention to perform in accordance
with those agreements (Ring and Van de Ven, 1992; Nooteboom, 1996). Goodwill trust is associated
with integrity, responsibility and dependability (Das and Teng, 2001a). While these forms of trust may
be present to some extent in the early stages of an outsourcing relationship, they can also develop further
over time.
2.3. Transaction cost economics and control
A common framework for viewing the choice of governance structures in inter-rm relationships is
transaction cost economics (see, for example, Gietzmann, 1996; Seal et al., 1999; van der Meer-Kooistra
and Vosselman, 2000; Spekl, 2001). TCE is based on the notion that rms choose efcient organisational
forms or governance structures based on transactional issues, such as rm-specic investments, and
external or internal uncertainty (Ittner et al., 1999). Governance structures can be characterised as one of
three forms: markets, hybrids (including strategic alliances) and hierarchies (Williamson, 1991). TCE is
based on the idea that three aspects of transactions determine the appropriate mode of governance: the
frequency of the transaction, the uncertainty encompassed in those transactions, and the asset specicity of
the transactions (Williamson, 1979). Asset specicity, in particular, is said to be of particular signicance
in explaining the choice of governance structure.
Asset specicity is the degree to which an asset can be redeployed to alternative use without sacrice of
productive value. It is the opportunity loss associated with the early termination of a relationship (Spekl,
2001). Asset specicity can arise in six ways: site specicity, physical assets specicity, human assets
specicity, brand name capital, dedicated assets and temporal specicity (Williamson, 1991). Under TCE,
it is assumed that a high level of asset specicity creates dependency between the parties in a relationship,
increases switching costs and leads to difcult governance situations.
Markets, hybrids and hierarchies rely on different control mechanisms to enable successful contracting.
Whereas markets rely on free competition to ensure control, and hierarchies rely on authority, hybrid forms
of control generally entail long-term contracts. Hybrid governance structures are long-term contractual
relations that preserve autonomy by providing added transaction-specic safeguards (Williamson, 1996,
p. 378). The safeguards often include hostage arrangements to correct market asymmetries. For example,
parties to the relationship may transfer assets that can only be fully recovered if the contract is executed
successfully. High levels of uncertainty associated with hybrids, may make it difcult to specify ex
ante performance criteria within contracts, and in the face of high asset specicity, alternative control
mechanisms such as specialised dispute resolution mechanisms may need to be put in place.
TCE models have been criticised for not considering adequately the social context within which trans-
actions are embedded. It has been argued that social embeddedness not only inuences the design of
the control systems, it also inuences the relationship and each partys behaviour, including the level
of opportunism (Granovetter, 1985; van der Meer-Kooistra and Vosselman, 2000). A critical concern in
all inter-rm relationships is the attitudes and personal relationships between the two parties (Faulkner,
1995). In particular, trust has emerged as an important way of reducing opportunism, and as a factor in
the design and study of control systems (Ring and Van de Ven, 1992; Gietzmann, 1996; Nooteboomet al.,
1997; van der Meer-Kooistra and Vosselman, 2000). In the following section, two recent models that draw
on TCE to depict control systems in outsourcing relationships will be outlined; one model integrates TCE
and trust.
2.4. TCE-based models of management control
Spekl (2001) developed a TCE theory of management control to explain nine archetypes of control.
These control archetypes vary depending on three dimensions: task programmability, ex post information
impactedness (output measurability) and asset specicity. Spekl (2001) specied two control archetypes
for outsourcingrelationships: hybridarms-lengthcontrol andhybridexploratory control. Todate, Spekls
model has not been used in empirical research. van der Meer-Kooistra and Vosselman (2000) developed
a model of control in inter-rm relationships that integrates TCE concepts and trust. They identied three
management control patterns relevant to outsourcing relationships: the market based pattern, bureaucracy
based pattern and trust based pattern. In the market based pattern, market mechanisms dominate the
relationship, and this is similar to Spekls archetype of market control. However, Spekl does not see
market control as a suitable archetype for outsourcing relationships. The bureaucracy based pattern is
analogous to Spekls hybrid arms-length control, while the trust based pattern bears some similarities to
hybrid exploratory control. While Spekls (2001) model focuses on the characteristics of the transaction
as a determinate of the control systems archetype, van der Meer-Kooistra and Vosselman (2000) provide
a more complete analysis by considering not only the transaction characteristics, but the transaction
environment, the characteristic of the parties to the transaction, and the role of trust in achieving control.
The market based pattern suits transactions characterised by high task programmability, high mea-
surability of output, low asset specicity and high task repetition. Many suppliers will compete for the
contract, and market prices will be directly linked to the quality of the output of the outsourcers activi-
ties. Detailed contracts are not required and the possibility of returning to the market for competing bids
provides discipline for the current outsourcer to provide an efcient and effective output. In the face of
effective market mechanisms, no specic control instruments are needed to manage the relationship. The
institutional environment is not relevant, and nor is supplier reputation, prior history of cooperation, or risk
attitude. If one party to the relationship behaves opportunistically, another party can be chosen without
high switching costs, as there are no specic investments. The transaction environment is characterised
by low uncertainty and many available alternative suppliers.
The bureaucracy based pattern, or hybrid arms-length control, suits transactions that have high task
programmability, high output measurability, moderate asset specicity and lowto mediumrepetitiveness.
The transaction environment has relatively low uncertainty and the future is fairly predictable. Controls
will be prescriptive and include detailed rules of behaviour and rigid performance targets. These will
be captured in detailed contracts, which are used to monitor performance. Comprehensive selection
criteria are set up and formal bidding is used to select a partner. Hostage arrangements can be used to
ensure compliance to contractual provisions, and arbitration may be used to resolve contract disputes
and to counter opportunistic behaviour in an environment of moderate asset specicity (Spekl, 2001).
Contracts are specic and long-term, and the autonomy of the two parties is preserved. In this situation, a
combination of behaviour and outcome controls will be used, which is consistent with Ouchis prescription
for control systems in the face of high task programmability and high output measurability. Trust plays a
limited role in the bureaucracy based pattern, but is important in the early stages of a relationship. Where
human knowledge and skills are critical to the quality of the work, the outsourcing rmmust perceive that
the outsourcer has high levels of competence trust and contractual trust in order to select the outsourcer
and to proceed with the contract.
The trust based pattern of van der Meer-Kooistra and Vosselman (2000) is characterised by low levels
of task programmability, low levels of output measurability and high asset specicity. Transactions are
not highly repetitive. The environment is highly uncertain and risky, so trust becomes the dominant
mechanism for achieving control in this form of relationship, and this mitigates the risks associated with
high asset specicity. The initial selection of the outsourcer is based on perceptions of competence trust,
contractual trust and goodwill trust, which arise through friendships, former contractual relationships
and reputation. Initially, contracts are merely broad frameworks, which then develop further over time. A
series of control devices, such as personal consultations and intense communications, are put in place to
develop competence trust and goodwill trust. In addition, the institutional environment can stimulate the
development of competence trust and contractual trust, through certication of the rms activities and
legal regulations. Goodwill trust becomes the solution to overcoming information asymmetry, and regular
personal contacts and an attitude of commitment can lead to its development. Control systems, in general,
are more informal under these forms of relationships, and often take the formof social controls. Consistent
with Ouchi (1979), behaviour controls are not suited in these situations of low task programmability, and
when controls are formalised they tend to emphasise outcome controls, and these develop over time
through the sharing of private information and the alignment of the parties performance expectations.
Trust is necessary to achieve control, as activities and output cannot be measured with any certainty.
The transaction characteristics of hybrid exploratory control are similar to those of trust based control,
except that asset specicity is moderate rather than high. Under the Spekl model (and under TCE in
general) high asset specicity (as found under a trust based pattern) cannot be tolerated in an outsourcing
situation as it increases the potential for opportunistic behaviour and information leakage, requiring the
outsourced function to be taken back in-house. However, rms do continue to engage in outsourcing in
situations of high asset specicity. The trust based pattern demonstrates that the development of goodwill
trust and contractual trust can mitigate opportunistic behaviour and the abuse of unequal bargaining power
(Sako, 1992, p. 39; van der Meer-Kooistra and Vosselman, 2000). Similarly, under hybrid exploratory
control, exclusive contacts with suppliers are considered unacceptable, as they increase asset specicity,
dependence and risk, in the light of incomplete contracts. However, organisations do enter into exclu-
sive contracts with outsourcers. Again, goodwill trust and contractual trust will counter the potential
opportunistic behaviour. Table 1 contains a summary of the characteristics of the transaction, transaction
environment and parties for the three patterns of control, as well as the form of control mechanisms and
the role of trust in achieving control.
Thus, depending on the characteristics of the transaction, the transaction environment and the parties,
we would expect the MCS of outsourced operations to follow one of the three control patterns outlined
Table 1
Control mechanisms and trust
Outsourcing
control pattern
Characteristics of the transaction,
transaction environment and parties
Control mechanisms The role of trust in achieving
control
Market based
pattern
Transaction
High task programmability
High output measurability
Low asset specicity
High repetition of transactions
No specic control instruments
required as market mechanisms
dominate
Not relevantswitching costs
are low
Competitive bidding at
periodic intervals
No detailed contracting
Market prices linked to
standardised activities and
outputs
Transaction environment
Many potential parties
Market price contains all the market
information
Social embeddedness and
institutional factors not relevant
Parties
Not important
Bureaucratic
based pattern
Transaction
High task programmability
High output measurability
Moderate asset specicity
Low to medium repetition of
transactions
Outcome and behaviour
controls, focused on direct
intervention by outsourcing
party
In selecting the outsourcer,
when human knowledge and
skills are important to the
quality of the work, the
outsourcing rm must perceive
high levels of competence trust
and contractual trust in the
outsourcer
Rigid performance targets
Detailed rules of behaviour
Detailed contracts
Comprehensive selection
criteria and formal bidding
Transaction environment Hostage arrangements
Future contingencies known
Medium to high market risks
Institutional factors inuence
contractual rules
Parties
Competence reputation
Medium risk sharing attitude
Asymmetry in bargaining power
Trust based
pattern
Transaction
Low task programmability
Low output measurability, that tends
to increase over time
High asset specicity
Low repetition of transactions
Outcome and social controls
develop over time
Broad non-specic contracts
that develop time
Performance assessed
through broad emergent
standards
High levels of information
sharing and communications
Perceptions of competence
trust, contractual trust and
goodwill trust may determine
the selection of outsourcer,
and must be assessed in
advance
The institutional environment
can stimulate competence
trust and contractual trust
Table 1 (Continued )
Outsourcing
control pattern
Characteristics of the transaction,
transaction environment and parties
Control mechanisms The role of trust in achieving
control
Opportunistic behaviour and
information asymmetry will
be overcome by developing
goodwill trust and
contractual trust
Regular personal contacts,
intense communications and
an attitude of commitment
can stimulate competence
and goodwill trust
Transaction environment
Future contingencies unknown
High market risks
Social embeddedness
Institutional factors inuence the
relation
Parties
Competence reputation
Experience in networks
Experience with contracting parties
Risk sharing attitude
No asymmetry in bargaining power
above. In a market based pattern, there are no explicit control mechanisms and trust is not relevant in
achieving control. Under a bureaucratic based pattern, outcome controls and behaviour controls are the
prime control mechanisms, and trust plays a minor role in achieving control. Under a trust based pattern,
outcome controls and social controls emerge over time, and trust plays a signicant role in achieving
control.
3. Case descriptionthe outsourcing of IT&T at Central Energy (Central)
Central Energy is an Australian company operating in the electricity industry, which outsourced its
information technology function. The company was selected as a research site, as it was known to have
well-established outsourcing contracts.
Data were collected through semi-structured interviews with key managers in the electricity rm who
were involved in the decision to outsource the operation, and in the ongoing management of the outsourced
function. These managers worked in the areas of nance, information technology, shared services and
contracting.
1
Interviews lasted two to three hours each. Access was also gained to relevant company
documents. Two researchers were present at each interview to enhance the reliability of the interpretation
of interview material and conclusions drawn. All interviews were tape recorded and transcribed. The
completed write-up of the case study was sent to the interviewees for comment and to the company for
nal approval.
2
The purpose of the interviews was to understand the nature of the relationship between the company
and the outsourcer and type of control system used in the outsourcing relationship. To provide a con-
text for the study, the following two issues were investigated: the motivation for the rm to consider
outsourcing, and the criteria used to select the outsourcer. To investigate the form of MCS, the focus
1
Four different managers were interviewed (one was interviewed twice) at the end of the rst two years of the outsourcing
contact.
2
Even though all company names are disguised, as part of gaining access to the company the researchers agreed to allow the
company nal approval over any material published.
was on understanding the nature of the formal contract entered into with the outsourcer, and the pro-
cesses used to achieve control over the rst two years of the relationship. To assess the appropriateness
of the control activities and to obtain a perspective of the managers perceived success or otherwise
of the outsourcing venture, managers were asked to reect on the benets that they had gained from
outsourcing.
3.1. Background
Central Energy was formed in 1995, through the merger of two electricity authorities, Hilton Energy
(Hilton) and Woodside Electricity (Woodside). Central distributes and retails electricity and value-added
energy services to more than a million people across a large, diverse area. Central also sells major electrical
contracting services throughout Australia and retails energy services to major industrial and commercial
clients across two states of Australia.
Deregulation of the Australian electricity industry led to considerable changes for organisations like
Central. Increased competition occurred through the privatisation or corporatisation of state-owned mo-
nopolies. In Centrals home state, the industry was broken up into a number of separate corporatised
entities that manage electricity distribution, generation, and the electricity grid. Adding to the increased
competitive pressure, all customers were able to buy power from any of the states electricity distribu-
tors. Thus, distributors can seek customers from other states, making the customer base more vulnerable.
Improved customer service and reduced costs have become prime considerations. To remain competitive
in this environment, Central established four separate businesses and a holding company. Each business
was required to make a prot. When services were provided from one business to another, they were
supplied on a commercial arms-length basis.
During the merger, the executive steering committee decided to outsource the information technology
and telecommunications (IT&T) function. This occurred within two months of the merger.
3.2. Motivation for outsourcing IT&T
Centrals stated policy was to . . . ensure that all internal services are provided effectively and ef-
ciently to the core Network and Energy Services businesses. Where internal services did not meet the
level of quality or cost of external suppliers, competitive tenders were sought and evaluated. Thus, cost
effectiveness and strategic issues were primary considerations in outsourcing decisions. However, the
specic factors that motivated the decision to outsource IT&T were broader and included the search for a
solution to the problem of merging two very different IT cultures; the need to improve cost management
of IT&T; greater access to technical knowledge and expertise; and the need to bring more discipline and
control to IT&T.
The merger of the two electricity authorities brought together two IT&T functions that were very
different in size and nature, as well as focus and direction. Developing a single, effective IT&T function
was seen as a major managerial issue and an important determinant of Centrals ability to compete in
the new contestable electricity environment. Hilton had 168 IT&T staff, compared with Woodsides 33.
Hilton was a mainframe environment with large-scale applications, and frequent cost over-runs. Woodside
had a very low cost infrastructure: its systems were small, not run on mainframes, and there were limited
funds for software development. Many of Woodsides IT staff took voluntary redundancies with the
merger.
Before the merger, cost management of the IT&T function was poor, particularly at Hilton. Cost
over-runs were common, and there was little control over the initiation of newprojects. Hiltons IT&Twas
strongly customer-focused so that a plethora of operating systems was supported and new applications
were developed continually. There was limited accountability for spending on IT resources. A senior
manager described the situation:
A business would ask IT&T for something to be done, but they were not being charged the true cost.
There was no discipline in the management of costs. One of the drivers in the move to outsource the
IT&T area was to introduce that discipline, so that if you do ask for something to be modied or
changed, someone comes back to you and says You know its going to cost you $20,000.
The transfer pricing system used to charge users of IT&T services sent the wrong signals, and led to
dysfunctional decision making. Favours and funny prices led to a lack of accountability and an absence
of commercial reality. Managers hoped that outsourcing of IT&T would help curb spending, as real
money would be seen to be leaving the organisation. An IT manager described past practices:
The IT cost was like a bottomless bucket. The projects were actually controlled by the IT people, not
by the users. They might have been initiated by the users, but basically, the users lost control. So the IT
people started to dominate the situation. Now that is the fault of the users, not a fault of the IT people.
The organisation recognised that it did not manage that well.
The cost of in-house IT&T for the two electricity distributors before the merger was estimated at $42
million per year. Many managers, however, believed that this was overstated. Nevertheless, IT&T was
clearly a signicant cost to the business and so provided opportunities for cost improvement and achieving
more control over IT developments.
Another reason for engaging in outsourcing was that the organisation would need to gain access to
high levels of IT expertise to compete effectively. It was considered difcult and impractical to supply
this in-house. One manager described the thinking:
I think that at the end of the day, you really have to understand what your core competencies are. That
is, what are the things that you are good at, that you do have an edge on, and that you really know the
ins and outs of it. No matter what business you are in, there are some things that you can do better than
others. It is a matter of identifying and really understanding those things. If you go back a few years,
we probably did not really have a feel for thatwe continued to do things because we had always done
them. It is a matter of sitting down and saying, what are we good at? What do we do that adds value
to our organisation? And if there is some lineball exercise or some clear-cut situation where we are
not adding value, then we have to think seriously about doing something else.
Central understood that its core business was energy services. The environment in which it was op-
erating placed greater demands on the business for smarter systems, which would involve high use of
sophisticated IT. Thus, it was envisaged that there would be greater reliance on the IT&T function in the
future, and it was of critical importance for survival. An external provider was believed to offer several
advantages over the in-house department. A manager described this:
The market is changing very dramatically and we do not have the depth in the IT group to be able
to provide IT solutions. We wanted to work with a partner whose core business was IT and therefore
was in a better position to search the world, to provide us with the right solutions at the right time.
Now I do not want to appear to be negative towards our IT groups, because they did carry us a long
way forward. The question is, did they get too expensive? We lost control of the IT spend, but also the
market had moved a lot quicker, and we dont believe the IT groups were dynamic enough to provide
the necessary solutions to go forward.
Thus, a strong motivation for outsourcing was managers perceptions that the use and development of
IT within Hilton was out of control. One senior IT manager described the situation that had existed at
Hilton:
In the past, utilities were fairly wealthy organisationscash rich and managed predominantly by
engineers who liked to build gold-plated systems. We now have redundant microwave links, multiple
computer sites, you name it. It was technology gone mad. Whereas the old Woodside was managed by
a man whose single focus in life was to build low cost solutions.
Some businesses within Central had started to develop their own IT groups and this hastened the
need to engage a highly competent IT outsourcer to bring IT planning and operations under central
control.
3.3. Criteria used in the outsourcing decision
In mid-1996, Central called for tenders for the IT&T function. Bids from two large global companies
were considered, along with an in-house bid. All bidders needed to demonstrate that they could offer value
within the dynamic electricity environment. The criteria for assessing the tenders included the following:
the cost of providing the service; clear cost reduction paths; staff transition issues; the approach to
strategic planning of IT; what the tenderer could offer in terms of their experience, skills base and
competence; how they planned to manage the contract; and the nature of the billing arrangements. Each
criterion was weighted in the nal analysis, with the nal decision being made by the implementation
committee.
The successful tenderer, Global Systems (Global), was chosen for many reasons, including its reputation
and company values, the quality of its proposal, the ability to respond speedily to changes in the market,
leverage andwide international knowledge base. Other factors that favouredthe tenderer were the time-line
on cost reduction paths, and the way Global intended to deal with stafng issues. The in-house proposal
was said to be a clear third, largely because the team were unable to provide convincing arguments that
they were able to provide the necessary IT solutions for the future.
Interestingly, no IT staff were on the implementation committee as it was felt that they would have
too much self-interest in the projects outcome. However, they were consulted in the decision. Global
was physically located on-site, in the same area as Hiltons previous IT&T department. Central retained
ownership of the IT equipment.
Once the decision was made to outsource IT&T to Global, a team was set up to work with staff on
transition issues. Existing IT&T staff were given three choices: take a voluntary redundancy package,
transfer their employment to Global, or continue at Central in a different role. About half of the IT&Tstaff
left, with most of the remainder transferring to Global. Counselling and career transition training were
provided for some staff. Many employees that transferred to Global saw better opportunities for career
advancement in an organisation that had IT as its core business. Some initial problems were experienced,
with specialised knowledge of the IT systems walking out the door. As in many companies, when
redundancy packages are offered, it is often the most talented staff with best employment opportunities
that choose to leave. Many of the IT applications at Central were custom-built and not well documented,
so often only a few employees knew how particular software operated. In addition, over time some of
Centrals IT staff who had transferred to Global moved to other Global sites.
3.4. Managing the outsourcing relationship
The rst twelve months of the outsourcing relationship were described by one manager as rocky.
Indeed, it took about eighteen months for positives to clearly emerge. The key issues to manage
were: agreeing on the baseline level of service to be included in the contract; verifying the cost of
the baseline services; managing false expectations of staff; managing differences between the cul-
tures of Central and Global; the implementation of communication processes; developing trust; achie-
ving cost reduction; and implementation of the risk-reward system. These issues are considered in turn
below.
The contract contained an agreed price for baseline services and additional payments for discretionary
projects that were above that baseline. Baseline services were dened as . . . the cost of maintaining
all infrastructure and systems in the organisation at the level at which they were at the point that the
contract was signed. This denition was difcult to interpret. The problem in establishing the baseline
involved agreeing on which projects were discretionary (over and above baseline services and hence an
extra cost to Central) and which projects were included in the baseline service. During the rst year
of the contract there were conicts between Central and Global, as each had different ideas as to what
constituted baseline services.
Some managers at Central believed that clear contract specications were critical to ensuring a smooth
relationship:
People have to be very clear about their service level requirements. Not say 95 per cent uptime
or something like that. None of this arbitrary nonsense. Be very specic about what those ser-
vice level requirements arespecify as much as you can get down. And people may say Oh, its
not necessary because youre going to work these things out together. You can, but that means
there needs to be extreme trust and that only occurs when you are really partners. But you do not
start as partners. You start with the specications; you work to it and the supplier/customer rela-
tionship. And that is where we came from. In the beginning it was an unhappy customer/supplier
relationship.
Some managers believed that these problems could have been averted if more time had been spent
negotiating the contract. However, at the time of the merger there was a great sense of urgency to solve
the IT problem, and to get an outsourcer onboard.
Another issue that dominated the early days of the relationship was an extensive verication of the cost
of baseline services, which had not been specied in the contract. A manager explains why this was the
case:
With the merger of the organisation, redundancy programs were going on, and with uncertainty in
IT staff, there was a need to do something to get some stability in the process. The cost of putting
some trust in Global Systems during that six to nine months process was seen to be less than the cost
of delaying the contract verication prior to nal contract signing. This was the cost of provision of
baseline services. We entered into a contract that basically said, This is what we believe it is at the
moment, but it will be subject to verication in this next six months. That should not have occurred.
We should have spent more time as a business, chapter and verse, detailing what our expectations of
service were, what the limitations were, what they were really going to get out of it.
In the early days of the relationship many staff at Central were disappointed with Globals performance.
There was an expectation that Global would deliver massive improvements in service levels and costs
immediately. There were also memories of how good things were before the partnership.
Improvements were slowto emerge for a number of reasons. Some of the most valuable IT&T staff had
left the company, so the remaining staff did not have the skills to run some systems. Conicts emerged
from the different objectives of the two parties: the outsourcer was clearly trying to make a good return
from the account, while Central was trying to manage costs. It took some time before the two partners
were able to work towards shared objectives and targets for various projects. Also, managers within the
businesses were now being charged the full costs of their IT&T services, whereas they had previously
had much greater direct access to IT&T services, which carried few charges.
The decision to outsource IT&Twas made within two months of the merger. In itself, this was a difcult
blending of two very different cultures, but Central and Global also had very different organisational
cultures. Central was a merger of two traditional public sector organisations, but it was moving quickly to
adopt commercial practices and principles. Global was highly commercial and controlled in its operations.
One senior manager contrasted the two organisations:
The way Central works is to have the process in place, but to empower people to do what they need to
do. The account is probably worth 40 to 45 million dollars a year to Global Systems. My equivalent,
the number one person in Global Systems, has signing authority to only $5,000everything else goes
up the line into the bureaucracy. You can talk about bureaucracy in the public sector, but it is nothing
to what you see in the way Global controls what you can and cannot do. That is the way they work.
But having said that, they have introduced a rigour into this organisation, which was far too free with
its IT spend. That is a difcult thing to do with an internal IT shop.
After the rst eighteen months these differences became less important. One manager believed that
this might have been due to Global learning the Central way.
The manner in which Central related to Global changed over the rst two years of the contract. Ini-
tially, Centrals IT&TOutsourcing Manager was the sole contact point for Central, handling all day-to-day
problems and trying to build strong relationships. However, the four businesses of Central were distinct
and had very different needs and foci. Over time, Global assigned different service managers with re-
sponsibility for each business, to handle their own specic day-to-day issues. This allowed the IT&T
Outsourcing Manager to focus more on broader relationship matters. A greater focus came to be placed
on open communication channels and addressing issues up-front. Senior managers from both Central and
Global met monthly as part of an IT steering group, to work through the strategic plan, to discuss major
projects and to review spending to date. There was also a working group to handle applications for new
IT capital projects.
The issue of developing trust between Global and Central was seen as important to managers at Central.
Over time, the managers came to understand that Global was committed to the relationship and they
respected to high levels of skills and experience that Global brought to the relationship. A manager
outlined this viewpoint:
Central still wears by far the biggest risk in this relationship. If you assume the absolute worst, that
Global Systems delivers a system late, over budget and with poor quality, sure it might lose out on
a couple of million dollars prot, but the cost to Central would be signicantly more. So there is an
element of trust in this relationship, and Global Systems has a reputation to sustain in the marketplace.
It cannot afford to walk away from something like thisand it will not. These large organisations will
not and there is a good relationship between our CEO and their CEO to ensure that it simply would
not happen. There is too much win-win potential to come out of this.
Both parties worked towards building high levels of trust between the two organisations. Where there
were incompatibilities, Global replaced some of its staff who were directly involved with Central. Among
some of the individual businesses within Central, one source of mistrust arose from businesses being
charged for IT applications. Some managers felt that Global was ripping them off and was engaging in
point scoring. The source of this problem, however, was that, for the rst time, the businesses were now
being charged directly for using IT&T services.
The contract with Global was for the provision of management services, while Central continued to
own the IT infrastructure. One of the reasons for not giving total control to Global was the risk that if the
relationship were to fail with no control over IT assets, it would be difcult to recommence IT services
in-house or with another outsourcer. A senior manager explained the relationship between trust and risk.
The more you trust, the more you are prepared to hand over. The more you feel Hey things could
break down. What recourse do we have? What backups do we have? How do we rebuild if there is a
divorce? There is some hesitancy in relation to the ownership of assetsbut there is a gradual move
away from that thinking.
Newmanagement systems were implemented in Central to achieve greater cost control and management
of IT developments. Each of the businesses was required to submit an annual plan for new projects. Each
project needed to have strong business justications, and was reviewed by a committee that prioritised the
projects. An overall strategic plan for IT, formulated by Central and Global, was developed. This system
is a clear contrast to the pre-merger practice of ad hoc project development.
Another aspect that encouraged cost management was the direct charging of IT&T costs to the busi-
nesses. These costs were major overhead items that could run to many millions of dollars for each business.
The new systems encouraged an environment of accountability and cost consciousness. Managers within
the business units began to look for ways that they could break down the costs into manageable elements
that people in the operational areas could inuence.
There were no performance measures in the initial outsourcing contract. Eighteen months into the
contract, a risk-reward scheme was devised to monitor Globals performance. The rst application of this
was in relation to a newcustomer service system(CSS), a discretionary project. The systemwas developed
after several weeks of negotiation between the two parties. When Global undertook a discretionary
project, it would usually levy a charge that included direct costs, overhead and prot margin. Under the
risk-reward system Global would charge only direct costs to Central. Bonuses would then be paid, based
on performance in three areas: cost, quality and time. Table 2 provides some examples of the types of
measures that were used.
Thus, Central awarded Global a score out of 25 based on how prompt they were with delivering the
project on time. Depending on how the new system affected business continuity (which might be tested
over several months), Global would receive a score of up to 20. (Business continuity was concerned with
whether the new system resulted in interruptions to business, such as computer downtime, interrupted
access data, and external customer problems.) The targets that were set for each of the performance
Table 2
Performance measures used in the risk-reward scheme
Criteria Performance measures Weightings (%)
Cost Under- or over-budget 25
Quality Performance to test plan 20
Survey of end users 10
Business continuity 20
Time Delivery to schedule 25
Total 100
measures were very challenging. The score that Global received was then linked to a prot multiplier. An
overall score of 70 would return a normal prot for the project to Global, whilst a score of 90100 would
give it up to 150% of the normal prot. Global also conducted its own customer satisfaction surveys and
these data were shared with Central.
3.5. Benets of outsourcing
Managers had high expectations of the improvements that would result from outsourcing the IT&T
function. However, benets were slow to materialise, and it was not until after the rst eighteen months
of the contract that improvements could be clearly identied by Centrals managers. These benets
included the benets of access to Globals expertise and enhanced services; increased accountability and
cost consciousness within Central; and a greater discipline in IT planning.
The new competitive electricity environment placed increased demands on Central to gain access to
high IT skills and technologies. There was a strong motivation for outsourcing IT&T and Global was able
to provide those benets to Central. A senior manager described the difference Global made in this area:
I would say that they have brought into the organisation, in key areas, skills that we could not have hoped
to bring in. The year 2000 problem is a classic case. They have a big contract with a state government,
and the skills that they built up there and that they have available to them worldwide are very, very
good. They brought two specialists in. We paid big bucks for it, but we got it done in a fraction of the
time that it would have taken us to do it internallyto do the reviews, and put the processes in place
to allow us to then roll out our year 2000 plan. The ability to do that and put those processes in place
in an internal shop and get the right people for short periods of timealmost impossible!
The association with Global provided Central with the creative IT solutions that it was looking for.
Another manager conrmed the importance of Globals international networks:
And that is the way Global Systems operates, they have a client here, and a client there and if we have
a certain issue, what they do is bring someone in. They y someone in from the States or locally to
solve that specic problem because they have addressed it before in other organisations.
While IT&T was a major cost for the company, managers at Central were not overly concerned about
reducing these costs. Instead, they were more focused on ensuring that the resources were not wasted. To
that end, the company put in place new systems to help manage IT activities.
To encourage responsible IT use, the cost of the baseline services needed to be redistributed to the
businesses that were using the services. Amanager explained the philosophy with relation to the desktop
project, which was a project within the baseline.
What we have agreed to on the desktop project is based on actual charges per desktop per month for
a total service. We are putting the incentive clearly back on the business to manage the number of
PCs. Prior to this theres been absolutely no incentive for them to do anything smarter about managing
those costs because it was a lump sum. Now we can say If you go from 500 PCs to 350 PCs, you will
save yourself $200+ dollars per month per PC. We have taken a chunk out of the baseline cost and
substituted it with a variable cost. As long as the total number of PCs in the organisation does not fall
below 1200, these costs will be valid.
The costs of discretionary projects were charged directly to the businesses to which they related.
Central, however, was still attempting to develop equitable ways of charging the baseline cost to each
business. This activity involved determining the drivers of the cost of discretionary projects. A senior
nance manager outlined the difculties:
We had a sub-committee look at it in several ways, because you are not sure what the cost drivers are.
The helpdesk is one of the more expensive items. They decided to just divide the cost equally across
the four businesses and holding company. Which means the holding company pays too much. We have
30 staff and the Contracting business has 1200 staff. We have tried to nd a reasonable basis, and
sometimes that was just dividing it equally across all businesses, and that will remain until we have a
better understanding of what drives the costs.
As explained in a previous section, each business was required to submit plans of its IT requirements at
the start of each year, for approval. This provided control over costs as well as over the ad hoc development
of projects that had once existed. Having IT&T managed by an arms-length provider, which itself had
strict, bureaucratic systems in place, made the implementation of spending controls simpler and supported
Centrals attempts to control spending. Control over ongoing costs was also achieved through the monthly
IT charges being managed by the IT&T Outsourcing Manager. All charges were reviewed and checked
and only charges for the baseline and approved projects were paid.
Once Global was established as the IT&T provider, more systematic controls over new developments
were implemented. Businesses were required to present justications for all IT capital projects to the
working group. Aproject would only be approved if there was a strong justication and if it met the needs
across the business.
3.6. Summary and conclusion
The outsourcing of IT&T was seen by managers at Central as an effective response to the problems that
existed within its IT&T function, and these were essentially problems related to cost control and control
of IT planning and operations. It also provided a means for gaining access to world-class IT&T expertise,
which was essential for competing in the new contestable electricity markets. These problems were
essentially solved through the outsourcing of IT&T to Global. However, the relationship was considered
tobe verydifcult inthe rst eighteenmonths. The initial contract providedonlya broadframework, which
developed over time to incorporate more specic provisions of specic responsibilities and performance
targets, through processes of negotiation and communication with the outsourcer. While some managers
saw the incomplete contract as a source of conict that could have been avoided, this was not a universal
view. A strategic alliance with a cable supplier was undertaken two years after commencement of the
IT&T contract. This agreement was undertaken without a full written contractsimply a heads of
agreementas the managers negotiating the agreement had seen the problems that arose with the IT&T
contract. There was also a belief among some managers that a contract could be a source of mistrust
between parties. This new relationship was to be characterised by an open book approach to the sharing
of information. Performance was to be tied to risk-return, and a steering committee consisting of managers
from both rms was to develop performance indicators to support areas such as growth, delivery time
and cost. A manager described how the new relationships would proceed, compared to the IT&T project.
Its virtually the same selection process, but were going to implement it in a different way. Were not
going to tie it to a legal contract; we will try and build it on trust from day one. Now we could fall at
on our face but some experiences that Ive had suggests the legal agreement does introduce a sense
of mistrust from day one, because all the is have got to be dotted and the ts have got to be crossed.
I have to admit our lawyers are not exactly ecstatic about this direction but it have accepted it with a
few clauses that weve had to put in to keep them happy. But what were saying is that were not going
to be tied to a legal agreement. This thing we want to have is an arrangement and partnership built on
trust.
4. Analysis and discussion
In this section, we consider the characteristics of the transaction (task programmability, output mea-
surability, asset specicity and frequency of the transaction), the transaction environment and the parties,
and assess whether the type of control mechanisms in place and the role of trust in achieving control
matches any of the three control pattern presented in Table 1.
4.1. The inter-rm control model
4.1.1. Characteristics of the transaction
In general, it was not easy to achieve a high level of task programmability at Central. High levels of
uncertainty arose from the complexity of the technology, the range of the IT tasks, and the ambiguity
of the IT market. While there were some routine IT tasks involved in the outsourcing contract, it was
still difcult to specify ex ante procedures and processes needed to ensure success. The high levels of
uncertainty made it difcult to develop specic contract provisions prior to engaging the outsourcer, and
in the early days of the relationship.
The level of output measurability was low initially, but increased over time as Central worked with
Global to assess the quality of the delivered outcomes of the outsourcer. This was possible due to the high
level of IT expertise that was retained within the electricity rm, which was developed further after the
IT functions were outsourced, as well as through the mechanisms that were used to increase information
sharing during the execution of the contract. In the case of more discrete IT projects (such as the customer
service system), there was a lower level of uncertainty and output measures were pre-specied. Over
time, both parties to the relationship gained some experience in specifying output measures and targets,
as evidenced by the development of the risk-reward scheme.
The level of asset specicity is a complex issue to assess. Ownership of the physical IT assets and the
software were retained by Central, which managers believed safeguarded themfrombeing over-dependent
on the outsourcers. However, the granting of exclusivity to Global created a high level of dependency
on that one supplier. Global developed considerable levels of knowledge, skills and experience that
were tailored to Centrals needs to allow them to execute their contract effectively (high human asset
specicity). Also, the outsourcers were located on-site (high site specicity). The two parties to the
relationship invested considerable time in establishing good working relationships with individuals and
groups in either party. Switching costs were highany withdrawal of service by the outsourcer would
have had a devastating impact on the ongoing operations of either party. Thus, the relationship was
characterised by high asset specicity. Under a bureaucratic pattern of control, dysfunctional behaviour
arising from high asset specicity would be protected by contractual rules, while under a trust based
pattern, high levels of trust would mitigate any opportunism or power plays resulting from high asset
specicity.
The transactions included in the outsourcing relationship consisted of a mix of repetitive transactions,
and one-off projects. This mix of transactions increased the level of uncertainty and contributed to low
task programmability and low output measurability.
Thus, in the early days of the relationship, the characteristics of the transaction indicate that the out-
sourcing relationship between Central and Global largely following a trust based pattern; low task pro-
grammability, low levels of output measurability that increased over time, high asset specicity, and a
mix of low (and high) repetitiveness of transactions. However, as task programmability and output mea-
surability were gradually becoming higher toward the end of the research period, this could signify a
move towards a more bureaucratic pattern of control.
4.1.2. The characteristics of the environment
The environment within which the outsourcing relationship operated was one of high risk and high
uncertainty, particular in the early days of the contract. Future developments in IT technology were dif-
cult to foresee and forecast with any accuracy, and a changing and uncertain competitive electricity
environment made it difcult to predict competitor and customer actions. Deregulation of the electricity
industry resulted in increased competition as well as increased opportunities for Central. However, the
implications of these changes for the future business of Central were unclear. The high risk and un-
certain setting also led to the relationship placing greater reliance on social embeddedness, through the
development of competence trust and goodwill trust as means of control (this will be discussed further
in a later section of this paper). In summary, the characteristics of the environment within which the
outsourcing relationship developed are those associated with a trust based control pattern, as outlined
in Table 1.
4.1.3. The characteristics of the parties
A high level of competence, outstanding reputation and extensive experience as an outsourcer were
highly important characteristics that Central sought in their outsourcer. Due to the high level of risk and
uncertainty in the outsourcing activity, Central could not risk engaging an outsourcer that did not have
such qualities. While risk sharing and lowinformation asymmetry did not seemto be evident in the earlier
days of the relationship, as the relationship matured, Central came to share more information with Global,
and through the risk-return system the sharing of risk was explicitly encouraged. Thus, the parties to the
relationship came to display characteristics closely associated with those of a trust based pattern.
4.1.4. Summary
Thus, the three contingent factors of the characteristics of the transaction, environment and the parties
point towards a trust based pattern of control. This is particularly the case in the early months of the
relationship. However, as the relationship matured, the levels of task programmability and outcome
measurability increased through joint activities and the increased knowledge that developed between the
two parties. This is more characteristic of a bureaucracy based pattern.
4.2. Control mechanisms
Trust based patterns of control are characterised by outcome and social controls that develop over
time. There is no reliance on behaviour controls, and trust forms the prime means for achieving control.
Reliance on formal outcome controls is low at the start of the relationship, but increases over time. The
relationship is characterised by relatively unspecic general thrust contracts, performance assessment
based on broad emergent standards, and information sharing due to the participatory, interactive nature
of the process of contract execution. In this section, we examine these control mechanisms and the role
of trust in achieving control in the case study.
4.2.1. The contract
Poorly specied contracts have been cited as a major reason for the failure of some outsourcing rela-
tionships, particularly in the IT area (Robertson, 1998; Domberger, 1998). However, there are situations
where high levels of uncertainty make complete contracts unattainable. Some managers at Central be-
lieved that the lack of detail in the contract specications was a barrier to establishing smooth relationships
with the outsourcer, particularly at the start of the relationship. These problems related to the ambiguous
specication of the baseline services that needed to be maintained to achieve the xed payment, and the
precise cost that the outsourcers would charge Central for those baseline services. There was also an
absence of performance measures and targets, which were then negotiated over the rst few years of the
contract. Central prepared their contract in haste and this clearly led to dissatisfaction among managers
with the lack of precision in the provisions of the contract.
Being risk adverse, it is understandable that managers may desire contracts to be tightly written,
particularly given the critical nature of the function that was outsourced and the size of the contract.
However, the complexity and uncertainty encompassed in the outsourced IT tasks made it unrealistic to
expect that all important aspects of the operation and relationship could be specied and incorporated
into a contract (Spekl, 2001). In these cases, important aspects of the relationships can only evolve over
time (Das and Teng, 2001b). As the relationship develops, partners may come to recognise specic needs
and requirements, which were difcult to anticipate at the start of the relationship. In the rst eighteen
months of the relationship, Central was able to work with Global to resolve perceived inadequacies in
the initial contracts, as both parties together improved their knowledge of the tasks and their execution.
More sophisticated provisions were incorporated into the contract to cover areas such as performance
measurement, occupational health and safety standards, better assigned responsibility for costs, and
specications for the sharing of cost improvements.
Some managers at Central saw the incomplete contract as a limitation and a source on conict that
impacted unfavourably on the relationship with Global. However, it could be argued that even if more time
had been spent on formulating the contract, given the high levels of task uncertainty and low outcome
measurability encompassed in the delivery of the base IT services, the contract may still have been
incomplete. While the conict and negotiations with Global may have been regarded as time consuming
and dysfunctional, some managers acknowledged that this was an important way of developing shared
understandings and objectives. The move towards the formulation of the new strategic alliance based on
the heads of agreement was recognition by some managers that in some situations contracts cannot be
easily formulated and an attempt to do this may lead to initial mistrust.
4.2.2. Performance measurement
It has been suggested that a rm may gain control over the function being outsourced through ongoing
monitoring of work performance, as well as monitoring aspects of the outsourcing relationship throughout
the contract period (McFarlan and Nolan, 1995). This may be achieved using performance measures and
benchmarks, which focus on areas such as customer satisfaction, delivery responsiveness, product quality
and cost, and either included within the contract, or negotiated at a later date.
High levels of uncertainty in the specication of the outsourced function made initial performance
standards difcult to specify. Through numerous discussions and meetings between managers at Central
and Global, performance measures and targets were developed to provide the most appropriate incentives
for the outsourcer to deliver quality services. A risk-reward scheme was introduced to encourage the
outsourcer to achieve more prots when undertaking a new discretionary project, while also delivering
cost savings to Central. The Central case emphasises the way in which incentive systems can be structured
to benet both parties in the relationship, effectively encouraging the developing of shared goals, and
encouraged goodwill trust. Thus, the two parties were able to develop outcome controls as their shared
knowledge of the processes increased over time.
4.2.3. Information sharing through participatory, interactive processes
There were many activities undertaken by managers at Central and Global that involved participatory
processes and knowledge sharing.
Key issues in establishing protocols for effective communications between the rm and its outsourcer
included the number of points of contact within the rm, and the regularity of formal meetings. An impor-
tant issue for managers at Central was establishing the point of contact to manage the relationship. Initially
the IT&T Outsourcing Manager handled day-to-day problems that emerged between the outsourcer and
the various businesses of Central. One manager at Central suggested that in managing the transition, this
manager should have focused solely on establishing the relationship, leaving the day-to-day running of
the process to subordinates. Regular meetings were held between managers and the outsourcers to review
performance and to discuss future plans.
Establishing formal communication protocols are important in the early days of the relationship with
an outsourcer, when there are incomplete contracts, to establish the ground rules and expectations of each
party. This may involve single or multiple contact points, depending on the characteristics of the function
that is being delivered by the outsourcer and the complexity or critical nature of the service.
The mechanisms that Central and Global used to develop performance indicators also became an
important part of the participatory information sharing processes. First, the processes provided a forum
for interaction between the two parties, increasing the number of joint dealings and increasing familiarity.
The performance indicators also provided an efcient form of communication of expectations between
the two parties (Jarillo, 1988). Third, the design of the risk-reward system allowed both parties to share
in the rewards when new discretionary IT&T projects met expectations of effectiveness and efciency,
thus, contributing to the strengthening of the relationship.
4.2.4. Summary
The means by which Central used outcome and social controls to manage the outsourcing relationship
are largely consistent with the requirements of a trust based pattern of controlrelying on outcome and
socials controls, broad non-specic contracts that develop time, performance assessed through broad
emergent standards and high levels of information sharing and communications. This compares with a
bureaucratic based pattern that relies on outcome and behaviour controls, which include comprehensive
selection criteria and formal bidding, rigid performance targets, comprehensive rules of behaviour and
detailed contracts. However, there was reliance on formal bidding procedures to award the outsourcing
contract, and as the relationship progressed, there was a clearer specication of performance targets and
of the contract itself.
4.3. Building high levels of trust
Trust is vital in achieving control in a trust based pattern of control, but is of lesser importance in
a bureaucratic based pattern, and has no relevance in a market based pattern. In a trust based control
pattern, key forms of trust that work with control systems to reduce risk in outsourcing relationships are
contractual trust, competence trust and goodwill trust. Some levels of contractual trust and competence
trust are essential for both bureaucratic and trust based patterns, to allow the initial selection of the
outsourcer and for some form of contract to proceed. In a trust based pattern competence trust will
develop further over time and form a part of the control framework. Goodwill trust is difcult to achieve
in an outsourcing relationship (Das and Teng, 2001b), but is essential as it reduces the likelihood of
opportunistic behaviour. We have argued that there was a high dependency between Central and Global,
due to the exclusive nature of the supply contract, and the strategic nature of the information that was
shared between Central and Global. Goodwill trust will work with outcome controls and social controls
to reduce risk (Das and Teng, 2001a).
4.3.1. Building competence trust
There are several mechanisms that increase competence trust in an outsourcing relationship, which in
combination with outcome controls and social controls will reduce risk. The major competence-building
mechanism is proactive information collection (Das and Teng, 2001a). Central was careful to ensure
that the outsourcing company that they engaged had a strong reputation in the IT industry and strong
technical competence. Global was perceived by managers at Central as having high credibility, status and
competence in the ITindustry. On close examination of the interviewtranscripts it seems that the managers
at Central made limited reference to the technical competence of the chosen outsourcercompetence
trust was not considered a concern with Global. However, developing high levels of goodwill trust was a
conscious strategy followed at Central.
4.3.2. Building goodwill trust
It is clear from the quotations in the case studies that the outsourcing relationship commenced with a
low level of goodwill trust. Some managers at Central believed that this was a function of starting with an
incomplete contract and conicting priorities. It could also have be a function of the gap in knowledge,
insights and control that can appear immediately following the outsourcing of a key function (Mouritsen
et al., 2001). In addition, there were distinct differences in the cultures of the two organisations and this
made initial communications difcult. Managers were also very conscious of the need to develop trust
to make the relationship work, and implicit in the managers quotations in the case study is the need to
develop goodwill trust. The high level of dependence between the organisation and the outsourcer, and
the high risk for Central, led managers to work hard at resolving difculties and issues during the rst
two years of the contract.
Trust arises through processes of learning and adaptation, and this is not a passive exercise. Das and
Teng (2001a) argue that three sources of goodwill trust can assist in the reduction of risk in outsourcing
relationships. These are establishing mutual interests, building individual and team-level trust and joint
dispute resolution. Each of these activities is evident in the case study.
4.3.2.1. Establishing mutual interests. This is the primary means for building goodwill trust, and in-
volves partners to the relationship arriving at an understanding of the common areas of interest (Das
and Teng, 2001a). Central achieved this through a variety of mechanisms, including regular meetings
and communications. This allowed the ground rules for the operation of the contract to be established,
performance measures to be developed and the risk-reward system to be debated and implemented. The
development of a series of performance indicators itself, played an important role in the development of
goodwill trust. First, it provided a forum for interaction between the two parties, increasing the number
of joint dealings and increasing familiarity. This may encourage trust (Browning et al., 1995; Chiles and
McMackin, 1996). Also, the performance indicators may have provided an efcient way to communi-
cate performance expectations for both parties. Third, the design of the risk-reward system allowed both
parties to share in the rewards when new IT&T projects met expectations of effectiveness and efciency,
thus, contributing to a strengthening of the relationship of trust. While some studies have disputed the
compatibility of performance targets and specied contract provisions, at Central, the key to the accep-
tance of these outcome controls seemed to be the way in which the changes were introducedin an
atmosphere of communication and cooperationand perhaps to there being a certain level of goodwill
trust in place prior to their introduction.
4.3.2.2. Building individual and team-level trust. It has been argued that the development of trust
between individuals or teams and the outsourcer is important in developing goodwill trust between rms.
Many researchers have argued that trust between individuals is critical for cooperation to take place (see,
for example, Smith et al., 1995); however, this trust may take time to emerge. In the initial months of
the relationship, Centrals IT&T Outsourcing Manager was the sole contact point for Global, and he
set about developing personal relationships with key Global staff. This manager had extensive technical
knowledge and seemed to understand the sensitivities of establishing productive working relationships,
negotiating ground rules and opening communication channels. Once these relationships strengthened,
he set up communication points between Global and service staff in each business unit. At Central, some
mistrust initially arose when managers within the four businesses units were charged by the outsourcer for
their use of IT services. This action was met with suspicion and claims of overcharging. This reaction was
a result of the transition towards realistic charging for IT services, which had not been fully explained
to managers. Clearly, effective communication may provide a way to encourage the development of
goodwill trust, by clarifying expectations and encouraging repeated positive interactions.
4.3.2.3. Joint dispute resolution. Evidence from the case points to frequent meetings and communi-
cations, particularly in the early stages of the relationship that worked to establish the ground rules and
protocols. Joint dispute resolution allows partners to a relationship to develop a strong understanding
of perspectives and approaches, and is of particular importance in situations where contracts are not
precisely specied (Ring and Van de Ven, 1994).
4.3.3. Summary
Essential to achieving control in the relationship between Central and Global was the development of
trust. Unlike a bureaucratic based pattern or a market based pattern, control was difcult to achieve in this
relationship as the difculties in task programmability and output measurability meant that formal controls
were difcult to implement, particular in the early stages of the relationship. Trust, particularly goodwill
trust, played a role in working with control mechanisms to ensure control, and in allowing the operations
to proceed in the absence of tightly specied rules. Interestingly, goodwill trust continued to exist, and
may even have strengthened, in the face of the development of more rigid performance expectations and
the developing contract specications. This runs contrary to the arguments of some prior research, which
has argued that formal accounting and contracting may conict with the development of trust (see, for
example, Seal and Vincent-Jones, 1997; Seal et al., 1999). The development of goodwill trust also allowed
a relationship where there was high asset specicity, and hence high interdependencies and high risk of
opportunism, to continue and to remain under control.
5. Conclusion
This paper focuses on a case study of an outsourcing relationship, and howcontrol mechanisms and trust
worked together to achieve control. The characteristics of the outsourcing transactions seemed to meet
the requirements of a trust based pattern of control, and control was achieved through the development
of outcome controls and social controls and through the development of trust, particularly goodwill trust.
This paper contributes to the literature in several different ways. First, this paper draws on the three
pattern of control specied by van der Meer-Kooistra and Vosselman (2000), to add to the growing
knowledge of control systems in new organisational forms. Second, focusing on the three contingent
factorscharacteristics of the transaction, environment and the partiesto determine the formof control
pattern highlighted how the control pattern may gradually change over the life of a relationship, as those
contingent factors change. In the case study, as the performance standards became more specied and
as the contract developed, the trust based pattern of control began to move towards a bureaucratic form
of control. Finally, the paper provides some evidence that the development of trust may be compatible
with the development of tighter accounting controls and contracts, if trust is already well-established and
those controls develop in a supportive and cooperative manner, involving both parties.
The ndings of this study are of interest to managers who enter outsourcing relationships, and to
researchers who endeavour to understand the nature of control systems and trust associated with new
organisational forms. However, the limitations of the study must be acknowledged, and future research
directions considered. First, a key aspect associated with outsourcing is risk (Das and Teng, 2001a), and it
has been claimed that combination of controls and trust building will contribute to reducing risk. Risk was
not specically investigated in this study, and there would be considerable benets in investigating more
explicitly the controltrustrisk relationship in future studies. Second, the interdependencies between
the development of control in the inter-rm relationship and in Centrals own control system could
have been investigated in greater depth. It is clear from the quotations in this case study that building
of the relationship with Global led to changes in Centrals own internal control systems. For Central
managers there were changes inaccountabilities andresponsibilities, chargingandcost allocationsystems,
capital expenditure systems and planning systems. It seems that controls over IT operations, planning and
spending improved following outsourcing, in a similar way to the changes described by Mouritsen et al.
(2001) in his outsourcing case studies. The interdependencies between internal and inter-rm control
systems could form an interesting focus for future research.
Third, the model that was drawn on to shape the analysis was derived from TCE and, thus, could be
criticised for taking an approach that is too xed on transactions, at the expense of the relational aspects.
However, the model of van der Meer-Kooistra and Vosselman (2000) builds on the basic transactional
aspects of TCE, but goes beyond this to consider the contingent factors of the characteristics of the
transaction, the transaction environment and the parties, as well as role of control mechanisms and trust
in inter-rmrelationships. Nevertheless, there are other frameworks that have been used to study inter-rm
relationships. These include institutional theories (see, for example, Burns and Scapens, 2000) and actor
network theory (Mouritsen et al., 2001; Chua and Mahama, 2002).
Fourth, the evidence presented in this study is based on only a single example of an outsourcing
relationship, and access was gained only to one party to that relationship. Clearly, more extensive studies
need to be undertaken to explore the issues that arose in this study, and the perspectives of both the
outsourcer and outsourcing organisation should be investigated. Finally, the function that was outsourced
was information technology, which was of key strategic importance to Central, and it may be questioned
whether the control patterns extend to other outsourced functions, such as human resource management
or production maintenance.
Acknowledgements
We would like to thanks the two anonymous referees and the Editor for their excellent reviews and
suggestions that signicantly improved this paper.
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Management Accounting Research 14 (2003) 281307

Management control systems and trust in outsourcing relationships

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