Service Outsourcing: Capacity, Quality and Correlated Costs

44 Pages Posted: 18 Mar 2009 Last revised: 8 Oct 2016

See all articles by Z. Justin Ren

Z. Justin Ren

Boston University Questrom School of Business

Fuqiang Zhang

Washington University in St. Louis - John M. Olin Business School

Tianjun Feng

Fudan University - School of Management

Date Written: September 17, 2016

Abstract

This paper studies how to design service outsourcing contracts to ensure fast, quality services from an independent service provider. The outsourcer does not have perfect information about either the service provider's capacity cost (i.e., cost for providing fast service), or her quality cost (i.e., cost of achieving a high quality level). Moreover, the two unknown costs may be correlated with each other. We solve for the outsourcer's optimal outsourcing contract, and show that the structure of the optimal contract depends on the relationship between the costs. Specifically, we highlight the following observations when the two costs are negatively correlated: First, under certain conditions, the outsourcer may be able to squeeze the supplier's profit (information rent) to zero for an intermediate range of cost realizations; second, it is possible that the service supply chain is coordinated by using the outsourcer's optimal contract. We then examine the performance of two classes of commonly observed contracts that are relatively simple to implement. It has been found that these simple contracts generally perform well when the costs are positively correlated, but they could perform much worse when the costs are negatively correlated. Our results therefore caution outsourcing companies that the potential trade-off between capacity cost and quality cost may require a careful design of outsourcing contracts.

Keywords: outsourcing, service, capacity, quality, information asymmetry, contracting, queueing systems

Suggested Citation

Ren, Z. Justin and Zhang, Fuqiang and Feng, Tianjun, Service Outsourcing: Capacity, Quality and Correlated Costs (September 17, 2016). Available at SSRN: https://ssrn.com/abstract=1362036 or http://dx.doi.org/10.2139/ssrn.1362036

Z. Justin Ren

Boston University Questrom School of Business ( email )

595 Commonwealth Avenue
Boston, MA MA 02215
United States

HOME PAGE: http://www.bu.edu/experts/profiles/z-justin-ren/

Fuqiang Zhang (Contact Author)

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

HOME PAGE: http://www.olin.wustl.edu/faculty/zhang/

Tianjun Feng

Fudan University - School of Management ( email )

No. 670, Guoshun Road
No.670 Guoshun Road
Shanghai, 200433
China