Improving outsourcing negotiations

Improving outsourcing negotiations

By Dr. Samy Essa, Prof. dr. Henri Dekker and Prof. dr. Tom Groot 
  
Profit, non-profit and government organizations increasingly outsource parts of their business activities to external partners. In this way, organizations use the partner’s expertise and business capabilities to control costs and become more efficient, flexible and innovative. In practice, however, many outsourcing contracts fail to deliver on their promises. Conditions may have changed (especially for off-shoring outsourcing contracts to companies overseas), the contract may not have been executed as intended or the partners may start their outsourcing relation based on a faulty contract. Our research focuses on the latter explanation; we attempt to find out under which conditions partners are able to reach an optimal outsourcing contract. We define an optimal contract as a contract that identifies the total gains to be reached when both partners cooperate fully with each other. In our study, we use an experiment in which a company (called the buyer) outsources an activity to a supplier. Buyers and suppliers negotiate a contract that covers the acquisition of a machine and a service contract that defines two aspects: maintenance intensity and the delivery of spare parts. The price of the machine and the cost of maintenance and spare parts are negotiable. Participants in the game freely negotiate and choose among a defined set of prices and service levels. The set of alternative prices and service levels is calibrated in such a way that effective bargaining leads to an optimal contract for both partners in which the total gain (the joint profit) for the two partners is optimal. We had 350 participants (175 buyer-supplier dyads) play the game under different conditions and we monitored both the agreements reached as well as each partner’s communication with the other partner.

An important condition is the level of uncertainty: most outsourcing negotiations take place in uncertain conditions and their outcomes cannot be foreseen very well. We found that uncertainty influences the mental orientation of the partners: when prices are uncertain, buyers focus primarily on the maximum estimated price and suppliers on the minimum estimated price. It also influences the way in which each partner communicates in the negotiation. Uncertainty leads to more competitive negotiation behaviour, which means that partners focus primarily on their own benefits, even if this comes at the expense of the partner. More competitive negotiation behaviour appears to lead to contracts that produce lower joint profits. We found that two alternative measures help to change negotiation behaviour and improve joint profits. The first is to provide more detailed cost and price information on the contract terms. A practical example of this measure is to replace fixed prices by the total cost of ownership for service and spare parts. More detailed information facilitates more meaningful negotiations, which may reduce competitive behaviour and stimulate integrative negotiation behaviour instead. Partners using integrative negotiation behaviour try to make trade-offs or jointly solve problems to realize mutual benefits. A second measure is to monitor each partner’s behaviour more closely, by having their calculations and affirmations audited by a third party (a boss or an external auditor or consultant). Our results show that more detailed cost information and monitoring indeed lead to more integrative negotiation behaviour and better contracts with higher joint outcomes.

A second major theme in our research is the role of trust between negotiators. When partners trust each other, they indeed use more integrative negotiation tactics and reach higher joint outcomes. The negotiations do no take less time, though, but take even more time to conclude, however; trusting partners appear to exchange more information and they need more time to identify solutions that serve mutual interests better. A crucial question is: how does trust emerge during the negotiations between outsourcing partners? In our experiments, we see that uncertainty has a negative effect on trust creation. The use of refined cost information and monitoring in highly uncertain conditions remediates this problem. However, the best way to create trust is to use integrative tactics and reach high joint profits in the initial negotiation rounds. Once trust is created, this influences behaviour and outcomes in later negotiation rounds. Good behaviour and high joint outcomes in the initial negotiation rounds stimulate trust and predict subsequent integrative negotiation behaviour and high joint profit outcomes in later negotiation rounds. Our research shows that trust needs to be earned: only trust created by negotiation behaviour in the past influences negotiation behaviour and outcomes in the future.

A third and final theme is the question of which partner contributes what to the joint negotiation process and its outcomes. Most research looks at the level of the dyad (buyer and supplier combined) and analyses the behaviour and outcomes of the joint negotiation process. If we look at what happens at the individual level, we see that negotiation behaviour and outcomes are not evenly distributed between the partners. Positional differences appear to exist: on average, buyers negotiate more competitively and earn more than suppliers do. This may be caused by the condition that suppliers have to start bidding first, which may lead buyers to become more critical and reject most of the suppliers’ bids. It may also be caused by the participants’ perception that the supplier should serve the client, which makes them somewhat more lenient towards buyers’ bids. An important outcome of our study is that negotiation behaviour is reciprocated by the partner: if a negotiator uses an integrative tactic, this will also be used by his partner. In general, integrative tactics lead to lower individual profits for negotiators than distributive tactics. However, due to the reciprocity by the partner, the indirect effect is that the negotiator’s profit will increase. Overall, the indirect effects are larger than the direct effects, and therefore the final result is that the profit of the integrative negotiator will be higher than that of the distributive negotiator.

Based on our research, we conclude that outsourcing conditions and negotiations can be effectively managed by each partner in such a way that the resulting outcomes are conducive to a successful outsourcing relationship.

For further inquiries about the research project, please contact Dr. Samy Essa, s.a.g.essa@vu.nl.