Department of Information Systems and Operations Management, Michael G. Foster School of Business, University of Washington, Seattle, Washington 98195.
Outsourcing of software development allows a business to focus on its core competency and take advantage of vendors' technical expertise, economies of scale and scope, and their ability to smooth labor demand fluctuations across several clients. However, contracting a software project to an outside developer is often quite challenging because of information asymmetry and incentive divergence. A typical software development contract must deal with a variety of interrelated issues such as the quality of the developed system, the timeliness of delivery, the effort and cost associated with the project, the contract payment, and the postdelivery software support. This paper presents a contract-theoretic model that incorporates these factors to analyze how software outsourcing contracts can be designed. We find that despite their relative inefficiency, fixed-price contracts are often appropriate for simple software projects that require short development time. Time-and-materials contracts work well for more complex projects when the auditing process is efficient and effective. We also examine a type of performance-based contract called quality-level agreement and find that the first-best solution can be reached with such a contract. Finally, we consider profit-sharing contracts that are useful in situations where the developer has more bargaining power.