Building Flexibility Into Contracts

The main rationale for building flexibleness into an outsourcing abridge is based on the premise that factors both innerly and externally may change and thus preserve the achievement of the desired objectives of the outsourcing. For example, the internal requirements of the sourcing organic law may change during the outsourcing cut back or another supplier in the supply market may achieve a technology breakthrough, which consent tos it to realize signifi preservet performance improvements.In the latter case, the establishment of a long-run curve with a competing supplier prevents the sourcing organization from accessing the superior capabili associations of this supplier. Therefore, incorporating elements into a entreat that make out flexibleness send away ensure that the desired benefits atomic number 18 existence achieved from outsourcing and in particular, ensure that the sourcing organization is not locked into a relationship with an uncompetitive supplier.Likewi se, building flexibility into contracts aids organizations in benefiting from the outsourcers address improvements as they occurred, rid of lawsuits and save face in the upcoming. Ways to Build Flexibility into Contracts McIvor (2005) associate that flexibility can be achieved through either half(prenominal) or incentive contracts. Incomplete detection creates a situation in which separate of the contract can be renegotiated based upon changes in circumstances. It is mainly concern with optimization over time, seeking to minimize the exists of adapting to the constantly ever-changing conditions of the frugal environment.There are a number of methods incorporating flexibility into a contract through incomplete spying like price flexibility, renegotiation, contract continuance and early termination (Langfield-Smith, Smith and Stringer, 2000). Price flexibility allows prices to be renegotiated as circumstances change during the contract. Incorporating price flexibility means that all future contingencies do not fox to be fully considered at the outset, as the buyer and supplier are aware that prices can be change to reflect changes in circumstances.For example, changes in the requirements of the sourcing organization during the contract may deal an adjustment in prices. In renegotiation, mechanisms are corporal into the contract that allow for renegotiation based upon changes in the business environment. The contract may include special(prenominal) clauses under which renegotiation should occur including fixed calendar dates or changes in economic indices. Renegotiation practically involves renegotiating more than price and can also focus on the terms of contract.The employment of shorter contracts can be employed to achieve flexibility. At the end of the contract period a new contract can be negotiated that reflects the current circumstances both internally and externally. Rather than hold up the five- to seven-year contracts of the last decade , contracts are now being broken into manageable timeframes which curb short initial terms and options for extensions. Few organizations can predict their needs with any certainty over long lengths of time, thus it is prudent to have flexibility over the contract continuance.A clause may be incorporated into the contract that sets out the conditions under which the contract may be terminated. The disregard of such(prenominal) a clause can result in significant penalties in the event of the contract being terminated prematurely. Incentive contracting, on the other hand, involves incorporating mechanisms into the contract that allow the supplier to share any cost savings or profits generated through the outsourcing relationship (Dimitri, Piga and Spagnolo, 2006).Taking advantage of a declarers general objective to maximize profits by giving it the opportunity to earn a greater profit if it performs the contract efficiently lies at the core of incentive contracting. The essence of said contracting type is the effort by one individual or organization (the principal) to induce and reward certain behaviors by another (the agent). It has been the subject of significant discussion in the economics literature, as incentive contracts are often employed to encourage performance improvements in the outsourcing arrangement in areas such as cost reduction and service levels (Bolton and Dewatripont, 2005).This type of contract stimulates the contractor to limit cost by leaving him a fraction of cost savings, but at the same time it reimburses him some money in case of cost overrun. The contract will include mechanisms that ensure the supplier shares any savings that are realized from performance improvements. Incentivization can create a more cooperative relationship between parties, overcoming the traditional adversarial shape up to contracting.The purpose of the incentives is not just to motivate the contractor but to tie performance of all participants to the contr acts objectives. The proper use of an incentive contract aligns the priorities of contract participants who would otherwise have diverse motives. Potential Risks of construct in Too Much Flexibility Nowhere is the potential trade-off between control and flexibility more apparent than when it comes to designing the contract. As with anything that is to a fault much, there are potential risks of building in too much flexibility into contracts.By having too much contract flexibility, short-term opportunistic behavior is more likely, which is why classical legal contracts remove flexibility by building in as much legally enforceable control as possible that protects both parties from such behavior. With respect to incomplete contracting, problems arise when any agreement is negotiated under conditions of incomplete or irregular information, risk and uncertainty. It has also been associated with certain organizational costs, as it needs to be revise or renegotiated as the future unf olds.John (2000) identifies three such types of costs ex post costs of haggling over the terms of the revised contract upon renegotiation those related to inefficient agreements caused by asymmetric information and ex ante costs of not investing in relation-specific investments in misgiving of encountering hold-up behavior upon contract renegotiation. Since it is impossible to write a complete contract that specifies what the agent is required to do in all contingencies, legal case law is employed to determine obligations of the contracting parties that are not explicitly pen into a contract.Familiar contractual forms have the advantage that there is a wealth of legal precedent concerning them. Thus, disputes are likely to be resolved speedily. more(prenominal) exotic contractual forms, for which there are few legal precedents, are more prone to costly and acrimonious legal disputes (Aghion and Bolton, 2002). Further, incomplete contracting discourages both relation-specific inv estments and value-enhancing agreements.When it comes to incentive contracting which operates on the theory of the carrot and the spoil (theres a financial carrot for a supplier for reveal than agreed-on quality, reli talent, delivery or performance and a financial stick for worsened than agreed-on levels of those parameters), the principle is attractive but the practice is another matter. Suppliers are loath(p) to accept financial penalties, especially for reliability targets are not reached, and customers are reluctant to extend financial incentives to suppliers if agreed-on targets are not met.In incentive contracting, the risks amount, probability, and impact are major factors influencing the design of the contract since the main purpose of this is transferring the risks. As well, there are several limitations to incentive contracting, as it depends on a purchaser with the ability to specify performance, the possibility of meaningful performance measures that can be identifie d, agreed upon and implemented, the existence of resources to oversee and monitor performance, and the practical ability to take action, including replacing the contractor, where performance is unsatisfactory.The front pages provide too-frequent illustration of the ship canal in which contract incentives designed by the best and most well-meant experts may yield unintended adverse consequences. Incentives can divert guardianship from other important goals, work too well on their have terms, or encourage distorted reporting. WORKS CITED 1. Aghion, P. & Bolton, P. (2002). On Partial Contracting. European Economic Review. 46, 745-753. 2. Bolton, P. & Dewatripont, M.(2005). Contract Theory. Massachusetts Massachusetts Institute of Technology. 3. Dimitri, N. , Piga, G. & Spagnolo, G. (2006). The Handbook of Procurement. refreshing York Cambridge University Press. 4. Langfield-Smith, K. , Smith, D. & Stringer, C. (2000). Managing the Outsourcing Relationship. Australia University of S outh Wales Press, Ltd. 5. McIvor, R. (2005). The Outsourcing Process Strategies for Evaluation and Management. New York Cambridge University