Fixed-price or performance-based? Contract design with renegotiation for IT outsourcing

Renegotiation after software development is widely adopted by firms to mitigate uncertainties in IT outsourcing. This study examines the design and choice of fixed-price versus performance-based contracts in scenarios where firms may renegotiate software debugging time with the IT vendor after development. Through a contract-renegotiation model, we find that without renegotiation, despite incurring a higher contracting cost, the performance-based contract increases the profit of the firm by regulating the vendor’s debugging effort, compared to the fixed-price contract. Renegotiation generates two key effects: the uncertainty-resolving effect (addressing development uncertainties) and the effort-incentivizing effect (stimulating the vendor’s effort), which collectively enhance the firm’s profit. Interestingly, when renegotiation is introduced, the uncertainty-resolving effect renders the ex-ante effort regulation of performance-based contract ineffective. Consequently, considering the higher contracting costs of performance-based contracts and the dual benefits of renegotiation, the firm prefers a fixed-price contract ex ante while renegotiating with the vendor ex post. • This paper examines the design and choice between fixed-price and performance-based contracts with renegotiation. • We find that renegotiation generates uncertainty-resolving and effort-incentivizing effects, both of which benefit the firm, and the uncertainty-resolving effect renders the ex ante effort regulation of the performance-based contract ineffective. • This work bridges a key discrepancy between theoretical research and business practice: while theoretical models suggest that performance-based contracts provide stronger incentives to IT vendors, fixed-price contracts are more prevalent in practice. • We propose an optimal outsourcing strategy for the firm: entering into a fixed-price contract with the IT vendor ex ante, and renegotiating initial contract after software development.