Software Development Outsourcing and The Principal-Agent Problem (Part II)

In part one, we discussed the principal-agent theory, an economic framework for analyzing the relationship between a Principal and Agent. Now, we’ll explore practical strategies for applying this theory in software outsourcing partnerships.

The process of Software Development Outsourcing can be broken down into three distinct stages: Selection, Execution, and Post-Project.

Selection

It’s important that you consider everything before signing an outsourcing agreement, as even small mistakes can have an effect on the long term success of the solution. Prior to engaging with an outsourcing agent, it is important to consider the phenomenon of ‘Adverse Selection’ as described by the Principal Agent Theory. This highlights the challenge of assessing an agent’s reliability and suitability during the selection process. Before you engage with an outsourcing agent, you cannot judge:

1. Productivity, soft skills, education and other qualities that determine the Agent’s performance are often hidden characteristics during the selection process.

2. The Agent’s hidden intentions such as maximizing their profit by consuming ‘perks’, shirking, and gathering valuable knowledge are essential to consider during the selection process.

Uncertainty arising from limited access to key information can lead to poor decision-making, potentially obstructing your goals.

Quick note before we look into solutions for the Adverse Selection problems:
Be careful with budgeting. There is a real danger of partial market failure if you cap the hourly rate too low. High quality agencies might not apply for low to average paying projects, while low quality agencies will be more than happy getting average rates for sub-par results.

Here are three ways to ensure you’re paying a fair rate when outsourcing software development:

1. Selection criteria – Start off by writing down some measurable selection criteria. This will allow you to differentiate between different agencies. Then ask for documentation that proves their answers. This will lower uncertainty over some performance indicators.

2. References – Read the reviews provided by each outsourcing agency and reach out to their references. This will give you an idea of what it’s like to work with them, and they might let you know about some red flags to look out for.

3. Screening and self-selection – This method consists in cutting-out a small part of the project and awarding it to an agency, as a way to judge their quality. On top of this, you can also give them an incentive related to the quality of work, which would further reduce the attractiveness of the project for lower quality teams.

Execution

Even after selecting an agency for your software development needs, you may still face limitations in controlling and evaluating their efforts due to the hidden actions that are difficult to monitor. The agency’s informational advantage may lead to the use of discretionary freedom to maximize their own profit, potentially resulting in inefficiencies in the software development process for your software solution.

Here are some suggestions for preventing wrongdoing by the agency:

1. Monitoring – the most cost efficient way to monitor your outsourcing agents is to evaluate their outputs regularly, as monitoring inputs is both time intensive and easy to manipulate.

2. Contractual Agreements restrictions – Instead of trying to track the inputs, you can choose to agree on coding guidelines, process definitions and project management rules. This will reduce your agents freedom but it’s a good way to reduce your own risk.

3. Incentive-compatible contracts – While it may be challenging to implement, agreeing on performance-based incentives is an effective strategy to align the goals of both parties. It’s important to choose incentives that the agent has control over but cannot manipulate.

In conclusion, during the execution stage, it’s crucial to prioritize the quality of the delivered software, taking into account factors such as maintainability, reusability, and scalability to ensure a worthwhile long-term investment.

Post-Project

Future-Proofing your Product

Although it’s the final stage of each project, it’s important to plan for its execution in advance to prevent dependence on specific agencies. Implicit knowledge or exclusive skills possessed by an agency can be manipulated in advance, leading to potential hidden intentions and higher costs for the Principal in the future. Thankfully, preventing this scenario is easy with the following two simple pieces of advice:

1. Pick the right tool – You must insist on using standard tools and well-known technologies for most of the projects. On top of this, you must ask any Agent to provide you with high quality, detailed documentation. In case your use case requires a new technology that the market isn’t too familiar with, opt to work with multiple agencies. This will increase competition in future projects.

2. Size of projects – By cutting down on the size of each project, you’ll increase the number of interactions with each agency. When an agency is aware there is potential for more projects, they won’t exploit an opportunity to hold you up. Along these interactions, you’ll be able to better judge your agent and he’ll be able to increase your trust.

Endnotes and Exaud

“Building loyalty between your company and outsourcing partners is a simple and cost-effective way to ensure a good product and positive experience. Companies with stable, dedicated teams are typically better suited for this, as each individual is more likely to take responsibility for the end result. At Exaud, we prioritize building strong relationships with our clients to ensure their satisfaction. Don’t just take our word for it, check out our DesignRush reviews to learn more about our successful partnerships. Contact us today for a free quote!