The Use of Management Control Mechanisms to Mitigate Moral Hazard in the Decision to Outsource

Authors


  • We are grateful for valuable comments from Abbie Smith (Editor), Chris Armstrong, Ramji Balakrishnan, Linda Bamber, K. Ramesh, an anonymous reviewer, conference participants at the 2011 Journal of Accounting Research Conference, and workshop participants at the University of Wisconsin, Michigan State University, and the University of Georgia.

ABSTRACT 

Using archival data from the U.S. passenger airline industry, this study examines whether management control mechanisms aimed at mitigating moral hazard explain outsourcing decisions over and above transaction cost economics (TCE) determinants documented in prior research. Consistent with TCE theory, we find that in-house production efficiencies and our proxy for transaction risk (i.e., deriving from transaction infrequency, transaction complexity, and relationship-specific investments) significantly explain the extent of outsourcing of aircraft maintenance. We extend TCE insights to show that incentive delta (i.e., the sensitivity of CEO portfolio holdings to stock price changes) strengthens the negative association between production efficiencies and outsourcing while incentive vega (i.e., the sensitivity of CEO holdings to stock return volatility) weakens the negative association between transaction risk and outsourcing. Monitoring strengthens the negative association between in-house production efficiencies and outsourcing, but has no effect on the transaction risk–outsourcing relation. The results suggest that the use of outsourcing to achieve cost savings is promoted through both incentive contracts and monitoring, but outsourcing to achieve the desired risk level is promoted only through incentive contracts.

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