Evaluation of flexibilities in outsourcing agreements through the real option approach

Since '90s, outsourcing concept became prevalent as a management strategy and business model. Outsourcing agreements are three to five years on average and depending on the market changes the customer has certain options such as: to expand or constrict the service scope, to penalise or award the vendor according to the service level agreements (SLAs), to abandon the service or to switch to another vendor. Having these real options included in an outsourcing contract gives valuable flexibilities to the service receiving company. In this study a method, based on real options has been developed for modelling and evaluation of flexibilities in outsourcing contracts. The effects of such flexibilities on the total project cost and on the selection of the service provider were calculated using the recommended model through a simulation method. The recommended method was found to yield more effective results than traditional methods particularly in markets with high level of uncertainty.