Designing effective incentive‐oriented contracts for application service provider hosting of ERP systems

Information systems (IS) outsourcing has been viewed as an attractive option by many senior managers generally because of the belief that IS outsourcing vendors can achieve economies of scale and specialization because their only business is information processing. The challenge of implementing, operating and maintaining enterprise resource planning (ERP) systems and the outsourcing service offered by ERP vendors have made ERP outsourcing an attractive option for some organizations. However, although IS outsourcing is now a major industry, the outsourcing of ERP applications is still in its infancy. This paper explores ERP outsourcing in terms of the application service provider (ASP) approach where a third‐party vendor hosts, manages and maintains various data and ERP applications on behalf of different clients. Critical to the management of the ERP outsourcing relationship is the outsourcing contract, which, if improperly or incompletely written, can have significant negative implications for the outsourcing firm. Contracts that encourage vendor performance and discourage under‐performance are therefore clearly of interest to managers. Although many articles have appeared on outsourcing, the issue of incentive contracts for ERP outsourcing has not been adequately addressed by researchers, partly because of the infancy of this area. In this paper, an approach to analyze incentive schemes and structuring ERP outsourcing contracts for the mutual gain of the parties is presented.