Management of Innovation and Intellectual Property in Outsourcing Projects

Innovation outsourcing creates two critical risks for a client firm. The first risk arises when a client discloses his/her technological knowhow and intellectual property (IP) with the service provider but the latter misappropriates the IP toward its own commercial benefit. Second, in the absence of perfect monitoring, the service provider might exert suboptimal effort on the innovation project. Management of client's technology and innovation effort of agent are both crucially important in innovation outsourcing. It is shown that client can deter these risks by designing an appropriate contract. Two distinct regimes are considered. In Regime1, the client operates in an environment where IP cannot be protected. In Regime2, client's IP is fully protected either due to strong legal enforcement or due to availability of a technological solution. First, it is found that an incentive payment scheme linked with project outcome can mitigate the shirking problem. Second, in Regime1, the client must provide higher compensation to the agent when compared to Regime2. A carrot and stick strategy involving higher incentive payments along with reduced sharing of background IP can deter the opportunistic behavior of the service provider. Third, if the cost of operating in Regime2 is prohibitively high, then the client can operate in Regime1 and yet obtain higher profits. In such a scenario, the client must use the carrot and stick strategy. Finally, due to predominant motive to reduce costs, clients might not be compensating their service providers appropriately. Such myopic cost-cutting strategy would exacerbate the IP misappropriation and suboptimal quality problems associated with outsourcing.