Formal vs Relational Governance
Successful IT outsourcing partnerships rely not only on formal governance through contracts but also on relational governance through interpersonal relationships between the outsourcing partners. An increasing stream of research has acknowledged that these two forms of governance are interrelated and can both substitute and complement each other. But is that the end of all we know? No. Based on my work with Eleni Lioliou, Angelika Zimmerman and Lan Gao*, we now know a lot more about the power and role of relational governance including about the pyschological contracts established between parties, and this will be the subject of Part 1 of this article. And in Part 2, in April 2015, we will illustrate from real cases how suchpsychological contracts, in association with other relationship aspects, make them a forceful complement to anyformalized, legal agreement.
Formal and Relational Governance In Outsourcing Arrangements
Governance has been regarded as a key mechanism propelling the outsourcing arrangement towards its objectives. Governance has two aspects:
- Formalgovernance refers to the development of a good contract and other formal instruments of governance, such as service level agreements (SLAs), key performance indicators (KPIs) and other formal control mechanisms. Formal governance aims to coordinate activities between partners and prevent opportunistic behaviour through the creation of a mutually agreed upon and legally binding set of acceptable behaviours.
- Relational governance refers to softer, more ‘human’ elements of the outsourcing relationship, which provide a form of ‘social control’ and serve to coordinate activities and mitigate risks of opportunistic behaviour. Most frequently, relational governance has been operationalized in terms of trust. Some researchers have also investigated relational governance in terms of informal or social control mechanisms. A large range of other relational elements have been investigated less frequently, for example commitment, communication, and mutual dependence. Below I add the notion of the psychological contract as an important relational governance mechanism.
Formal and Relational Governance: How Do They Interrelate?
As outsourcing practices have matured, there have been efforts to develop a more thorough understanding of the interrelationship between formal and relational elements of governance. Inresearch, a major focus has been on the ‘substitutive’ vs. ‘complementary’ nature of the relationship between contractual and relational governance.
The substitution stream of research views formal and relational governance as functional equivalents, and because both formal and relational governance are doing the same thing, one can replace the other. Furthermore, the workings of formal governance can dampen the levels of relational governance. For instance, the existence of rigid contractual processes can be perceived as a signal of distrust. Conversely, the workings of relational governance can dampen the functioning of formal governance. Organizations may, for instance, downplay and bypass formal governance processes because they are over-depending on their prior good relationship. We have found this in many cases, and invariably this tendency goes too far and a corrective swing towards more formal contractual elements occurs.
The complementarity stream of research, on the other hand, finds that formal and relational governance have unique strengths and that one can compensate for the weaknesses of the other. According to this view, formal and relational governance reinforce and enable, rather than negate, each other. On this basis, a good contract can actually set the grounds for trustful relationships to develop, and conversely, trustful relationships can facilitate the crafting and design of appropriate contracts.
Conditions for Effective Substitution
Recent research has gone further than this, and provides great insight for practitioners. It turns out that effective substitution and complementarity between formal and relational governance depend on specific conditions:
- With regard to substitution effects, formal governance substitutes for relational governance if a certain degree of distrust exists between the outsourcing partners.
- Starting conditions of trust and distrust can influence the degree of formal coordination and control (high or low) and how managers interpret the behaviour of their partners (positive or negative).
- High levels of pre-existing interorganizational trust increase the probability that partners choose a less formal mode of governance.
- The substitution between formal and relational governance depends on further conditions, including levels of interorganizational performance, type of outsourced assets, and the nature of the desired outcomes. Thus, low levels of interorganizational performance will lead to a perceived need for an increase in formal coordination and control.
- In the presence of knowledge-based assets, firms tend to substitute formal by relational governance, while in the presence of property-based assets, firms tend to substitute relational by formal governance.
- Additionally, the choice of governance is affected by the nature of desired outcomes, which in turn depends on whether the firm pursues a strategy of value creation or value capture. Value creation is inherently more uncertain, and outcomes are frequently unknown. In this case, the psychological contract – thebeliefs regarding terms and conditions of a reciprocal exchange agreement between that person and another party – takes over after signing the formal contract, and relational governance becomes important at this stage, involving trust, shared identity, beliefs, expectations and understanding. By contrast, a strategy that aims to capture value is less uncertain, and outcomes and processes are therefore easier to outline. After signing the formal contract, a psychological contract takes over, but formal associations and processes regulate the outsourcing arrangement. In other words, relational governance substitutes formal governance in the case of uncertain outcomes, while formal governance takes over in the case of certain outcomes. In ambiguous situations contractual governance is more effective than relational governance, while in situations of ‘volatility’ relational governance is more effective.
- Certain substitution conditions are also tied to different phases in the development of the outsourcing arrangement. In earlier stages of an outsourcing venture, relational governance tends to substitute formal governance, because of the fluidity in goals, expectations and requirements. During the so-called development stage, however, there is a better understanding of tasks, processes and objectives, and both parties are therefore better able to establish formal rules and procedures. Formal governance then tends to substitute relational governance.
Complementarity of Formal and Relational Governance
What has the research found here?
- The content of formal governance practices (as a condition) can reinforce the development of effective relational governance.
- Conversely, the quality of relational governance (as a condition) can set the basis for the creation of efficient formal controls.
- Another condition of complementarity between formal and relational governance resides in previous interactions between the client and the vendor. Frequent interactions and close relationships between the two can lead to the generation of more complete contracts.
- Complementarity between formal and relational governances is further needed and supported where there is a lack of clear outsourcing goals and requirements.
In sum, prior research has distinguished between several conditions of substitution between formal and relational governance and a smaller number of conditions of their complementarity. We will extend the findings documented here in Part 2 by looking at rich case studies.
Further Findings: Substitution and Complementarity Interrelate….
While theory has framed complementarity and substitution as incompatible with one another, empirical research finds support that they can and do co-exist in reality, and this interrelationship can be positive. Our research finds that some informal control mechanisms do strengthen the effectiveness of certain formal control mechanisms and therefore produce complementary effects, but at the same time, they can weaken the effectiveness of others and therefore produce substitution effects.
In-depth investigations of formal and relational governance mechanisms have looked at their ability to replace, dampen, compensate and enable one another. Complementarity and substitution between formal and relational governance mechanisms can be causally connected, as complementarity can be a necessary precondition for substitution. In practice we have found that there can be a two-way causal relationship between the complementarity and substitution of formal and relational governance.
Enter The Pyschological Contract
In order to take a more in-depth perspective on the interrelations between formal and relational governance, we introduce the concept of the psychological contract. A psychological contract is related to aspects of relational governance, such as trust and commitment, but is also different from them. The distinguishing characteristic of the psychological contract lies in its contractual nature, which makes it psychologically binding and implies mutuality between the exchange partners.
Chris Argyris was the first to introduce the term ‘psychological contract’, describing it in 1960 as an agreement in which both parties have to have a shared understanding of what they are expected to contribute to each other. Others have emphasized expectations as a fundamental aspect of the psychological contract, expectations that cover a whole set of obligations, rights and privileges. Others emphasize the subjective nature of the psychological contract, by defining it as beliefs or perceptions of reciprocal and promised obligations.
One of the most influential categorizations of psychological contracts is in terms of ‘transactional’ vs. ‘relational’ types of contract. Transactional contracts refer to short-term, well- defined, performance-related arrangements where there is usually limited commitment, flexibility, involvement and investment. Relational contracts refer to longer-term, more ambiguous arrangements where there is high emotional involvement and investment, dynamic working conditions and subjectively understood terms. As we will show later, it is this relational type of psychological contract that takes part in relational governance.
Mutuality plays an important role in the psychological contract. Firstly, the psychological contract is based on perceived promises of reciprocal exchange and therefore refers to obligations of each partner rather than only one. Secondly, each partner in the agreement believes that the agreement is mutual, that is, a common understanding exists that binds the parties involved to a particular course of action. Thirdly, the psychological contract only ‘actually’ exists – and is not just subjective – if both partners hold the same expectations regarding their obligations to each other.
Psychological contracts also create a strong sense of accountability and are therefore psychologically binding. While formal contracts can be imposed on individuals, the psychological contract refers to individuals’ own beliefs about their mutual obligations. For this reason, individuals tend to identify with and hold themselves accountable against these perceived obligations. The psychological contract is therefore a self-regulating mechanism that can motivate partners to perform to the conditions of their agreement.
We can therefore define the psychological contract as ‘a perceived mutual agreement between two parties on the obligations of both sides, which creates a strong sense of accountability and is therefore psychologically binding’. Other elements of relational governance, such as trust and commitment, can be one sided and/or less psychologically binding. To make the distinction between the psychological contract and other relationship aspects more clear, we have to look at them in greater detail.
- Trust is perhaps the most frequently examined aspect in relational governance. Trust in an interfirm partnership can be defined as the willingness of each partner firm to be vulnerable to the actions of the other party, irrespective of the ability to monitor or control that other party. Interestingly, this definition by itself implies that trust can substitute monitoring and control mechanisms. Furthermore, we can distinguish between trust in the partner’s ability, benevolence and integrity. Ability-based trust refers to ‘the trustees’ skills, competencies, and characteristics that enable them to fulfill their tasks’. Benevolence-based trust depends on the extent to which a trustee is believed to want to do good to the trustor, aside from an egocentric profit motive, and integrity-based trust relies on the perception that the trustee adheres to a set of principles that the trustor finds acceptable. In our case, these principles concern primarily an adherence to formal contractual obligations. Trust (based on ability, benevolence or integrity) is not necessarily reciprocal but can be unidirectional.
- Commitment can be defined as the willingness of partners to exert effort on behalf of the relationship. In some partnerships, this may be the case for one partner, but not the other. Commitment need, therefore, not be mutual.
- Communication, including communication quality and the extent of information sharing, is particularly important in relational governance. Effective communication does of course involve both partners, because the sender and the receiver of a message have to achieve a consistency between the intended message and the received message. Communication is therefore only effective if it is reciprocal. However, effective communication does not necessarily create high levels of psychological accountability.
- Mutual dependence, on the other hand, is mutual by definition. It can be defined as the recognition by both partners in an exchange relationship that the relationship provides benefits greater than either partner could attain alone or with some other partner. Although mutual dependence is likely to create a strong sense of commitment, it is not necessarily psychologically binding.
In all this, the learning point for practitioners is that the psychological contract is related to other aspects of the relationship between outsourcing partners. Firstly, a psychological contract relies on a degree of trust in the other party’s integrity; in other words, a belief that the partners will commit to their promises and obligations. Moreover, the psychological contract affects other relationship aspects. For example, where an employer appears to breach the psychological contract with employees, this has a negative influence on employees’ trust in their employer, defined as beliefs regarding the employer’s integrity, motives and intentions, behavioural consistency, openness and discreteness. Breach perceptions have also been shown to negatively affect employees’ organizational commitment, which typically comprises identification, involvement with and loyalty towards the organization. All these are highly important considerations for clients and suppliers in outsourcing arrangements!
In this article we have established the importance of both formal and relational aspects of governance. We have seen that they can both substitute for and complement one another. We have also seen how they can interrelate in both positive and negative ways. We now know the conditions needed for effective substitution and complementarity.
We have also established, from the evidence, the key role the pyschological contract plays in outsourcing arrangements. If two collaborating parties hold a psychological contract, it means that they believe they have a mutual agreement, based on a shared understanding of what they are expected to contribute to each other. This perceived agreement creates strong psychological accountability, entailing high levels of self-control by the contract partners. The psychological contract does not control partners’ behaviour formally, like a legal contract. However, because of its mutual and psychologically binding nature, the psychological contract functions in a similar way to a formal governance contract. These characteristics distinguish the psychological contract from the other elements of relational governance, which can be not mutual and/or not binding. In Part 2 of this article I will use rich case studies to illustrate how important relational governance and the psychological contract can be in outsourcing, and how these are neglected at your peril.
* The full reference is Lioliou, E., Zimmerman, A., Willcocks, L. and Gao, L. (2014) Formal and Relational Governance in IT Outsourcing: Substitution, Complementarity and the Role of the Pyschological Contract. Information Systems Journal.