Applying real option approach to vendor selection process in IT outsourcing

Information technology (IT) outsourcing is one of the major issues facing organizations in today's rapidly changing business environment. Due to its very nature of uncertainty, it is critical for companies to manage and mitigate the high risks associated with IT outsourcing practices including the task of vendor selection. In this study, we explore the two-stage vendor selection approach in IT outsourcing using real options analysis. In the first stage, the client engages a vendor for a pilot project and observes the outcome. Using this observation, the client decides either to continue the project to the second stage based upon pre-specified terms or to terminate the project. A case example of outsourcing the development of supply chain management information systems for a logistics firm is also presented in the paper. Our findings suggest that real options analysis is a viable project valuation technique for IT outsourcing.