Costly Control: An Examination of the Trade-off Between Control Investments and Residual Risk in Interfirm Transactions

What is it about?

Management control systems mitigate but rarely eliminate the risks of interfirm transactions. The residual risk that remains after controls are implemented is the outcome of weighing inherent transaction risk against the transaction-specific cost of control and the transaction-specific appetite for risk. Using survey data on 287 information technology transactions, we provide evidence of tradeoffs and intentional incompleteness in the design of interfirm management controls. We find that misalignment in the relation between transaction risks and management controls is associated positively with buyer’s direct assessments of residual risks; specifically, underinvestment in controls is associated with greater residual risk. We find that lower costs of control weaken the association between misalignment and the buyer’s assessments of both residual performance risk and residual relational risk. Moreover, transactions for which the buyer has a greater appetite for performance risk exhibit a stronger association between misalignment and residual performance risk and a weaker association between misalignment and residual relational risk. We conclude that differing transaction-specific costs of control and risk appetite are important variables in explaining why firms employ different management control strategies for seemingly similar transactions. With differing cost of control and appetite for risk, firms make different tradeoffs between management control investments and deliberate acceptance of residual risk.

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Why is it important?

Prior research in the transactions cost economics traditional has not fully explored why firms facing common transaction risks use management controls with differing intensity. In this paper, we investigate two explanations: varying transaction-specific costs of control and varying appetite for transaction-specific risk. This study contributes a unique analysis of transaction hazards, transaction-specific costs of control, transaction-specific risk appetite, and the resultant effects on the investment in management controls and managers' calculated acceptance of residual risk. The paper also contributes to the strategy literature, in which prior ties and strategic resources are theoretically and empirically important to understanding interfirm transactions. Our findings support Zajac and Olsen’s (1993) argument that the resource based motivation for interfirm transactions is a complement rather than an alternative to transactions cost economics.