Startup Execution

Fixed Price vs. Time & Materials

The Challenge

Every business has problems that must be solved. Vendors recognize this and build solutions to help Customers address their needs. In most situations, solving the Customer’s problems requires a professional services project to implement the solution that addresses the Customer’s needs. This gives rise to the classic relationship between Customer and Consultant. In every project between Customer and Consultant, both parties have to decide whether a fixed price or time and materials (“T&M”) fee arrangement works best.

In many cases, the Consultant allows the Customer to choose between a fixed price and a T&M fee arrangement. In other cases, one method is chosen without a full understanding of the tradeoffs, which increases the probability that a suboptimal fee arrangement will be selected. In order to choose the best project pricing structure, it’s important to break down the individual considerations that apply. This is especially important if the Consultant and the Customer prefer different fee arrangements. In this article, I’ll present the decision factors between fixed price and T&M in the context of the overall project discovery, proposal and delivery process.

The Process

Many resources document the project lifecycle as some variation of a “plan, design, implement” or an “analyze, prototype, refine” methodology. While these methodologies provide a strong framework to deliver a project, they don’t capture the nuances of the Consultant/Customer relationship from pre-sales discovery through post-sales delivery. In focusing on the choice on choosing between fixed price and T&M fee arrangements, I’ll ignore the many variations of waterfall or agile development processes and focus simply on the project engagement process presented below.

Every engagement between a Consultant and a Customer goes through some form of the discovery, proposal, and delivery process described above. The Discover phase focuses on obtaining a high-level understanding of the situation and the possible solution. The Propose phase focuses on analyzing the situation and building a preliminary design, which is key to determining a fee structure for the project. The Deliver phase focuses on implementing the proposed project, executing on the project management and change order approach determined by the agreed upon fee structure. Each of the seven sub-bullets that span the three engagement phases present specific tradeoffs driven by the choice of fixed price or T&M fees.

The Tradeoffs

Collect Requirements

Every discovery effort requires the Consultant to obtain at least a high-level understanding of the Customer’s requirements. Fixed price engagements require the project requirements to be well defined during the Discover phase. Customers must be able to commit to key design decisions and assumptions before the project proposal gets built. If additional investment is required to determine key design decisions and assumptions, then a T&M engagement fits best. Obviously, poorly defined requirements put the Consultant at significant risk on any fixed price engagements.

Assess Complexity

Once the initial requirements are set, the team needs to assess the overall complexity of the project. Complexity threatens the profitability of fixed price projects. Many factors increase project complexity, including: dependence on emerging technology, requirements to interface with many systems, significant reliance on third-parties, lack of staff experience with the technology or industry, geographically dispersed teams, use of non-dedicated resources, solution risk to high-value assets (such as human life or large monetary systems), and unreasonable expectations. Fixed price projects are best if no more than one of these complicating factors exists in a significant way.

Complexity leads to unpredictability. Unpredictability requires flexibility in order to adapt to unforeseen changes. Given the high degree of flexibility required, time and materials engagements are best when significant complexity exists in a project.

Size Project

Even the most knowledgeable and experienced consultants have difficulty providing accurate cost estimates on larger projects. If fixed prices are required, then the Consultant should segment any large projects into smaller, fixed price sub-projects. Otherwise, the Consultant must add huge contingencies that drive up the overall project price. In contrast, T&M projects are suitable for both large and small projects.

Refine Project Parameters

As the discovery effort winds down, the Consultant begins working on the proposal. An important part of the proposal effort is the iterative refinement of the key project parameters: scope, time and cost. Fixed price projects require a higher level of certainty on these parameters than T&M projects. Incomplete requirements, project complexity, or customer indecisiveness usually results in multiple iterations to increase the certainty of these project parameters. If both the Consultant and the Customer are willing and able to invest the time, energy and effort to cycle through multiple iterations, then a fixed priced engagement is possible. However, if either the Consultant or Customer are unwilling or unable to cycle through many iterations, then T&M would be preferable.

Determine Primary Risk Owner

From a cost perspective, Consultants want profitable engagements while Customers want projects to finish on budget. Fixed price projects require the Consultant to assume the profitability risk. Cost overruns eat into the Consultant’s profit, or in the worst case, result in the Consultant losing money to deliver the project. Consultants generally avoid this challenge with T&M projects because the Customer bears the budgetary risk of any cost overruns. Ultimately, a decision has to be made regarding which party assumes the profitability or budgetary risk.

Manage Project

With fixed priced projects, the project manager focuses on protecting the originally agreed upon project scope. As a result, the Customer must accept “No, not without a change order” as a response to scope creep. In situations where the Consultant’s documented assumptions become invalid or the Customer is unable to satisfy their responsibilities, the Customer may be forced to accept a change order. This focus requires a strong project manager and may strain the relationship between the Consultant and the Customer.

However, with T&M projects, the project manager focuses on diligent progress tracking and regular status reports to ensure project is delivered within the estimated cost and timeframe. The Customer is constantly kept abreast of how well project is tracking to progress and the likelihood of hitting the estimated cost and schedule. A less seasoned project manager can typically deliver T&M projects, as the primary responsibilities are easier to execute.

Adapt to Changes

With fixed price projects, the need to protect the scope, time and cost means adapting to unplanned, unforeseen situations becomes more difficult. In contrast, because the Customer bears budgetary risks on T&M projects, the Customer enjoys broader latitude to change the project’s scope, schedule, or costs while project is mid-flight.

The Bottom Line

Given the challenges of the tradeoffs above, fixed price projects generally result in higher priced projects. Fixed price projects require more effort and expertise during both the pre-sales cycle as well as the post-sales project delivery phase. This effort and expertise comes at a cost. In addition, to minimize the chance of losing money on the project, the Consultant naturally adds extra padding to fixed price quote. T&M projects are almost always cheaper since the Customer accepts responsibility for any cost overruns.

The table below summarizes the tradeoffs of the seven project engagement tasks above and their impact to the bottom line.

Ultimately, the decision of fixed price or T&M fee arrangements revolves around finding the right fit for the Consultant and the Customer. When both the Consultant and the Customer have a clear understanding of the tradeoffs involved, navigating the project engagement process and choosing the optimal fee arrangement becomes a smooth process for all parties.