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November 21, 2012

Fixed Price vs Time & Materials: Which is the Better Contract Type for Software Development?

3 mins read

Pen next to the word "CONTRACT."I had a discussion with a client recently about which contract type was better for a software development project: fixed price or time-and-materials (T&M).  This question seems to be as old as contracting itself.  However, it’s important to pick the right contractual arrangement or you could end up with unmet expectations, hassles, and headaches.

Fixed price and T&M each have their strengths and weaknesses.  And it’s hard to determine the correct answer until you dig a little deeper.  The answers to a few key questions will help you determine which might be the better choice for your software development project.

Question 1: Do You Know What You Want?

If you don’t have a pretty good idea of what you want, it’s hard to write a good fixed price contract.  You probably won’t be able to give the vendor enough information about the scope of the project to develop a reasonable bid.  After all, if you don’t know what you want, how will the vendor know what to build?  This might be a good place to use T&M if only to get a better handle on what it is you want – this is usually called “discovery”.  Once you have a solid understanding of the project’s scope, then you can pursue a fixed price contract for that defined scope.

Question 2: How Much is Managing Risk Worth to You?

Pen on a contract on a table.A big reason to use fixed price contracts is to manage risk, but you do pay a premium for it.  Here’s the deal:  Using a T&M approach, a project might be estimated to cost $250,000.  It could end up costing $200,000.  But it could also end up costing $400,000.  With T&M, you bear the risk of that variability.  Using a fixed price approach for the same project, you might sign a contract for $300,000, which is a little more than the T&M estimate, but you’re guaranteed the project’s cost won’t exceed what’s in the contract.

The bottom line is you’re paying for an outcome in a fixed price contract instead of simply paying for someone’s time.  You specify the “what” and leave it to the vendor to determine the “how” for the most part.  The vendor assumes the risk of delivering the outcome you want.

Question 3: How Important is Flexibility to You?

T&M contracts provide a lot of flexibility.  Fixed price contracts and flexibility?  Not so much.

In a T&M arrangement, you’re paying for someone’s time in the form of an hourly rate and can usually direct how that time is spent pretty easily.  It’s typically much harder to change direction in a fixed price arrangement – there’s usually negotiation with the vendor to work out the specifics and a price tag associated with the change.  There are ways to build flexibility into a fixed price contract to handle the things that always come up during the course of a project, but in general, a T&M arrangement will provide more flexibility than a fixed price arrangement.

Picking the right contract type is an important factor in the overall success of your project.  Choose wisely knowing the strengths and weaknesses of each type and how they relate to your software development project.

What other factors are important to determining the right contract type?  Which type of contract do you use more and why?

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