Fixed Price vs Time and Materials - Which One Makes More Sense

There is no such thing as a fixed price project.  There are time & materials projects and there are projects that start as fixed price but have additional costs added to them as the project unfolds.  A fixed price project shifts risk management to the vendor and provides no incentive to the buyer to finish the project.  Time & materials projects are more likely to be well-defined and more successful than fixed price projects because the buyer has an incentive to control scope and costs.

Traditionally, there are two types of project contracts: fixed price and time & materials.  In a fixed price contract a vendor and buyer agree on a price the buyer will pay for a set of products that the vendor will produce and deliver. In a time & materials contract the buyer agrees to pay an hourly or daily rate for time spent by the vendor to complete and deliver a set of products.

From a financial perspective most people would initially agree that fixed price contracts are safer for the buyer than time & materials contracts.  No matter how long it takes the vendor to produce the end product the buyer's costs are fixed.  Or are they?. 

Fixed Price
If a fixed price project has a well-defined contract and the project is managed to the letter of the contract the buyer will receive the best possible deal for the time, money and effort expended.  But most fixed price contracts are incomplete or make incorrect assumptions.  When these omissions or errors are discovered during the project changes must be made that increase the final project cost.  No contract, no matter how well written, can predict and define remedies for all of the potential risk events in a project.  The effort required to resolve risk events, like time and effort overruns and changes in scope, throughout the life of the project will drive costs above and beyond the original contracted price.

All fixed price projects guarantee the buyer will pay a specific amount as long as there are no scope changes and no delays caused by unforeseen events.  Of course the odds of there being no delays and no functional changes on a project are close to astronomical.

Fixed price contracts provide no incentive for the buyer to finish the project.  The buyer may want to finish a project to realize a return on investment, but this is a soft incentive.  If the system is not mission critical, and most systems aren't, the buyer has no incentive to finish.

Fixed price contracts increase the risk for the vendor that the buyer will try to introduce new activities or deliverables into the project that were originally out of scope.  "Its just a little change that will take no time to implement."  This puts the onus on the vendor to control scope. (Which is like placing the fox in charge of the hen house).  Most vendors can crank out change requests on a project like McDonald's cranks out burgers and fries.

During a fixed price contracts the vendor and the buyer will spend an inordinate amount of time preparing, evaluating, and arguing over change request to determine what is within the original project scope and what is a legitimate change and outside of the original project scope.

Fixed price contracts motivate the vendor to cut corners in order to finish all the in scope deliverables on time and on budget.  Corner cutting will occur especially when a project's tasks run past major deadlines.  Eventually the vague contract or the limits in the functional specifications of the product become the vendor's most powerful tools.  They are used generate change requests that drive up the price of the end product to recoup the losses the vendor is taking on the fixed price portion of the project.

Fixed price contracts lead to poor client/vendor relationships.  As the vendor tries to do the least amount of work to complete the assignment and the buyer tries to get the most functionality for the money invested the relationship between the buyer and the vendor sours.  Eventually the relationship becomes strained which explains why the duration of most vendor/buyer relationships is one to two years.  After about two years the buyer is sick of the vendor making promises he can't keep or cranking out too many change requests forms.  And the vendor is dismayed by the buyers lack of real understanding of the their requirements.

Time & Materials
No buyer is going to enter into a time & materials contract where the deliverables are ill defined and therefore the costs are unlimited.  But if all contracts had to be negotiated on a time & materials bases, both the vendor and the buyer are motivated to create smaller contracts with clearly defined and achievable deliverables.

Time & materials contracts motivate the buyer and the vendor to have the project finish on time in order to stay on budget.  The buyer has an additional incentive to control scope to stay on budget.  While the vendor is motivated to do a good job in a timely manner to secure follow on business.
If all this is true, why is there not more demand in the market for time & materials contracts?

Most organizations believe the myth that fixed price projects mitigate the risk of cost over runs and that time & materials projects are more risky.  But in a fixed price contract risk isn't being limited or eliminated it is merely being shifted from the buyer to the vendor.  In The Fifth Discipline, Peter Senge calls this "shifting the burden".  Shifting the burden occurs when the buyer wishes to avoid risk by ensuring that as much risk as possible is assumed by the vendor.  If the project fails the vendor takes the blame.  However, both the vendor and the buyer will "feel the pain" if the risk is only shifted and not eliminated.

A more appropriate approach to managing risk is due diligence on the part of the buyer.  When purchasing professional services the watch words are still caveat emptor.  Trying to set a fixed time, fixed scope and fixed cost on a complex project doesn't work in the variable and dynamic information technology business.  We have to be prepared for changes and to eliminate or resolve (not shift) the risks associated with changes.  The only way to do this is to architect solutions for the big picture but build these systems in small manageable and well defined pieces.

Enough projects fail in the information technology business that one would think by now we should have caught on to what causes the failures.  The primary cause of project failure is fixing a price on a poorly defined product and then failing to meet price, functionality or benefit expectations.  If the product is not well defined or if a large amount of "customization" is required to the product being purchased then a fixed price contract is a huge risk for the buyer and the vendor.

If you are currently working on a fixed price project be aware of the additional costs incurred to manage the project to completion.  They will probably match or exceed the original fixed price cost of the project.

If you're looking to abdicate all responsibility for your project's success to a third party vendor and are prepared to spend much more than your initial budget then a fixed price contract is the way to go.

If you're thinking about going to tender with a project consider the benefits of time & materials projects over fixed price projects.  If you understand your business, understand your requirements and manage the projects scope and risks a time & materials contract is the better choice.

All risk events can be better resolved by breaking projects down into smaller more manageable increments and by making each increment a time & materials project.  When the clock is ticking for both the buyer and the vendor everyone has an incentive to deliver the best product they can on time and on budget.

Originally published by Graham Boundy, Consultant, Project X Ltd.

Comments

[Graham Boundy]

The main point I was trying to make in this article is that the buyer of a fixed price project has no incentive to finish and therefore they will dither.

[melvin]

I don't agree on some points where fixed price provide no incentive for the buyer and leads to poor client/vendor relationship. You made two contradictions. You stated that "In a fixed price contract a vendor and buyer agree on a price the buyer will pay for a set of products that the vendor will produce and deliver." Another paragraph states "The buyer may want to finish a project to realize a return on investment, but this is a soft incentive. If the system is not mission critical, and most systems aren't, the buyer has no incentive to finish". Why would customer spent something in which he is not sure that it is mission critical or benefitting the company? Nobody is wasting resources especially value for money. Preset condition to get involve in FIXED PRICE should be defined scope, requirements, and schedules. We mentioned schedules, FIXED PRICE should be acquainted with FIXED PERIOD to gain and realize return of investment. Even if there is indeed a spillover of efforts, that's the time you may charge a T&M manner.

Fixed priced contracts help your client budget and understand value for monies spent. You are taking a risk in bidding fixed prices. Your reward is the potential of doing the job for less cost than Time and Materials would have been thus increasing your profit. The fixed price protects the downside risk for the client. Don't let them manage your rates and your price to

[Stephen]

Melvin:

Some intersting points. I will review them in context to a new post I am doing on pricing models. In the meantime, I will see what Graham's thoughts on this as this was originally his.

[Graham]

I agree, the buyer looks for a fixed price contract in an attempt to manage his budget, costs and risk. But he will also have a contingency fund in place to allow for scope changes, overruns and slippage. In affect he knows that the “Fixed Price” isn’t really a “Fixed Price” but a rough estimate of the cost of the finished product.

The buyer may want to finish a project to realize a return on investment, but this is a soft incentive. If the system is not mission critical, and most systems aren't, the buyer has no incentive to finish.
Let’s be clear on what I mean by “Mission Critical”: If it doesn’t work someone will die, or the company will go out of business. On projects that run over, and lots of them do, companies tend to continue to run the old systems and limp along until the new system is ready. Thus avoiding deaths or bankruptcy.

As long as the business has an alternative approach to getting their information or running their business they will wait a long time for a new system to be ready. And they will incur the additional cost. I know of a number of companies who didn’t intend to spend two or three times the original fixed price, but that’s what they spent because the business was willing to wait patiently for all the deliverables to be finished and they paid for changes because the projects had acquired momentum. Expectations had been set that the new system would be better if only people would be patient and wait for it. Once a project is in this mode, and the Business knows it is not costing them any more because the project is fixed price. Or they are willing to wait and pay for changes because the changes are reasonable justified and needed.

This is when the fixed price project model collapses and the death spiral begins… The vendor is interested in finishing, but may not have enough contingency to finish, so he is constantly looking for ways to remove things from scope, or add things to scope and introduce change requests to continue money flowing into his company, and thus keep the project limping along. The purchaser is in the opposite frame of mind: digging their heels in and maintaining or containing scope and limiting spending. As a result the vendor/client relationship suffers.

At the beginning of a project nobody intends to spend money on something they are not sure is mission critical or doesn’t benefits the company. At the beginning of a project, nobody thinks they are wasting resources. But after a project is started and has momentum it is very easy to fall into the trap of “just continue until we’re finished” and forget to look at the collapsing business case that got you there in the first place, or the change in business direction that makes the whole project un-mission critical. Once the project is rolling and money has been spent, when things run over time and budget, the company is more likely to invest “just a little more money” to get to the finish. In for a penny, in for a pound. They are less likely to abandon the project and be perceived as wasting the companies money. After all everyone wants to be successful, do the right thing and deliver the goods.

Unless the product being purchase is a commodity (which customer developed systems are not) then no matter how diligent a purchaser is they will never account for all of the preset condition required to FIX the exact PRICE based on explicitly defined scope, requirements, and schedules. Therefore there will always be a risk that the project will run over, that details will be missed that Time and Materials change request will occur.

My advice to clients is to break a project down into smaller and smaller functioning deliverable components until the pieces can all be managed easily on a time and materials basis. That’s the best way to eliminate risk from the project. The T&M project still has a schedule to be met and scope to be contained but now everything is manageable and everyone has an incentive to finish their work.

Fixed priced contracts only help clients budget the pieces they know about and gives them only an estimate of the value they will receive for monies they will spend. In reality they will spend over and above the fixed price on changes and won’t recognize any value until the project is completely delivered.

The biggest risk I take on when bidding fixed prices is that I will have to continually manage customer expectations about what is in scope and what is out of scope for the fixed price. My reward might be doing the job for less cost than the fixed price I quote thus increasing my profit. But not likely, because in a competitive situation I will have to bid low to get the business, and hope I can make up the difference in change requests to be profitable. The fixed price contract is a way for a purchasing manager to prove to his company that he chose the lowest price bidder. If there is more that one bidder there is no protection of the downside risk for the client, because everyone will “do what it takes to win the business” (i.e. low ball it) and hope to make up the difference (i.e. profit margin) on change requests.

In the Time and Materials scenario the market manages my rates – economics 101 - supply & demand. If I deliver quality product to my customer in a timely manner then that customer will perceive/receive value, limit their risk and continue to pay the market rate for my time.

If I fail to meet my customer’s expectations he is free to go to the market and find better skills at a price the market will bear.

Or if he feels my rates are too high he can go the the market looking for someone who will deliver the same value at a lower rate.

All I’m saying is let’s not be delusional about what a fixed price contract really is. It’s an estimate of how much the vendor thinks it’s going to cost to do the work prior to change requests. Everything after that is T&M.

[Jim]

One of the problems with fixed priced projects is that it assumes the customer knows exactly what they want before the project starts. The vendor may wish to tell the customer the holes in his spec or suggest other approaches but in the competitive situation that is not smart. So what one does is realize that there will be change requests.
On the flip side, if the spec is so tight there is no need for changes, it likely is not something requiring much creativity. Even in those cases, the business requirements may change base on new ideas the user has or some management change.
Even a simple rewrite of an old system has changes to make it better, faster, more user friendly, etc. The characteristic of our busines is that it is never static. New ideas, new software, new technology, business changes, and personnel changes, all affect the solution.
Breaking the project into manageable, shorter projects will make the project cost more menageable and by delivering value in the short term the overall project could pay for inself. This type of design is more challenging but make the project more manageable.
By the way, I think the expression is "in for a penny, out for a pound."