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Fixed Price vs Time & Materials: Which is the
Better Contract Type for Software Development?
Posted on November 21, 2012 by Excella
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 is 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 is 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
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, at least to get 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?
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
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 project.