When starting a software development project, determining the right type of contract is one of the most critical decisions you’ll face. The way a service provider contracts with their clients is one of several factors that directly affect profitability.
The two main contract types are fixed-price and times-and-material(T&M) contracts. In this article, we’re going to find out what each of those means, what the main differences are, and which one makes more sense for specific situations.
What is a fixed-price contract?
A fixed-price contract is exactly what it sounds like – an agreement where a software development provider agrees to complete a specific project for a fixed price. Such an arrangement leaves little room for flexibility; fixed-price contracts are mostly used when requirements and specifications are predictable.
Fixed-price contracts pros
A business strategy typically revolves around clear deadlines and figures. Fixed-price contracts let you plan future expenses with a high degree of certainty, at least up to 1-3 months. That gives you exact figures to work with and build your quarterly strategy around. If, however, you’re looking at a longer project, other factors might come into play, and you should consider a different pricing contract.
There’s little room for surprises in a fixed-price contract between specific requirements, a fixed budget, and predetermined deadlines. Everyone involved knows what they’re supposed to do, what they’re getting and when.
Easy to manage
Because everything is agreed upon in advance, transparent and predictable, the process requires very little involvement and management oversight. Milestones are predetermined, and payments to the provider are usually based on them. Once you’re done with the initial meetings to define the scope clearly, you just need to wait for a finished product to reach your desk.
Fixed-price contracts cons
Lack of flexibility
This is the one major drawback of fixed pricing. Market conditions can change, expectations and goals can shift, and this pricing model makes it difficult to change course once terms have been established.
What is a time and material contract?
A time-and-material(T&M) contract is the complete opposite of a fixed-price arrangement. Instead of paying a fixed price upfront, you pay the software team for the number of man-hours spent on a project and the resources(materials) used. This is a much more adaptive model, commonly used when you aren’t certain how long a project will take or how much it’ll cost.
T&M contracts pros
Unlike fixed-price contracts, where you’re locked in with your original arrangement, time and material allows for changes in the project’s focus or implementation. Paying per unit of work completed lets you adjust work volumes, modify designs, change features, and generally pivot in a way that can be invaluable for longer-spanning projects.
Control over the project
Increased flexibility also grants you more control over how the work is being done. While the project’s outcome is (usually) predetermined, the road there isn’t. You can have regular meetings, evaluate how your custom software partner conducts the work, and provide feedback. This level of involvement allows you to address any issues or concerns immediately, ensuring the project meets your expectations.
T&M contracts cons
Low budget control
The malleable nature of time-and-material contracts comes at a price – literally. Since you’re paying for the amount of work completed, any changes naturally mean an increase in cost. The overall payable amount in such a project can sometimes snowball far beyond the expected budget. Of course, you can remedy this through regular, transparent communication with your software provider.
Requires more oversight
This is the flip side of increased control over your project. The more involved you want to be, the more key decisions depend on your input. This isn’t necessarily a con of all T&M contracts – you can, again, mitigate it by picking a partner capable of self-governing and only weighing in at key points.
Fixed price vs time and materials: how do you decide?
Knowing the difference between fixed price and T&M projects is an important step toward picking a suitable pricing model. If you’re still unsure, here are some simple questions to help you make a choice:
- Do you know what end result you’re after? If yes, fixed-price is for you. If no, or not exactly, go with T&M.
- Can you afford to stretch your budget? If you want to be certain what you’re going to spend, go with fixed-price. If your budget is flexible, opt for time and material to control what you get.
- What timeline are you on? The longer the project is, the more likely something will need modification. Consider T&M for projects over 3-4 months.
- Do you foresee any potential changes coming up during the project? If you’re sure nothing is going to change, a fixed price would work for you. If changes are likely, T&M will let you navigate them more effectively.
Fixed-price and time-and-material(T&M) contracts are two sides of the same coin. Each comes with a distinct set of advantages and disadvantages, and the best choice for your situation heavily depends on factors such as your budget, how well your project’s future is planned out, and your risk tolerance.
Ultimately, picking a pricing contract is one of those choices you make early on, which can affect the entire course of your project. As such, it’s important to weigh both sides of the situation and choose carefully. Understanding the trade-offs of either choice will help you get the most out of your business venture and pave the way for a productive partnership with your software development provider.