Software Development Pricing Models: Fixed Price (FP) vs Time & Materials (T&M)
Contributor: Alexander Sharko, Project Manager at Archer Software
With regard to software development pricing models that work for IT consulting and outsourcing markets, there are usually two opposite approaches mentioned: Fixed Price and Time & Materials. Let’s start with a brief overview of how we at Archer Software see both of these approaches, and then we will take a look at the Pros and Cons.
Fixed Price (FP):
Scope, features, definitions and often timeframe are fixed too;
Payments are usually made by scheme:
The downside: this pricing model is very rigid when it comes to changes. For the majority of the projects that last longer than one man/month, this approach will cause either a lack of the most needed features or problems with their integration. A deeper vision of the product and the market comes as the project progress, and an understanding of the audience comes with users' feedback. Therefore, the most valuable product features often become clear closer to the end of the project rather than at the moment the initial requirements are defined. But the FP model by definition is not meant to accept changes to the original scope.
Time and Materials (T&M):
While software development budget planning project budget is estimated in terms of magnitude but not fixed to a specific amount;
Scope, features and delivery plans are flexible and open to on-the-go changes to a rather high degree;
Payments are usually made on a monthly basis for the resources used within the past month.
The downside: the final cost of the project is not defined. It does not mean it cannot be narrowed down to some decent range, but the exact amount is not there on paper. But let’s see below whether it is really as dangerous for your business as it seems.
In brief, we would say that in many cases when you think FP is the only choice for you, there is actually a way to run project under t&m pricing model and earn more for the business and the product. So every time you want to stick hard with FP, we recommend you considering a T&M approach once more. And here is why.
Common Reasoning for Going with Fixed Price Contracts:
1. The vendor team is unknown: their quality, skills, trustworthiness? You want risks to be carried by the vendor, not by yourself.
The problem with this idea is that the FP approach does not solve this problem, at least is not doing it better than t&m pricing model.
What gives you faith that an unknown outsourcing team will deliver without wasting your time and prepayment amount?
You would be right in saying that in this case, you would lose only pre-payment, not the whole budget. But if analyzed from the correct angle - it is absolutely the same situation that you would have at the end of the first two-week sprint with the team running the project under t&m pricing model - you can evaluate the results and make a decision to stop the work if you are not satisfied with the skills / quality / communication.
It has nothing to do with selecting the FP model that will freeze your product vision and requirements once and till the end of the project.
To check the quality of a new vendor, instead of considering FP as a solution, it would be better to try the mixed or Proof-Of-Concept approach. In this case, the team first makes a simple and small prototype while researching the biggest technical risks and proving the technical ability to build the project as planned. This approach may be useful not only help you to verify the idea, but also to verify the team.
2. You have only a Fixed Budget to develop the product and not more.
When offering you t&m pricing model, the vendor is not pushing you to start your project without any expectation of the time frame or the amount of cash flow needed. Let’s see what will happen if you go with the following approach:
Request a vendor to estimate the range of the resources needed to complete the scope;
Take, let’s say, 20% off your limited budget for a while. Depending on your own feeling of how final your vision of the product is, you can tweak the size of this buffer – the clearer the features definition is, the smaller buffer can be;
If the budget left over is inside of the estimation range, start the work and be with the team under T&M with every 1- or 2-week delivery;
Start working with the core features first – the most important or the most representative for the app;
Tweak the scope and change the features, clearly seeing in the project plan that the Project Manager will provide you the impact these changes will have on your budget and timeframe;
When getting closer to the end of the project budget, consider if the 20% buffer you left is needed to be spent on finishing the initial set of features or on features that you need now, which are actually completely different from those you had in mind a few sprints back.
In fact, following this format, with T&M you will have a business-level control on your product (unlike with the FP process).
And few more challenges to consider with FP:
The vendor, on his side, will reasonably try to balance the risks that you are putting on him and will have to add the resource buffers to cover the technical and management risks.
That means that in an average situation with FP, not only will you pay more than you have to, but you will also have your requirements frozen. Under t&m pricing model, this delta can be spent to implement some extra nice-to-have features and tasty delights.
In a worst-case scenario, when the outsourcing vendor starts to run out of time and budget, he will choose the only way that is not fixed in Fixed Price Contracts – a decrease in quality. So in fact while running the project under FP you control neither the features nor the quality of the product implemented.
3. You want vendors to bid to compare the prices.
As mentioned above, planning to go with T&M doesn’t mean you shouldn’t request the estimates from the vendors. FP and T&M are approaches to running the project, not to selecting the vendor for it.
Few cases when FP will be an appropriate model and will work for you:
Medical, governmental, military and other projects where the quality bar is obliged to be so high or the business cost of change is so dramatic (e.g. additional licensing procedures are required) that all the requirements are strictly defined, clarified, documented and officially frozen by the whole group of business and development teams.
Small prototype-alike, temporary solutions or apps for internal usage where the quality bar is not important and product needs are not dependent on the market.
Fixed Price vs Time & Materials pricing model differences summary
Time and Materials
“Fixed price works well for small, well-defined projects. If you use it for anything else, you will pay a price in product and technology-implementation quality” Andrey Akselrod, Co-Founder & CTO, Smartling.