The Myth of Fixed-Price Contracts

Typically, CIOs deal with either fixed-price or time & materials projects. In a fixed-price contract the buyer agrees to pay a specific price 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.

On the face of it, fixed-price contracts appear to be financially safer. No matter how long it takes to produce the end product, the buyer’s costs will not vary. Or will they?

The truth of the matter is that true fixed-price projects are as rare as Hollywood producers with big hearts and small egos.

Accommodating The Unforeseen

If a fixed-price project is well defined 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 cost.

No contract, no matter how well written, can predict all of the potential risk events in a project and define remedies for those risks. 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 that the buyer will pay a specific amount as long as there are no scope changes and no delays caused by unforeseen events. And yes there is a chance of this happening, just as there is a chance of winning the lottery. Just don’t stake your future on it.

Lack Of Incentive

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.

Such 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. “It’s just a little change that will take no time to implement.” This puts the onus on the vendor to control scope, which is like putting the fox in charge of the hen house. Most vendors can crank out change requests like McDonald’s cranks out burgers and fries.

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

The vendor will be motivated to cut corners in order to finish all the in-scope de-liverables on time and on bud-get. 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 to 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.

It’s not hard to see that fixed-price contracts can 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 two parties sours and becomes strained. This leads to termination of the relationship, often within one to two years.

The Case For 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. If all contracts had to be negotiated on a time & materials basis, both the vendor and the buyer would be motivated to create smaller contracts with clearly defined and achievable de-liverables.

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 for time & materials contracts?

Most organizations believe the myth that fixed-price projects mitigate the risk of cost overruns 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 his book 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 watchwords 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 IT 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’re looking to cede 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. If you understand your business, understand your requirements and manage the project’s 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 buyer and vendor, everyone has an incentive to deliver the best product they can on time and on budget.

Graham Boundy is an executive consultant with Fathom Information Technologies Inc. He specializes in knowledge and information management, and data –