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?.
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.