Software Development Contracts: Fixed-price vs. Time-and-material
In IT software development it can be quite a dilemma to decide which pricing model to select when hiring a development team. There are two main types of software development agreements: fixed-price contracts and time and materials contracts. A fixed-price contract functions as its name suggests: you hire a software company for a set sum of money to complete a predetermined scope of work. With time and material contracts there is no predetermined set price for the project. Instead, you agree to get billed by the software house for their time plus any related costs associated with developing your project.
Each type of contract has its strengths and weaknesses. Choosing the right pricing model means figuring out which one suits your own project’s specific needs best. The pricing contract you choose should fit with your company’s requirements and goals, operating procedure, and budget. In this article, we lay out which situations suit using fixed price and which time and material contracts as well as outline each type of contract’s advantages and disadvantages.
Fixed Price Contracts
When to Use a Fixed-Price Contract
Fixed-price contracts are great in certain situations. This type of agreement should definitely be used in situations where you have a team of business analysts who can record your project’s specifications and perform risk analysis. When you know exactly what you want in your project: a fixed-price contract is the right call. It also works well if you have a well-defined micro-project whose development is unlikely to be planned.
Fixed-price contracts are well suited for projects with a limited feature scope or well-defined projects that already have detailed specifications and risk analysis. They are the right choice when you already know all of your requirements going into hiring a software house and have clear deadlines. They work best when you know your requirements will not change and there is no need for flexibility during the project. They also work well when the work is “turnkey” and the software company you are hiring has completed very similar projects multiple times in the past. When your project is short (will only last 3-5 months) often a fixed price agreement is the way to go as well.
Fixed price agreements work best with projects that have a well-defined scope because it is easier to provide a cost estimate for them. Projects whose requirements are not fully defined don’t fit well with fixed-price contracts because it is difficult to estimate their cost in advance. If you don’t know exactly what you want your venture to entail, using a fixed-price arrangement can be risky because you might not get a project back that you like.
Advantages of Fixed Price Contracts
One advantage of choosing a fixed price contract for software development is that they allow you to predict everything involved in your development process. When using this pricing model everything from team size, costs, time frames, work schedules, and the final product is discussed and agreed upon in advance. This leads to another benefit of fixed price model: transparency. It is clear from the onset exactly what you are getting when it will be delivered, and how much (and when) you will pay for it. This also means there is a low financial risk because the software house you hire can’t overcharge you without advance notice. This means there is little to no risk of overspending your budget.
Having a fixed deadline is a huge benefit of using these contracts. Laying out the final scope and detailed features of the project in advance allows the development team to better estimate the timeline of the project. When the software house is able to come up with a clear plan they can set definite deadlines that allow you to easily coordinate the work of your other teams, such as marketing plans for your product. Another advantage of fixed price settlement related to this is an easy to follow development schedule. You will know what features are being implemented during the development phase and will be able to tell if there is a delay in delivery.
Disadvantages of Fixed Price Contracts
One disadvantage of fixed price contract is that they have a long planning phase. First, business analysts on your side need to come up with project specifications and perform detailed risk analysis and then to draft an accurate estimate, the software development company you hire needs to plan features thoroughly. This process can take weeks (or even months sometimes) to complete.
Another downside to fixed price contracts is that the process is inflexible. Once you have signed the agreement, it is set. There is no option to make changes or add additional features (even if the market changes on you and they become necessary to add or remove). The only way to adjust the scope of the project would be to renegotiate and go through the planning process once more or request CRs (Change Requests) after the contracted project is completed that is individually planned and priced.
Time & Materials Contracts
When to Use a Time & Materials Contract
Time and materials (T&M) contracts are great for projects whose requirements are not fully known. They work well with projects that may have requirements changes over the course of development. If you want the flexibility to modify the scope, vary the workload, or change features while your project is ongoing then a time and materials contract is the right choice for you. Overall, T&M contracts are perfect for projects that are not fully defined upfront and are expected to have dynamic requirements.
Time and materials contracts allow you to pivot and react to changes in the market. If you need to integrate user feedback into your development process, time and material contracts allow you to do this. When you know little to nothing about your target market you should use a T&M contract. When the scope of your idea is undefined and the process of defining it could potentially take more time than the development itself, the right fit is a time and materials contract. This type of agreement works well with raw or innovative product ideas.
Advantages of Time & Materials Contracts
Time and materials contracts let you pay for the actual time spent building your application. This type of arrangement is flexible and permits you to make ongoing changes to your product, adjust features, pivot, change priorities, and implement changing market and user needs into your idea as it is created.
One advantage of these contracts is that they allow for a simple and quick start. Unlike fixed-price contracts, time and materials contracts don’t require a detailed, and final, product plan to get going. All you need to do is define the scope and the minimum viable features it requires in order to start development.
Another advantage of time and materials contracts is it allows for quick and practical hypothesis testing. With this style of contract, you can build a minimum viable product quickly and test it out with real-world users. This lets you reiterate the scope based on feedback. Continual user testing and iteration help improve product quality.
Disadvantages of Time & Materials Contracts
A disadvantage to T&M contracts is that they have low budgeting control. On account of the scope of the project not being defined in detail from the start, it's impossible to know what the exact final cost of software development will be. The best you will get is an approximate estimate of the cost based on the assumed number of working hours it will take to complete the development of your idea. Your actual cost for the venture could go way over budget. Moreover, defining an exact release date can be next to impossible.
Another downside to these contracts is uncertain deadlines. Projects can change based on market needs or change on the go, ideas and solutions are tested and those that succeed are developed further.
When selecting between the two main types of software development contracts, fixed price and time and materials, make sure to choose the one which best suits your project. Fixed price contracts work best for projects whose specifications are predetermined. They are rigid but budget-friendly and let you know exactly what’s going on right from the onset. T&M contracts work best for projects that don’t have fully defined specifications. They work well when you need flexibility during the development phase to allow for ongoing changes. If you still have some doubts about what contract type to choose, contact us and our specialists will help you make the right decision!