Time and materials vs. fixed-price – Deciding on the best contract type for your project

Intro

Determining the best-fit engagement model is one of the major considerations for any startup or SME executive who launches a new software development project. The primary models – time and materials (T&M) and fixed-price (FP) – offer distinct advantages and challenges. Exploring these approaches, their ideal use cases, and how to manage risks effectively is key to building a productive and successful collaboration with your technology partner.

This guide examines the opportunities and challenges of both models, the situations where each works best, and actionable strategies for managing risks. By the end, you will be equipped with the insights needed to make a well-informed choice that goes hand in hand with your project objectives.

Time and materials – What is it, when to choose it, pros and cons, risk management

1.

Explaining the time and materials (T&M) model

A time and materials contract implies paying a supplier a fixed per-hour cost for software development, based on the actual number of hours worked per week, month, or quarter. This engagement model is typically used when the scope is not rigidly defined and requirements evolve during the development process. 

Similar to building a house where you pay builders monthly and cover material costs, T&M contracts often bill by labor hours but may also include charges for materials and fixed costs. This strategy emphasizes working together, blending the client’s vision with the provider’s expertise, which can expand the project scope and foster stronger teamwork. 

2.

When you should choose the time and materials agreement

This approach is most practical when:

1. The scope is unclear or expected to evolve. For instance, a startup is developing an MVP with room for iterative enhancements.
2. Innovation plays a central role in the project. This could involve developing AI-based software using a trial-and-error approach.
3. You need an adaptable approach. For example, scenarios where reprioritization or responding to market changes is crucial.

Time and materials contract vs fixed-price – when the former is preferable

3.

How the T&M agreement works in practice

Let us consider the development of a custom mobile banking app. Early discussions outline key features such as account management, transaction history, and fund transfers. Over time, other features like integrating AI-driven financial advisors or support for cryptocurrency transactions may be introduced. A T&M contract allows for the project to evolve and grow without being tied to a fixed budget or deadline.

4.

Benefits

Flexibility

T&M contracts allow for adjustments to the scale and priorities of your project as new insights emerge, which is particularly useful in innovative or exploratory endeavors. You can have visibility into how resources are being used and acquire better control over the project’s direction.

Faster project initiation

Unlike agreements with a fixed price, the T&M ones can accelerate project initiation as they do not demand comprehensive upfront specifics on every detail of the work.

Transparency 

Frequent reporting and ongoing updates inform clients about progress and spending. This ongoing exchange helps promote transparency across the project and strengthens trust between stakeholders.

More effective outcomes

T&M contracts’ iterative approach typically produces superior products, as teams can adapt and improve features through continuous input rather than sticking to a strict blueprint.

5.

Challenges and risk management 

Uncertainty

However, the absence of a comprehensive, detailed specification means that the budget can only be estimated approximately rather than calculated precisely. 

How to mitigate the risks. Build a solid project foundation with detailed initial discussions to clarify expectations. Set up milestones, even when the full scope is undefined, and plan for regular evaluations to revise estimates and timelines as the project evolves. Use time-tracking tools for transparency and effective resource tracking.

Scope creep

Another potential drawback is scope creep, a gradual expansion of project essentials that can inflate costs and timelines. This risk is more likely in the absence of strong management capable of maintaining the agreed course.

How to mitigate the risks. In such projects, a skilled manager is necessary to document and authorize all additional work, keep thorough records of scope discussions, and avoid reliance on verbal agreements.

Increased client input

T&M contracts often call for more active client participation. You will need to monitor progress and provide feedback frequently to make sure the project stays on track. This may be challenging if you favor a less involved role.

How to mitigate the risks. Set clear communication expectations from the start. Agree on manageable check-ins and feedback cycles for both parties. Define boundaries for client input to prevent excessive involvement in the process. 

Fixed-Price – What is it, when to choose it, pros and cons, risk management

1.

Explaining the fixed-price (FP) model

A fixed-price (FP) or fixed-bid contract is a conventional agreement where both the client and vendor set a fixed cost and timeline before project commencement. This model is most effective when the scope, features, and timelines are clearly outlined and unlikely to change throughout the process. It provides structured budgeting but may be less flexible if unexpected changes arise. 

2.

When you should choose the fixed-price agreement

Fixed-price contracts are optimal in cases where:

• The project scope is well-defined. As an example, we can look at building a corporate website. Its requirements are specific and consistent – and are not expected to change. 
• Your budget is limited. And staying within this budget is a top priority. 
• You are aiming for a short-term project. These are low-risk tasks with minimal potential for change; for instance, designing a promotional campaign website.

Fixed-bid vs. time and materials – when you should opt for the former

3.

How the FP agreement works in practice

For example, you consider creating an informational website for your small-to-medium business. You specify features like a homepage, contact form, and service descriptions. With clearly defined requirements, a fixed-price model helps the vendor deliver the project on time and within budget and minimizes the need for frequent input. This approach works well when both the scope and deadlines are well-established. However, if you add new features or make changes during development, a T&M contract might suit you better, as it offers the versatility to adjust.

4.

Benefits

Price certainty and consistency

A key advantage of fixed-price contracts is the guaranteed cost structure. Buyers can plan their budget with precision since the total price is known upfront, which aids in cash flow management and resource planning. This certainty minimizes the risk of budget overruns often seen with other contract models.

Defined project goals and deliverables

Typically, fixed-price contracts involve well-established scopes, deliverables, and deadlines. This precision helps both parties align their expectations from the start and generally facilitates smoother execution and communication.

Reward-based performance

Your vendors have an incentive to complete projects efficiently, as they keep any savings from finishing below budget. This can promote higher productivity and innovation, which eventually benefits both sides.

Vendor assumes the risk

A fixed-price agreement places the financial risk mainly on the vendor, who must adhere to the budget and schedule set for the project. For buyers, this transfer of risk offers security against unforeseen price escalations.

5.

Challenges and risk management 

Limited room for modifications

Once a fixed-price contract is in place, altering the scope can be problematic and expensive. Any changes might require renegotiation or result in additional fees, which can potentially cause conflicts between the parties.

How to mitigate the risks. Include a change management clause. Establish a clear procedure for managing scope changes, including pricing revisions and approval processes. This provides both parties with a structured approach to handle adjustments without conflicts.

! If you have a large and complex project in mind, fixed-price contracts are often impractical due to numerous dependencies. In this case, sticking to the T&M model is highly recommended. 

Possibility of cost miscalculations

Vendors might misjudge project costs when submitting a bid for a fixed-price contract. If actual expenses exceed their estimates, they could cut corners or reduce quality to stay within budget.

How to mitigate the risks. Conduct detailed cost estimations. Apply historical trends, risk analysis, and expert consultations to formulate accurate cost estimates. Add allowances for unforeseen costs.

Antagonistic dynamics

The structure of fixed-price contracts can occasionally create antagonistic dynamics between buyers and vendors. Conflicting interests may surface if unforeseen issues arise – and trigger conflicts over who is responsible for delays or incremental costs.

How to mitigate the risks. Implement clear communication practices and a dispute resolution mechanism. Maintain ongoing and open conversations among stakeholders to address issues promptly and cooperatively. In addition, include provisions for mediation or arbitration in the contract to resolve conflicts amicably.

Conclusion 

T&M vs. fixed-price – ​​Which contract model suits your needs?

Selecting the appropriate engagement model depends on your project’s nature. For stages like discovery or MVP development, where requirements can be clearly defined, a fixed-price contract can be a suitable option, as the scope is easier to estimate. However, for projects where the concept is still evolving or where substantial user feedback is needed, a time and materials contract offers greater flexibility. Some companies may also offer a hybrid model – fixed-price for initial stages and T&M for subsequent development phases – but this is a less common practice. 

It is worth noting both the project’s scope and your preferred involvement level, along with your tolerance for risk. By evaluating these aspects and consulting with your vendor, you can choose the agreement that best positions your project for success. At Touchlane, we work with both fixed-prices and time and materials projects, so we can accommodate our clients with the model that fits best for them.