As published on Forbes.com
Many businesses struggle with creating attractive pricing. Those who sell services often struggle the most. I often get asked about the best way to price services. I’ve written about the Failures of RFPs and Hourly Billing, and How to Propose Fixed-Price Proposals for Complex Projects. In some cases the principals will try to define a hybrid model of fixed fee and hourly billing. Combining the two together could be the biggest mistake you can make pricing services.
In the articles referenced above, I explain that fixed-fee contracts make sense when we are delivering value and both parties can agree on the outcome or results. Time and Materials (T&M) contracts are best when we have uncertainty, are not sure of the detailed requirements, or cannot easily define the potential outcome.
Fixed-fee projects reward innovation. If the vendor can deliver the desired outcome on an accelerated schedule, then they reap the rewards of the surplus. Meaning, if the vendor anticipated 200 hours, and they deliver results in 150 hours, then they still get the money for the full value of the contract. Hence, the client received quick results, and everyone is happy.
T&M projects imply shared risk. What I mean is that if the project scope changes, new needs come up, or the client decides to change direction, the client and the vendor recognize that the client is paying incrementally based on effort… not necessarily results.
The Biggest Mistake Is Hourly Billing With A Cap
In the contracting world, some vendors will propose an agreement for Time and Materials Not To Exceed (T&M NTE). T&M NTE means that you bill based on effort… up to a point. Some confuse this with fixed price projects. Not so much… The fixed price project rewards you if you perform efficiently. T&M NTE provides no reward if you perform ahead of schedule. But, it provides a penalty if your effort goes beyond the maximum effort. So, you get your normal margin if things go as planned, and every hour beyond the maximum erodes your margin until you end up losing money on the deal. With no upside and only downside, you should never agree to that model.
Why as a client you should avoid “T&M NTE”
As a client, many organizations feel that T&M contracts amount to a blank check. So, when project outcomes are not sufficiently defined for fixed price contracts, companies feel that they can engage a vendor in a T&M NTE model. The theory is that the vendor should know what the maximum effort should be. If it takes longer than that, then the vendor cannot charge more. The challenge, however, is that if the vendor ends up being upside down on the project, at least one of three things will likely happen: 1) They will try to deliver the bare minimum to be acceptable; 2) They will shift from high-value to low-value resources to theoretically reduce their losses (a curious theory that rarely works in practice); or 3) They will be on a quest to “get even” for all future projects.
In terms of reward and punishment, T&M NTE does not offer a carrot… only a stick. If as a vendor your client proposes T&M NTE and you think that the maximum value is a reasonable top side, then suggest a fixed-price project. If you go that route, you could end up with the stick… but you also can be rewarded with the carrot.
A Word Of Caution About Fixed Fee Pricing
One common mistake on fixed-fee pricing is to think of a given month, client, or task in isolation. When this happens, you build so much risk-avoidance into your price (meaning you pad the number so much) that the price is unreasonable to the client.
For example, you might bill your clients $100 per hour (for simple math). On a typical project, you bill them 35 hours per month for $3,500. In some peak months, you billed them 50 hours per month. You might think, “I need to protect against the worst case. So, I’ll charge 10% more than my worst case, or $5,500.” That won’t be appealing to the client who is typically paying much less. Instead, follow these three simple steps:
- Clearly define how you’ll measure success and in what timeframe: If you agree that you’ll deliver something over four months and the client decides they want it sooner, they can pay a premium for faster completion;
- Identify assumptions that could change scope: It’s easy to get worried about the unlikely circumstance that can change scope dramatically. Document those items that are NOT included in the agreement. You can even explain, “If one of these circumstances takes place, it could dramatically change the scope of the engagement and the cost would increase.”
- Be reasonable: Your goal is to provide and receive good value over time. If on average things are working out, then don’t’ worry if one month you are over by 10% and another you are under by 10%. Be sure to include language that you can terminate with one month’s notice. This way, if things are not working out and your client is not reasonable, you don’t feel stuck. In order for this to work, both parties need to see good value.
It’s Your Turn
Where have you seen fixed-price proposals help you win business? Where have you struggled with pricing?