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Project management: the challenge of fixed-price contracts

Konstantin Boyko
Konstantin Boyko CEO
6 minutes to read

Project management with a fixed-price contract is not always the most straightforward of tasks. While there may be a higher reward profile — a natural temptation to succumb to – this comes hand-in-hand with a minefield of risks and unique challenges. A fixed-price contract is one of the riskiest choices a supplier can opt for.

Here, we will outline these challenges and the benefits of alternative approaches while suggesting some strategies managing fixed-price projects that must be in place to minimise the risk of a fixed-price project falling apart.

The different types of contracts

The defining concept of a fixed-price contract is – you guessed it – the client buys a set of services for one set price. Sounds simple, but it rarely is. Problems commonly occur if completing and delivering the work takes more time or costs more money than anticipated in the budget. Under a fixed-price contract, the client won’t be obligated to pay any more. Which obviously leaves the supplier out of pocket. In fact, additional funding from the client is only likely if the client requests a change in the project that would increase costs.

That’s not the worst of it. The risk of incurring additional costs will rest solely with the supplier who must continue to work on the project until all is complete and has been accepted and signed off by the client – to do anything less could risk a breach of contract. Hardly an appealing deal when you consider the many ways a project might unfold.

As a firm fixed-price contract means the buyer pays the seller a set amount, regardless of the seller’s costs, suppliers tend to feel a lot more comfortable working under one of the other two general types of contracts: time-and-material (T&M) contracts and cost-based contracts. Both of these contracts are much more likely to make your partnership run smoothly.

T&M contracts

They offer services or products based on hourly rates listed in the contract and materials. Therefore, if a project ends up taking longer or costs more to complete than predicted, the client can top up the funding or adjust the ceiling. T&M contracts are recommended for projects where the scope may not be clearly defined or is likely to change course – they just make more sense than fixed-price under these circumstances.

The bottlenecks and advantages of T&M contracts

+ absolute flexibility and freedom to change specifications and a set of features;

+ the project is divided into small sprints which are easy to control;

+ the model eliminates almost all the fixed-price contract risk and fits virtually any kind of projects;

+ the client plays a crucial role and controls the whole process;

+ transparency of costs;

+ no charges for uncertainty and changes;

+ no need to negotiate work conditions for a long time;

+ in short, it’s very user-friendly.

there’s a financial risk that a project budget will become enormous;

considerable efforts for managing and monitoring;

it doesn’t work if you’re going to test the waters before entering the market. 

When you should go for hourly rates:

  • long-term projects with a vague scope and incomplete documentation;
  • tasks with no deadline and estimations;
  • projects that need support from the third-party;
  • testing new ideas.

Cost-based contracts

These contracts set out an estimate of the total cost to establish a ceiling and budget; again, the client will be responsible for adjusting both as the project develops. The concept of a cost-based contract is that the exact specifications cannot be pinpointed – the supplier endeavours to meet the requirements, but will not be forced to shoulder the burden should the project run over.

Cost-based contracts are also known as cost-plus agreements; they’re based on the predicted budget and additional fees or rewards.

Typically, these types of contracts are used for governmental projects, however, they may work for other industries including IT as well.

Benefits and limitations of cost-based contracts

Unlike in the FFP method, it’s easy to calculate the budget in cost-based contracts. You can use different formulas, the most common of which is Product Costs + Profit.

The client can predict the profitability of the project right from the start and develop an effective pricing policy.

The difference between FFP and this method is that everyone is ready for unexpected events.

The service provider has the right to increase the rate and the client is obliged to cover additional costs – contractors negotiate such risks on the signing a contract stage.   

The biggest drawback of cost-plus is errors in estimations. If future sales are wrongly predicted or the consumers’ demand is underestimated, then the project is likely to be a loss.

Inflated prices, on the other hand, can distract consumers from business and its production.    

In addition, this model doesn’t take into account competitive prices and possible changes in market conditions.

Since prices are pre-established, businesses don’t have incentives to be more efficient and cut costs. 

Comparing with managing fixed-price projects, costs plus require closer monitoring.    

When should you opt for the cost-based model?

  • when your goal is to create a unique value proposition or deliver the cost-leadership strategy;
  • when you operate in the industry with equal costs and pricing policies;
  • when the price for your solutions reflects their real value. For example, cost-based pricing doesn’t work for SAAS or software development.  

Fixed-price contracts pose the most significant risk to the supplier. If they are accepted, they must be project managed with care and discipline.

How to manage fixed-price projects

The number one reason fixed-price projects fail is that a clear and agreed-upon definition of the project’s scope is lacking, or changes to the scope are not adequately managed. So, taking the additional time to minimise all ambiguities before the project begins will be worth its weight in gold. If you must go ahead with the FFP method, here are some top tips on how to run a fixed-price contract in project management.

Set clear parameters

Clearly defined parameters are crucial to managing a fixed-price project. Communication is critical to define the scope, objectives and deliverables (preferably using clear criteria). Leave no part of the agreement vague or subject to interpretation or the project could suffer due to the lack of clarity.

A work breakdown structure (WBS) is essential

Breaking down the project into deliverables is of particular importance in a fixed-price project to ensure both the supplier and the client are on the same page when it comes to the details. A robust WBS also keeps the focus on the work that needs to be done to complete the requirements of the contract’s scope of work.

Manage strictly to scope

Keep an eye on the details to avoid incurring extra cost. Work needs to be performed within the scope and if the parameters need to be changed, must be agreed, worked through and recorded in the contract.

Hold regular reviews

The best way to keep your fixed-cost project under control is to make the time for regular reviews. This will ensure the team is conforming to the requirements of the contract and the work is fulfilling the acceptance criteria – it will also highlight any issues the minute they occur.

Lockdown acceptance

Obtaining client acceptance at regular intervals throughout the performance of the project is important to ensure the supplier is delivering exactly what is expected, with client confirmation. This takes time, true, but it is nevertheless important.

Working on fixed-cost projects

Keeping both parties well-informed every step of the way lies at the heart of a successful working relationship involving fixed-cost projects. Otherwise, the supplier could risk wasting time and energy on something the client isn’t invested in. Expect to schedule more time-consuming meetings, drafts and outlines than you might expect from other types of contracts – this will allow the time for providing feedback, adjusting expectations and nipping potential problems in the bud. With fixed-cost projects, communication is everything, and meetings can ensure that any twists or turns the project may take can be addressed with clients as soon as possible.

How to manage changes to fixed-price contracts

It’s also best to set some ground rules regarding changes that might be required as the project unfolds. If a client decides they want to make a change, the supplier’s first move should be to outline the likely cost and schedule impact whilst (tactfully) making it clear that any change must be priced, agreed and signed by both parties before it can be implemented. Of course, nobody wants to look like they’re pinching pennies, but a fixed-price job has certain requirements – letting a client know as early as possible what they might expect should they wish to make changes should ensure the process runs smoothly.

Fixed-cost contracts need special treatment to stay on track such as careful management of project costs, clear communication, regular meetings and transparency in dealing with the contract itself. But do the rewards really mitigate the risk?

When to use a fixed-price contract?

Below are a few situations when you can try your hand at fixed-price project management: 

  • projects with a predefined scope of work;
  • projects of any size with prepared documentation which is unlikely to change;
  • internal projects aimed at developing simple products or prototypes;
  • basic tasks which are not closely monitored.

Having tried both of the methods, we’ve found that T&M contracts work better for our business model that FFP agreements.

Alongside a dedicated team headed by the project manager, we offer clients to pay only for real hours worked with no obligation to continue if they don’t want to.

We have experience working effectively with contracts that offer value to both client and supplier. For help in the delivery of your next project, contact us today.

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