Managing Fixed Price Contracts
It’s a trend that has been increasing for the last decade: more clients want fixed-price contracts, especially for longer term engagements. But fixed price contracts are more risky than cost-plus contracts for service providers and need more attention to control both scope and costs.
There are several areas where a fixed-price contract can backfire. As an example, let’s pretend a large IT service provider is contracted for a system integration project using a fixed price contract.
A subcontractor is hired to write parts of the system. The contractor has no prior experience with this subcontractor. Also, this is a first of a kind implementation, so the contractor has no intellectual capital to draw on for this work. The subcontractor’s initial estimates are too low, so the contractor has to double the estimate and add a contingency reserve.
When the deliverables are produced, the client declares they do not satisfy the functionality requirements. The subcontractor disagrees, and the contractor is stuck in the middle. To make it right, the contractor obtains the code from the subcontractor and makes changes to meet the customer’s demands, resulting in a one-year delay at a cost of one million dollars.
The above scenario is like a long-running play: it is performed somewhere in the world every day. But the contractor can take measures during the project life-cycle to control risk in a fixed-price arrangement:
1. Decision to Develop a Proposal
- Try to understand why the client desires a fixed-price arrangement.
- Gauge client’s attitude and philosophy regarding other fixed-price projects. A fixed-price contract can be considered when the customer is strategic, financially viable and stable, and a favorable business relationship already exists with the customer.
- The contractor must have high confidence in its ability to deliver. Conduct additional peer and risk management reviews before writing the proposal.
2. Proposal Development
- Document roles, responsibilities and assumptions while creating a detailed scope definition.
- Use an estimating process with reviews, estimating metrics and bottom-up estimates.
- Create a contingency reserve at major task level and plan for incremental delivery to ensure that progress is realized and customer expectations are satisfied.
- Assess customer’s ability to perform its part of the project: can the customer fulfill its obligations? Can customer staff be replaced or trained?
- Plan for a longer than usual negotiation period. Establish non-negotiable conditions and be willing to walk away. Negotiate price, scope, quality and contract terms by involving the legal department early-on.
- Encourage client organization responsible for negotiating fixed-price agreement to have buy-in from business units that will be affected. These other business units may not have the same mind-set as the contracting organization and will find fault with the contract.
- Discuss risk mitigation strategies during contract negotiations and include them in the Statement of Work.
- Realize the client wants to limit introduction of change orders. The original contract should be very specific and have clear, concise, and objective completion criteria.
- Subcontracts should be fixed-priced. However, avoid a fixed-price contract with a new subcontractor where no prior relationship exists.
- Be very specific with subcontractor SOWs, ensuring liability is passed through to where the problem exists.
- Staff project with proper level of experience. Clients expect an “A Team” to be assigned to their project and have little tolerance for staff that does not demonstrate a high level of knowledge and professionalism.
- Provide growth and career opportunities to all consulting staff to encourage high morale.
- Demonstrate flexibility and concern for consultant’s personal and professional commitments to maintain a stable team, thereby reducing chance of turnover.
- If project spans geographies, appoint an Assistant Project Manager in key locations to address immediate concerns. Empower the Assistant Project Managers to make timely decisions and ensure Project Manager supports those decisions.
6. Financial Management
- Monitor financial information on weekly basis. Ensure the project manager is the reviewer on all expense reports so they have the opportunity to reject a travel report should the situation arise.
- Frequently review invoicing schedule with client and send courtesy communication with information on upcoming billings prior to receipt by client.
- Review conditions of fixed-price contract with client to ensure all parties are adhering to agreement.
- Invoicing should be calendar-based, not deliverables-based. Do not include holdbacks, and avoid complex payment metrics and complex acceptance criteria. Involve senior management in aggressively handling disputes.
7. Change Management
- The contract should include a change control process allowing the contractor to renegotiate cost, schedule and scope. Familiarize the customer with the change process early in project by introducing a no-cost change and walking them through the process.
- Include a rate escalation for inflation in case the change control process lengthens the schedule.
- Use Exchange Requests when client insists on keeping time and budget constant. In an Exchange Request, new scope is added only if an equivalent portion of existing scope is dropped. This helps prioritize the most important components of scope. The dropped scope then forms a basis for add-on projects.
R. Buckminster Fuller said, “A problem adequately stated is a problem well on its way to being solved.” While a fixed-price contract is risky for the service provider, this risk can be aggressively managed during the proposal development, contracting, and execution of the project.
Tom Grzesiak, PMP, is an instructor for Global Knowledge and is the president of Supple Wisdom LLC. Tom has over 20 years of project management and consulting experience with IBM, PricewaterhouseCoopers, and dozens of clients. He has trained thousand of project managers and consultants. Global Knowledge is a worldwide leader in IT and business training. More than 700 courses span foundational and specialized training and certifications. For more information, visit www.globalknowledge.com