When purchasing custom software development services, choosing the right contract type is crucial for project success. Therefore, at Fabrity we have distilled our experience into a CTO’s guide on the advantages and risks of the three main IT contract models. Â
This knowledge will empower you to make informed decisions when working with IT outsourcing partners.
A fixed-price contract specifies a predetermined amount to be paid for the performance of a specific IT service, usually consisting in the delivery of a well-defined task or project. The service provider adds an overhead to the expected cost, usually of about 15%, though sometimes as much as 30% is added for complex projects. This is to account for unexpected events and to function as an operational buffer against the risk of underestimation of the cost or labor required. Additionally, the costs of analysis for a project or a section of a project can range from 5% to 30% of the project value, especially when one of the requirements is to provide detailed technical documentation.
A fixed-price contract is suitable for projects where there is a well-defined final product, such as:
The main advantage of this model is its predictability and lower risk. If the initial business analysis is done well, you will know what to expect, what will be delivered, and at what price. Fixed-price projects usually have a well-defined time frame and low risks of delays. They are also very useful for procurement departments, as the total cost of the project is precisely determined before it starts. Similarly, project sponsors know exactly how big the investment will be and when they can expect results.
The main issue with this model is its lack of flexibility. Changes to the scope of the project cannot be made without renegotiating the contract and may require a roll-back to the analysis phase. This can make changing the project scope prohibitively costly. For the client’s product owners, the fixed-price contractual model creates a significant risk, as they have limited opportunities to change the project scope, even if business requirements evolve. Therefore, this model is only applicable to a relatively narrow range of IT projects of a repetitive or standard nature.
Under a Time and Materials contract, the client pays for the work time of the developers and other team members and for the necessary materials, such as software licenses. The end goal is to reach the so-called “business definition of done” or a predetermined outcome. In other words, it is to meet a specific need of the client. For example, the final objective might be the creation of a bank payment gateway module for a little-known e-commerce system, where the API documentation is poor, and a lot of R&D work needs to be done. Note that no strict time frame is determined, meaning that the final cost of the project is entirely dependent on the amount of work it will require, which is not predictable.
T&M contracts work well when:
This is a very flexible format, allowing the development team to respond to the changing business situation and needs on an ongoing basis. It is an ideal solution for R&D processes. Leveraging the advantages of a T&M contract requires close cooperation between the client’s team and the development team, allowing them to gain knowledge from the senior members of the external team provided by the outsourcing partner.
Compared to other types of contracts, T&M carries the highest risk of exceeding the budget, as a result of the many unknowns and unforeseen challenges. Because the cost is tied to the amount of work put in by the development team, it is not possible to accurately determine the final cost at the beginning of the project. Successful implementation of this model requires very good control of business outcomes, in the sense of providing value that is understood as a solution to a specific problem. Therefore, a lot of knowledge is needed on the client’s side, including establishing a work backlog, project management, and budgeting. Fabrity mitigates this risk by supporting the client on the management side. Analogously, the outsourcing partner needs to have a mature and competent team or the ability to selectively choose required skills.
QT&M is a type of contract where the client pays for the functionalities delivered and accepted in the form of predefined stages. Usually, the main part of the project is preceded by a business analysis (Sprint 0), the aim of which is to precisely define the client’s expectations and the tasks that need to be included in the project backlog, mainly in business, rather than technical, terms. An important element of the preparations is also the division of the project into small sections of work.
QT&M model works best for projects such as:
This contractual model allows the client’s product owner to control the costs, because they know exactly what functionalities are paid for. At the same time, there is flexibility as to the scope of the project, albeit within closed, quantifiable stages. This allows for the possibility of modifying the scope of the project, depending on the current business situation, by choosing between work packages. This contractual model reduces design risk, while maintaining flexibility.
For this model to be viable, the IT service provider needs to have extensive experience in business analysis to determine the work stages or “packages.” These are clearly defined and quantifiable, which makes the project predictable, but also makes it impossible to go beyond their predetermined scope without changing the valuation of the project. A team hired under a QT&M contract must have the ability to work according to Agile methodologies and have good short-term planning ability for a closed range of tasks. Finally, the IT service provider must be able to properly assemble the team employed on the project, determining its size, seniority level, and composition, so that individual stages are carried out efficiently and correctly, and their valuation is competitive.
Having laid out the theoretical features of these three financing models, let us look at their practical applications in several business scenarios.
For this analysis, we created a hypothetical client—a manufacturing company from Germany that makes small metal products with a high precision of workmanship, such as bearings, screws, and fastening systems. Because they make a wide range of products with different specifications, dimensions, and applications, they have an extensive product catalog. They already have an online system allowing their customers (distributors in various markets) to place orders that they have been building for a few years on their own.
They decided to undertake two separate projects:
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Using these realistic case studies and based on our experience, we will analyze the advantages and risks associated with each of the three contractual models applied to the services provided by an IT outsourcing partner. Additionally, to paint a full picture, we will include the scenario where the project is carried out using the company’s internal resources without the help of an external IT service provider.
This project has the following time frame:
In total, the project requires 25–28 weeks of work.
Our client also plans to implement a B2B online store, which will be available to small customers purchasing selected items from the assortment (about 1,000 SKUs in total). Due to the wide range of products, the company plans to simultaneously implement a PIM system to manage the entire product base. The decision to launch an online store result from the fact that the company wants to obtain an additional source of revenue from a large number of small orders that are not worth servicing by the sales team, so a self-service model is needed here. It also wants to develop sales in promising markets where there are no representatives or local distributors yet.
The project scope:
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Estimated project time:
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In total, the project requires around 60 weeks of work.
Fabrity is a software house specializing in bespoke software development, digital solutions including e-commerce, web portals and UX/UI design, as well as blockchain and low-code development.
We build software development teams covering all skills and project roles: full-stack developers, frontend and backend developers, DevOps, Cloud and QA engineers, as well as UX/UI designers, business analysts, project managers, and Scrum masters.
We can help you augment your IT staff to meet the growing demands of your business or build a dedicated team for a complex project. Alternatively, we can step in to enhance an existing solution or provide software consulting services.
Over 50 corporate clients have benefited from our solutions. We focus on long-term relationships: 90% of our clients have been working with us for more than five years.
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