Growth
December 7, 2020

The new software pricing model: why fixed price and T&M are NOT enough

Filip Pietraszkiewicz
Business Development Specialist

When starting a cooperation with a software development agency, one of the most crucial decisions that must be made right off the bat is the selection of the appropriate pricing model. It's pivotal as it will have a huge impact on the whole project: processes, time-to-market, price, client's involvement and his comfort of work.

Up until recently, companies were choosing mainly between fixed price and Time and Materials (T&M) pricing models. Each of the models has its own strengths and weaknesses, and is appropriate for different project methodologies.

After a decade of working closely with clients from all around the world, learning how this business of expectations vs. outcomes work, we have developed and incorporated a new pricing model: Full Time Equivalent Engagement (FTE Engagement). 

Allow me to detail the two most common pricing models first, and then, by comparison, show how FTE Engagement works and we think it's best suiting our culture and philosophy.

Software Development Methodologies

Choosing a billing model for a project does not happen in a vacuum and out of context. It should be a consequence of choosing a specific software development methodology along with its processes and deliverables, be it waterfall and agile (regardless of whether we are talking about kanban, Scrum or Extreme Programming).

For the sake of simplicity, each IT project consists of roughly 4 stages:

  1. Research
  2. Design
  3. Development
  4. Testing

In case of waterfall, we move on to the next phase only once the former is finished, documented and signed-off. In case of agile, by contrast, all stages are run in parallel with sprints that tackle specific problems or functionalities, followed by the release of the latest working version.

The pricing model one chooses must correspond with the software development methodology. If you work in the waterfall model then you are probably doomed to use the fixed price contract. If, on the other hand, agile is your thing, you have mostly Time & Materials or FTE Engagement to choose from.

Fixed Price

Fixed price means that you agree on a single, predefined sum for a specified scope of work within a certain period of time. To give you a real-life example, it’s like when you order a birthday cake for your daughter’s birthday party. The scope you order from the bakery around the corner is a strawberry cake with lemon icing on top and your daughter's name written all over the top with white chocolate. The deadline is two days from today and you agree to pay $35 for the service. Sometimes in advance, too. This is what a fixed price model is in a nutshell and it works pretty well for non-complex errands. As long as you receive exactly what you ordered and that's not always the case, sadly.

ProsCons
- Known price means no surprises
- Known timeline and set deadlines
- Little to no involvement in the development process from the client's side
- Long process of planning and documenting each stage
- Focus on delivering agreed scope of work, not on a better product
- High risk of having product that doesn’t fit the market
- Very hard to make changes during and after the project once it starts
- It is difficult to change the product quickly in case of market or legal requests

So far the fixed price contract sounds great, doesn't it? At least on paper. You know well what you will get, when and for how much. No surprises. Unless, that is, it turns out the product isn't what the market or its customers wanted.

So what could possibly go wrong?

Software development in the waterfall methodology means that an application must be designed, detailed and described along with all its features and components before it can go into production. Every little element is going to be priced and documented separately. This means three things:

  • The agency will spend a significant amount of your time detailing and polishing documentation;
  • Almost all decisions regarding features and functionality will be made with relatively little knowledge about the product. Surely, research can be conducted beforehand and the agency can host a Design Sprint, but it's rarely the case for the waterfall methodology.
  • Every change, regardless of how small it is, will require additional valuation, which again will consume time and resources or even force a significant step-back in the project for which you will have to pay extra.

On top of that, once software developers start working on coding wireframes, few things might happen: 

  • UX/UI design might not be suitable for coding;
  • Beautiful design might be very unintuitive and unusable from the user point of view;
  • User requirements might change in the matter of days and/or the market might innovate into something that wasn't foreseen in the project, forcing you to yet another round of design, functionality change, documentation and development.

The worst thing, however, is that the fixed price model forces developers to deliver the final product based on the detailed scope of work as accurately as possible, rather than delivering the best possible product. Due to the fixed price model's limitations developers are rarely involved in the project before the development stage so their concerns and ideas are not taken under consideration. And when they are finally given a stage to perform, it's usually too late for any changes.

Those are the reasons why most of the software development is being done using agile methodology.

Time & Materials

Time and Materials is an approach in which clients are billed for the time dedicated experts spend on developing the product based on hourly rate that has been agreed on in the contract.

ProsCons
- Flexibility of agile development
- Better Product-Market fit
- Work on the product itself starts earlier
- Lower risks of potential failure
- Timeline is difficult to predict
- Costs are difficult to predict
- Higher involvement from the client side in the development process

Time & Materials model allows one to work in sprints, where it's often the client who decides on the next feature that will be designed or developed from iteration to iteration. Each sprint is followed by a demo of what has been built and allows validating both UX/UI and performance.

Each successive sprint is planned based on a greater understanding of the problem, which results in a product better adapted to the market realities and user expectations.

In this regard, though, T&M can require higher involvement in product development from a client. It may seem like additional workload, but it isn't from an outcome perspective. If one calculates the amount of time and energy that might be needed to fix a product that doesn’t meet market needs, that initial involvement really pays off.

Unpredictable costs are another worry with T&M. Customers fear that one day they will be surprised by an exceptionally high invoice they weren't ready for. Or, similarly, that it will be difficult to predict the ongoing monthly costs, keeping in mind that the project can change its course and its timeline a few times as it goes. If this happens, it gets harder to allocate and plan the project's budget and the costs can grow exponentially.

Before moving on to the FTE Engagement pricing model, lets go back to the question, whether it makes sense to combine fixed price model with the agile approach.

The scope of work often changes in the agile methodology. We add features, modify them, change the order of features developed as we go and see best for the product and its final outcome. Now imagine that every time we make even the smallest change we would need to price it and produce a detailed documentation before moving to the development stage. It would be the opposite of agile and efficiency which makes agile and fixed price an unlikely duo.

Full Time Equivalent Engagement (FTE Engagement)

Most of intent's past projects had been carried out on the basis of the Time And Materials (T&M) billing model. At some point, however, we decided this does not fully reflect the transparent nature of how we approach co-operation with our partners and clients. Therefore, we have created a new model to meet our own, high standards: full time equivalent engagement (FTE Engagement).

In short, FTE Engagement means hiring specialists exclusively and paying for the full Man Days that these specialists have dedicated to your project and its end-result. We call such specialised teams pods. Their strength lies in the fact they can be deployed quite fast and with industry-specific expertise depending on the project, adding tons of value to every project (be it extensive customer knowledge, tech consulting, Go-to-Market and Product-Market fit experience of the pod).

Let me elaborate.

ProsCons
- Predictable monthly costs
- Dedicated and exclusive team of specialists 
- Higher efficiency due to the lack of task and project switching
- Far greater and industry specific know-how of the team
- Requires a higher dose of trust in a partner
- Deadline may be harder to predict

FTE Engagement is our proprietary concept that gives one the most significant advantages of employing someone full-time without the burdensome disadvantages of having someone on his/hers payroll (sick leave, social security, medical insurance, holidays and restrictive labour laws to name just a few). 

In reality, this means that our developers only work on one project at a time. They devote their full attention for 8 hours a day and 20 days a month to one client, which is rarely the case in a T&M model. They do not lose efficiency or focus, time and attention switching between projects doesn’t occur and, thus, they can go really deep into understanding key elements of a client's project and that project only.

What is equally important is that our partners most often need from a few to a dozen developers for their complex and long-term projects. Due to the fact that developers usually work on one project, we establish teams of specialists that have already worked together and are industry experts, which makes the whole development process way more efficient and smooth. One can consider those teams as his/hers dedicated and exclusive product delivery team, just not in-house. They do, however, feel responsible for the product's success, as all owners should.

FTE Engagement has one more advantage over T&M. It makes each month's deliverables and costs predetermined and they can't be exceeded. Simply because each specialist will dedicate no more than 8h per day, which gives 160 hours per month. It makes it easier to estimate the value of the project over time and there are no surprises, which is what clients sometimes fear when working in the T&M model.

However, this billing method requires a lot of trust between a client and a tech partner. At the end of each sprint you will not get a detailed report on how many hours of work each feature took. We rather encourage our partners to take part in demos that show the progress of work on an ongoing basis and allow them to test the product on the go.

Conclusion

One should never think about pricing models in a total isolation from project management methodologies and should always consider pros and cons of each combination.  

Fixed price contracts might be good for some very simple, predictable projects with limited features. In all other cases, it is better to opt for an agile approach that leaves you with either T&M or FTE Engagement.

Time and Materials is a very convenient pricing model, but in our opinion FTE Engagement has significant advantages:

  • Developers are exclusive and work only on your project;
  • It's easy to estimate monthly cooperation costs;
  • It is less burdensome than recruiting an in-house band.

If you would like to discuss details of your project and how we can go about it, let us know through the contact form.

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Written by
Filip Pietraszkiewicz
Business Development Specialist

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