Jessica Richmond, director of strategic initiatives at Rock Creek Strategic Marketing, and Mike Kapetanovic, founder of Reef Light Interactive, explain how you determine which billing method is right for you
Every industry veteran has his or her preferred billing method. Some prefer fixed pricing arrangements while others prefer straight hourly billing. Regardless of individual preference, each billing method has its perks, and the decision should be based on which method is in the best interest of your firm, yourself and your client.
The simple fact is, nothing lasts forever: our services, clients, rates and talents are all products of our times. The days of a simple and straight-forward six to eight page informational website are behind us. Simple websites have become more data-driven. Web and mobile applications have become more prevalent. Stability, security and scalability are not only best practice considerations, but also the expectations of clients investing large sums of money in their website build or redesign.
New technologies and more complex solutions lead to higher budgets, greater lead times and increasingly variable scope. Under the circumstances, it is more important now than ever to re-evaluate your billing structure.
Three of the most standard, industry recognised billing methods are:
1 Firm Fixed Price (FFP, often referred to as “Fixed Rate”)
Put simply, you provide work to clients based upon a fixed price and scope. Generally speaking, clients appreciate this method, as they can manage their budget without unexpected surprises. While fine and dandy for the client, the burden falls on the shoulders of the developer to develop a crystal-clear and concrete scope for the contract and to ensure that the project is implemented within scope and under budget. Margins have the potential to be higher with this billing method, but it’s our responsibility as developers to make sure that we profit during these engagements, as we take on the majority of the risk.
The Fixed Rate method can also turn you into the “Scope Police”, because the onus is on you to ensure that any work outside the original agreement is charged for, to make sure that you are compensated for the extra time and expense.
The key to success under the Fixed Price method is managing client expectations along with profitability. To that end, a successful vendor must clearly communicate expectations from the outset and to alert the client whenever a change to the job falls outside of the job’s original scope. Otherwise, you may as well start doing everything pro bono.
2 Time and Materials (T&M, often referred to as “Hourly”)
Like any good ex-con or divorcee can tell you, attorneys love this billing method. Under Time and Materials billing, each hour (or minute) that is spent performing services for the client, from brainstorming solutions to management of the client’s project, is billable. First and foremost in the “benefits” column, this method can be lucrative. Provided that you are a fastidious enough record keeper that you can account for your work in fractions of the hour (attorneys typically charge in tenths of an hour), every minute that you work is a minute that you are getting paid for.
Much to your client’s chagrin, this can get expensive. As a result, depending on the client’s resources and financial abilities, they may or may not like this type of arrangement, as risk of change in scope, hardship or your incompetence falls squarely on their shoulders. Consequently, under this arrangement, it is all the more important that the client is provided with the scope of the work and a realistic (and honest) estimate, based on your understanding of the job, based on your prior industry experience. If a change is required, it’s much easier to continue moving forward without any addendum, provided that overage is documented.
Interestingly, in the interactive industry, we have seen many requests for T&M based contracts, with clients thinking that this would help them secure projects at a lower cost. For smaller development shops with less time or capacity to thoroughly bill for all time spent on projects, this may be in fact be true. However, it is important to also look at the motivators: FFP contracts encourage the vendor to be efficient, whereas T&M contracts encourage the vendor to be as slow as possible.
3 Cost Plus
While smaller shops may be sticking to FFP contracts and the mid-size firms are optimising T&M contracts, the big systems integrators have discovered the best of both worlds. “Cost Plus” contracts offer a baseline contract that only covers costs, with an opportunity to cash in on a bonus (aka the “plus”) by exceeding client expectations at the end of the contract. While a 3% bonus may not sound like a lot for a six-figure contract, firms supporting enterprise projects with large multi-million dollar budgets have found that managing these projects correctly can be very profitable.
With cost plus contracts increasing in popularity at the enterprise level, it is important for firms with big growth aspirations to have the appropriate corporate structure for these types of contracts, as supporting a cost plus engagement requires more infrastructure and governance of the corporation’s time and financial tracking systems to ensure excellent product delivery, support and customer service. Want to be a big time firm for the government or private sector? Get your ducks in a row with regard to the above models and brush up on your understanding of Earned Value Management (EVM). This contract model requires extremely detailed planning, scoping and evaluation setting before contract initiation, a talented project management office (PMO) to lead the implementation, and very advanced financial management and accounting structures to set the company up for success.
In addition to the monetary “plus” bonus at the end of the contract period, firms and clients both benefit from focusing on innovation and excellence rather than cutting corners to up an FFP profit or dragging out a project to increase T&M hours. One point worth noting is that by constantly striving to exceed client expectations often results in repeat business, so you would do well to move away from a “launch and leave” approach to client management.
So which billing method is better?
Some argue FFP while others argue T&M. Proponents of each have valid points, and ultimately which method is chosen is a matter of personal preference and individual circumstances. That being said, we argue there is no almighty billing arrangement sitting on high. No billing structure works best in every given situation and each have their selling points. But consistency in your contract approach will greatly reduce administrative and management burdens.
As such, the prudent entrepreneur should carefully consider the options and be strategic about their contracting approach. It is important that businesses in our field re-evaluate our billing methods as the industry, as well as individual market players, continues to evolve in terms of their internal culture, types of services and clients. Billing arrangements of the past may not continue to be good fits for modern clients.
Make sure your firm is managing for the present but structuring for the future. In order to make that determination, here are a few considerations to determine which method is right for your next engagement.
What works for the firm’s management styles and approaches? Is this a firm that operates on a project/account basis? Or does it instead function as a matrix organisation, supporting clients in a more agency-style environment? Does your firm have a management approach that is part of your core competency and offering, such as an Agile shop? Or does your firm pride itself on having the flexibility to uniquely support a variety of client needs and management approaches?
In selecting a billing method, or combination of methods, to pursue, you will need to think hard about the impact on your corporate culture. If you are an Agile shop running in sprints, the FFP model is very risky. Are your employees and managers going to be empowered and encouraged to recommend an alternate course when additions to scope run the project from black to red? Furthermore, can you afford to stay in business under that model? Running flexible projects with inflexible budgets is a tricky proposition.
On the flip side, if you are a focused firm with renowned experts in XYZ technologies, you will find your firm quickly unable to meet market demands and raising hourly rates can stave off opportunities unnecessarily. Choosing FFP in that situation can deliver a benefit to both the client and the firm, allowing the team to focus on efficiency and excellence in products as opposed to finding cash-rich clients and spending half of your time itemising and legitimising your bills.
FFP puts the risk on the firm, while T&M puts the risk on the client. Before determining where the risk should lie, you need to balance the needs and risks of a particular project to your firm and determine whether this falls within acceptable parameters of risk to both your firm and your client. As a project becomes more novel, falls outside of previously cultivated competencies of your firm or if your firm would have to work with business partners it has never worked with before, uncertainty increases. Likewise, when dealing with more risk adverse clients, uncertainty and their willingness to agree to hourly billing are inversely related. This situation incentivises flat fee arrangements, when possible. At a minimum, it makes it all the more important for you and your client to have an unreproachable meeting of the minds as to scope and estimated cost.
Market and client demands
Many clients prefer FFP because it allows them to confidently budget what they will have to spend for an online presence. However, an experienced T&M shop should be able to provide a reasonable range for the project and install reporting mechanisms that ensure transparency in billing. Industries may differ in their approaches to contract models, with clients like the government often requiring FFP for lower level (under six figures) while still requesting hours (and ensuring that our taxpayers get the best of both models), while many private firms prefer T&M as a way to manage their vendors and control the risk.
Nature of the work
Some projects do not fit the FFP method right away. For example, software development projects (ie custom modules, R&D work or extremely custom integration efforts). This is also the case with projects that require a truly Agile environment. Agile approaches require Agile budgets and by nature cannot be firm or fixed.
If the client accuses you of “nickel and diming” them with every billing cycle, you will waste a ton of time dealing with them and be unlikely to receive future work. Under a T&M arrangement, this leads to more time on the project and even higher bills for the client. This can lead nowhere but to a bad relationship. Not good for your brand, not good for your reputation and not good for follow-on work. Just plain not good. Clear communication and understanding, along with timely and regular billing, are key in keeping good client relationships during a T&M contract.
Diligent watching of scope is critical for any contract model, but you may need more reporting with T&M, as the client is responsible for the risk. Transparency and project management must be balanced, as the client pays for your time as a project manager as well as your time as a designer.
Try creating basic burn rate trackers, and for larger projects report on EVM. We have found it very effective to work with our clients collaboratively to determine their pain points, areas of interest, and what questions their higher-ups want answered. Make sure your client’s project manager is fully equipped with this information in advance and you can avoid those difficult and disappointing invoice discussions down the road.
Where you are now may not be where you want to be in five years. Think about your firm’s strategic plan and monitor the procurement trends of the industry. If your firm is becoming a larger enterprise player, start planning the infrastructure for Cost Plus contracts now. If you are determined to remain a small, boutique firm, you will retain your flexibility and can utilise process and structure to reduce reporting and management burdens regardless of the contract type.
Whether you (or your client) are big, small, old, new, rich or poor, proper scoping and complete transparency from initial negotiation onward is key. In web development (as in life), if you do not understand the needs, risks, hopes and fears of all parties concerned, your contract will be a roadmap to disaster. Considering these seven factors, and thinking and acting strategically when it comes to contracting models, will reduce headaches and increase profitability, giving your team time to focus less on billing and more on innovating.