How to Negotiate Fixed Price Contracts

How to Negotiate Fixed Price Contracts
Daniel Elizalde

Fixed Price (a.k.a Fixed Fee) are SOWs where the budget, timeline and deliverables are clearly specified. The Vendor is committing to deliver everything that’s written in the SOW within the allocated time and for the specified budget. Nothing more, nothing less. Therefore, in this type of SOW, the Vendor is the one absorbing the risk. If they underestimated the effort, too bad, they are still on the hook to deliver everything in the contract.

To mitigate this risk, Vendors usually add a “buffer” or “padding” to the SOW. Clients can expect to see a 20% to 40% increase in price for a Fixed Price SOW, which is actually the right thing for the Vendor to do. That’s the way they protect themselves from the unknown.

Fixed Price SOWs are great when the project scope is well defined. This means that you already went through the effort of doing market/user research or going through a requirements gathering phase with your users and stakeholders. As a result, you have a solid understanding of what needs to be accomplished. (BTW, requirements gathering phases are great candidates for T&M SOWs). Going into a Fixed Price SOW with fuzzy requirements and unreasonable expectations is a recipe for disaster for both parties.

If your requirements are not clear, don’t be afraid to break your project into smaller SOWs (even if they are all Fixed Price SOWs) and commit to only one at a time. Smaller projects means shorter timelines, smaller budgets and smaller scope, so even if the engagement goes wrong, not much is lost in the effort. This minimizes risk for all parties. Plus, as you complete each smaller SOW, your project needs will become more specific, and you’ll be able to more clearly define the next set of deliverables. Small projects also help Clients audition a new Vendor and learn about their delivery capabilities, before signing up with them for the full project scope.

As far as payment, invoices in a Fixed Price SOW are usually tied to milestones. For example, the contract will say that 25% of the total budget will be paid on milestone #1, 30% on milestone #2, etc. The invoicing schedule is usually a big part of SOW negotiation, so make sure to check out the key watchouts on invoicing below.

Key Watchouts for Clients:

1. Low bids = red flag: Be cautious of Vendors whose bid is too low. They might be low-balling the project just to get in the door, and they will bombard you with Change Orders afterwards. It could also mean that they don’t have a good grip on the requirements or they are really not that competent in your field. Regardless, you might want to probe deeper.

2. Include review times: Fixed Price SOWs usually specify a completion date that matches your requested deadline. It’s a good idea to ask for the full project schedule to understand how the Vendor is planning to run your project. Oftentimes, Vendors omit review times or give very few iterations to provide feedback. Make sure you are comfortable with the proposed number of review iterations and that they are including enough time for you to review and accept the milestone, especially if there are multiple people involved in providing feedback.

3. Reasonable timeframes: Make sure that the schedule  is realistic. Vendors will often try to compress project phases to meet your deadlines (in paper) and win the project. If you don’t think the timelines are realistic (or don’t have enough buffer for testing, deployment, etc), then work with the Vendor to come up with a better plan. Keep in mind that your expectations might be unreasonable to begin with, so you’ll have to deal with that as well.

4. Measurable Deliverables: Make sure deliverables are specified in a way that can be clearly measured. Linking the SOW to a test plan or user stories is a good idea. Avoid general or blanket statements like “vendor will perform stakeholder interviews”. Instead, aim for something like this: “vendor will perform stakeholder interviews on five (5) engineers from the Client team. The deliverable will be a document in PDF format that includes the interviews notes and insights”.

5. Invoicing: Your job as a Client is to negotiate an invoicing schedule that is beneficial to you. This means assigning small payment amounts to initial milestones so you can withhold as much payment as you can until the end of the project. This gives you more leverage in case the situation becomes sour. Keep in mind that these types of safeguards are common during the first SOW with a particular Vendor. Once you know each other better and have developed a sense of trust and partnership, there’s less of a need to do this (or maybe it’s the other way around, depending on the Vendor). Also, make sure that milestones are clear and that you have a way of accepting the milestone before the Vendor can submit the invoice.

Key Watchouts for Vendors:

1. DON’T low-ball: Clients can smell that something is wrong if your bid is significantly lower that other Vendors’. The thinking goes that if you could only get in the door, then you’ll make it up in the next project. This usually doesn’t work for several reasons: a low bid tells the client that you don’t understand their requirements, might not be as competent or that you just want into the account in a shady way. None of those options is good. Besides, even if you win the project, you are setting a low expectation with the client and believe me, you won’t be able to raise your prices next time. On the other hand, it could be a good strategy to go in with a lower bid, but make sure the client knows you are giving them a huge break because you want their business. That way, you are setting up the stage for being equal to the other vendors, and showing you are willing to go the extra mile to win the account. Full disclosure is the key here.

2. Include review times: This subtle point is often overlooked, but it can drive a project into the ground. In the SOW, specify the amount of time the Client will take to provide feedback. This will help your company plan for resource allocation, invoicing and estimated completion times. I’ve seen cases where after the contract was signed, the Vendor realized the Client needed 4 weeks to provide feedback (as opposed to the 2 days the Vendor planned in the schedule). This means that your project timeline is out the window and that you’ll have a lot of people on the bench until the Client provides milestone feedback/acceptance. Not ideal.

3. Reasonable timeframes: As the saying goes, you can’t make a baby with 9 women in 1 month. The software development lifecycle takes time (yes, even with Agile), and the SOWs need to reflect this. If the Client has unrealistic timeframes, don’t agree to them thinking you’ll be able to throw more people at the problem. Pushing back and setting more realistic expectations not only minimizes the risk on your part, but also educates your Client on what’s doable with the right level of quality. This is invaluable because it builds your credibility. By protecting yourself and looking after your Client’s interests, you stop being a Vendor and become a Partner.

4. Measurable Deliverables: Make sure deliverables are specified in a way that can be clearly measured. Remember that in a Fixed Price SOW, the Vendor is on the hook for delivering everything the SOW specifies. If the Client’s understanding of the deliverable is different or bigger in scope, they’ll push you to deliver their understanding of the SOW, not yours. These negotiations are not fun and can easily damage the relationship. It’s better to agree on as much as possible before starting the project and have a clear understanding of what “done” means.

5. Invoicing:  Try to tilt the invoicing schedule to your favor, meaning you should ask for bigger amounts of payment during the initial project milestones. The goal is to have a small amount (around 5%) remaining to be invoiced by the end of the project. The reason is to protect yourself in case the Client is not satisfied with the project and doesn’t want to pay. (But that never happens, right?)

6. Be careful with incentives: Some Clients add incentives and penalties on milestone completion (i.e. +/- 10%  if milestone is ahead/behind schedule). This is more common with government contracts. This can be a real issue because there are more unknowns in software than in other type of project (i.e. building a road). Software is harder to visualize and therefore harder to set expectations. Many things can go wrong on a software project, so make sure you are comfortable with the penalties and ensure the incentives are achievable before accepting this type of SOW.

As you can see, Fixed Price SOWs are a great tool when the requirements are well understood. But what to do when I know my requiremetns, but I only need help here and there? In my next post, I’ll discuss the last type of SOW: Retainer and Staff Augmentation SOWs.

So where do you go from here?

Now that you’ve gone through Part 3: Fixed Price contracts, it’s time to look at the other articles in the series:

Part 1: What Every Product Manager Ought to Know About Contract Negotiations

Part 2: How to Negotiate Time & Materials Contracts

Part 3: How to Negotiate Fixed Price Contracts

Part 4: How to Negotiate Retainer & Staffing Contracts

14 Comments

  1. K 2 years ago

    Hey, what happens when the customer asks for a ‘detailed cost breakdown’ and ‘split the cost % by roles’ etc. for a large fixed price project?

    • Author
      Daniel Elizalde 2 years ago

      I’d try to find out their intent. That type of cost breakdown is for time and materials. It’s usually OK to show the split between people and equipment, but more than that is hard. I’d recommend sitting at the negotiating table and figuring out what their real concern is and how to address it.

  2. Mahdi 2 years ago

    Thanks for the article, very useful.

    I had a question on a point you mentioned about using Fixed Price contracts on larger software development engagements “This is probably the most common type of contract for bigger software engagements.”.

    Would you please comment on what you consider a bigger engagement? I know it’s hard to quantify, I merely would like to understand your perspective and have some ideas about the size you are referring to.

    Let’s say, we had a team of 4 engineers, and 2 testers and 1 PM. If this team were engaged for 6 months on project, would you consider this large? or are we talking about a whole different scale of project to be “large” and a good fit for Fixed Price contract type.

    Thanks

    • Author
      Daniel Elizalde 2 years ago

      Hi Mahdi, I would consider an engagement of that size a “big” engagement for the purposes of your question.

      -Daniel

      • PZinDenver 2 years ago

        What’s the difference between large, as you requester asked, and big, as you replied?

  3. NAYEF 3 years ago

    Great Info ! What happens if the UAT cycle gets extended from 2 weeks to 3 weeks because the customer and now the vendor needs and additional 1 week of effort. Is this considered a change in scope, or are we still within the same scope and price

    • Author
      Daniel Elizalde 3 years ago

      Thanks for reading Nayef.

      Ideally, your MSA or SOW would have provisions for how long the user acceptance test (UAT) should take and what happens if you need more time. Overall, providing that extension of time can be an opportunity to strengthen your relationship with your customer as a concession you are making. Remember, there will be times when you are late, so you need to build that trust.

      Make sure you keep an eye on these delays, and if they become too frequent, then you could use that as an opportunity to create a change order for additional scope or sell other services to support your customer through the UAT.

      The most important aspect is that contracts are legally binding, but you should be flexible to create a good working relationship with your customers. The moment you start discussing that your customer is in breach of contract, then you already lost.

  4. Patrick Kearns 5 years ago

    Excellent guidance. For 6 years I managed a professional services business with more than 600 Consultants doing SOW consulting projects and these guidelines are very useful. Most companies use them internally and it is always good to keep everyone on the same page.

    • Daniel Elizalde 5 years ago

      Thank you Patrick! I’m glad you found the article to be useful. I agree, having some guidelines we can point to is a good way to continue conversations and keep everybody aligned.

      -Daniel

  5. RJ Rusnak 6 years ago

    Would you have an example fixed price bid that you could post?

    • Daniel Elizalde 6 years ago

      Unfortunately I don’t. The first contract is the NDA and after that, all further material is private. So I don’t have any public examples to share.

      Thanks for reading,
      Daniel

  6. Akhilesh Mohan 8 years ago

    Well explained. Thanks!

  7. viji 8 years ago

    It is a very Helpful post Daniel, As I need to implement fix price this article helps in laying my foundation right.

    Thanks so much!!!

    • Daniel Elizalde 8 years ago

      I’m glad you found it useful. Thanks for reading!

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