Businesses are in business to make a profit. That's no surprise. But profitability depends on many factors — including the way a service provider contracts with its customers. Two common contracts are fixed-price and time and materials (T&M). How to choose? This guide breaks down which contract makes the most sense for project-based work — be it a home renovation, the construction of a new apartment complex or the development of new software — as well as the pros and cons of each contract type.
Fixed-Price Contracts vs. Time and Materials (T&M) Contracts
Under a fixed-price contract, a service provider determines a set price for a project and the customer agrees to pay that amount. This type of contract tends to be used when the scope of a project and its necessary expenses are well known. For example, a contractor experienced in building two-car garages knows the price of materials and labor for such a project typically costs $8,000. As a result, that contractor may be more inclined to use a fixed-price contract that, after building in a margin for profit, sets the project's total cost at $9,200.
A T&M contract comes into play for larger projects with less up-front certainty about the full scope of work. Take, for example, a software developer tasked with building a new mobile application. Under a T&M contract, the software developer and client agree to specific prices for particular elements of the project — namely, the time (labor) and materials (tools) to build the applications — but the final price, which builds in the provider's profit, isn't determined until the job is complete. To protect itself, the client may stipulate a “not-to-exceed” clause to set a maximum amount on how much it will spend on the project.
|Fixed-Price Contract||T&M Contract|
|Determined at the start of a project.||Typically evolves during the course of a project.|
|Fixed at the start of a project.||Labor rates and cost of materials are determined at the start of the project, but the full cost is determined at the end.|
|Scope of Work|
|Typically small and well defined.||Larger projects whose requirements are hard to pin down at the outset of a project.|
|Set once project requirements are determined.||Based on the costs of time and materials for the duration of the project; may include a not-to-exceed-clause to keep costs in check.|
|Fixed.||Variable, depending on final cost of the project.|
Fixed-Price: Fixed-price contracts are suitable for projects whose scope is well understood — often because the provider has done the same or a similar project many times before. When determining whether a fixed-price contract is suitable for a particular project, it is important to weigh its pros and cons.
Fixed-price contract pros:
- All parties understand what goods or services will be delivered and how much the total project will cost.
- The project's scope of work, including specific phases and deadlines, is typically well defined.
- The service provider knows the amount of its profit.
- Fixed-price contracts tend to be easier to administer and require less tracking of expenses because the project's total cost is fixed at the outset.
Fixed-price contract cons:
- If unexpected obstacles arise that require more time or materials than originally anticipated, the provider must cover the costs, which decreases profits.
- If client requirements change, the contract will need to be amended or a change order will be required, either of which can delay the project.
When to use a fixed-price contract:
- Fixed-price contracts make sense when the scope of a project can be clearly defined up front.
- The service provider is relatively certain that the time and materials needed for the project won't change.
- Fixed-price contracts are suitable when the scope of a project is small, well defined and/or the company has done similar work for other customers.
Time and Materials
T&M contracts are suitable for a variety of projects, especially ones that are large in scope and/or whose scope is not clearly defined. As with any contract type, it is important to weigh the pros and cons before drafting — or entering into — such an agreement.
- T&M contract pros:
- Prices for labor and materials are defined at the start of the project.
- Changes can be made as a project progresses and needs change over time.
- Set prices for time and materials provide transparency and make it easier to increase a project's scope.
- The service provider's profit increases if the scope of work increases.
T&M contract cons:
- Contracts can be more complicated to set up and manage.
- Individual expenses must be carefully tracked and documented, which can be time-consuming when handled manually.
- Customers may be concerned about being taken advantage of, without a not-to-exceed clause in place.
When to use a T&M contract:
- T&M contracts are best suited for longer-term projects where exact requirements and costs are hard to estimate.
- This type of contract also offers flexibility in case requirements change.
Choosing Fixed-Price or Time and Materials: Which Is Best?
Like most aspects of business, determining which contract is “best” depends on a variety of factors. Fixed-price and T&M contracts are similar in that they both include a project's scope, labor wages and cost of materials, with profit baked into those prices. Their key difference is when the project's overall price is determined.
When to choose fixed-price: If a project meets the following criteria, a fixed-price contract may be suitable:
- The project is small in scope.
- The scope of the project can be clearly defined.
- The service provider has completed similar projects for other customers.
- The time and materials required to complete the project are unlikely to change.
When to choose time and materials: If a project meets the following criteria, a T&M contract may be suitable:
- The project is large and/or will require a relatively long period of time to complete.
- The requirements for the project are not well known at the outset.
- The project is new to the service provider.
- The requirements for the project are likely to change over time.
|When to Choose a Fixed-Price Contract||When to Choose a T&M Contract|
|The project is small.||The project is large and/or long-term.|
|The project's scope can be clearly defined up front.||The project's requirements are not well known at the outset.|
|The service provider has completed the same project for other customers.||The project is new to the service provider.|
|The time and materials needed for the project are not likely to change.||The project's requirements will likely change over time.|
From building a garage to developing a mobile application, projects come in all manner of breadth and cost, making project accounting and financial management software that automates tasks and helps track costs important. For some projects, a fixed-price contract, where the total cost is determined from the start, may make more sense; for others, an open-ended T&M contract may be better suited. Choosing the right contract for the right job can maximize a service provider's profit and a client's satisfaction.
Fixed-Price vs. Time And Materials Contracts FAQs
What is time and materials (T&M) pricing?
T&M pricing is one way a service provider can bill for a project. Under a T&M contract, prices for time and materials are established from the start, but the project's final cost is ascertained at completion.
Is time and materials a fixed-price contract?
Time and materials are components of a fixed-fee contract. They contribute to how much the project will cost, which is determined at the beginning of a project. There is also a type of contract called a time and materials (T&M) contract, which doesn't determine a project's total cost at its outset — only fixed prices for time and materials. This type of contract is useful when it's difficult to predict a project's full scope or duration.
What is the difference between cost-plus and time and material?
With a cost-plus contract, the service provider is paid for its direct and indirect costs plus an added fee representing its profit. With a time and materials model, the contractor builds a markup into costs that represents its profit.