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3 Pitfalls of Fixed Priced Software Development

July 26, 2016

Many companies like to outsource fixed priced software development projects in an attempt to control or minimally to limit risk. In reality, this may actually increase the project risk and may even put your project delivery in jeopardy.

1. Fixed Priced Projects Cost More

The main issue in fixed price projects is cost risk management. To manage risk, we buy insurance. We usually pay a premium over the expected cost to pass the risk to our vendors.

Professional software development companies are not in the business of losing money, so when they take on the fixed-price risk, they believe the additional premium they receive will be more than enough to cover the risk(s) they are taking on. 

 

Assuming things go as planned, you’ll end up paying for the cost of the initial estimate plus the additional risk premium, which will be higher than a Time & Materials based cost.

2. Misaligned Incentives

If you are having a new or complex application developed, you can not possibly figure out all your needs and requirements at the beginning. In 35 years of new software development, I am yet to find one application where all the needs were known and well understood before the start of the project.

Change management, the process of managing changes from the original requirements, puts you and your vendor at odds. You want to have the right software built. But your vendor, who has not signed up for implementing your newly discovered needs after the bid, wants to be paid for the extra effort. For most budget conscious companies, this creates a tug of war, usually resulting in reduced customer satisfaction and less trustworthy vendors.

 

Between taking a haircut in profit and taking care of customer’s additional needs, most vendors will choose to protect their profits. So you won’t get the best service from your vendor.

In reality, fixed cost for custom software is a myth (except for a small set of special projects). Your costs will typically increase, as you make changes.

3. Getting Locked In With a Low Initial Quote

Let me also share a dirty little secret of the outsourcing and offshoring industry. You may find vendors who will take on loosely defined projects at fixed price and at a low cost. It’ll be inexpensive and the vendor takes on the risk. You may even think have found the right people who understand your need to stretch your budget. Great! Or is it?

 

Vendors may give you a low bid to get the project, knowing full well that there will be a fair number of changes. Changes result in change orders, which result in additional costs. Half way into the project, when you are fully committed to your new vendor, the change orders start getting more and more expensive, providing a way for the vendor to make up for the initial lower fixed price. At this point, as long as you wish to complete the project, you, as the client, are not in control of the costs. If you cut down on the changes, you will get an inferior product. If you don’t, the project will cost more. A classic catch-22. The cost benefits of the fixed price development model will disappear with the escalating costs, which can get up to two or three times the original bid.

​What do I do?

The questions are then:

(1) when is it in your best interest to pay a premium and attempt to transfer the risk to your vendor and (2) when is it in your best interest to keep the premium and take on the risk?

 

If you know exactly what you want done, with a great technical specification, and feel confident that you will not be making any changes, then fixed priced projects are a good way to go. Simple maintenance work, infrastructure support, rewrites of old software, moving to another technology platform, small additional features to existing software with your current vendor may all fall in this category. When the potential surprises from unknowns are pretty small, you can pass the risk to your vendor and expect to get a good service.

 

If the specifications are not well defined, or you are developing a new product or a major new enhancement, there will always be some unexpected surprises. This will result in a higher number of changes. Therefore the premium you would need to pay for the higher risk would be relatively high as well: high enough so that vendors can believe that they will still make money after coming to terms with Murphy’s Law. The majority of custom software development projects fall into this category, and are not suitable for fixed price development. 

 

Your best defense: Use reputable vendors that you can trust, with a lower hourly/daily/monthly rate and who are interested in a long-term relationship. Be knowledgeable about the process, as well as the risks. Find a way to manage the risks intelligently and fairly, respecting that the relationship needs to work for both sides to be successful. After the software is built, you’ll still need your vendor for updates and bug fixes.

 

Do you have questions on which type of software development is better for you? Email info @ septium.net to setup a conference call to review your project’s specifics.

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