What is a Fixed-Price Contract in Project Management?
Fixed-Price Contracts for Professional Services Organizations
Managing fixed-price contracts is a source of struggle for many professional services organizations. Both private organizations and public companies need to paint a picture of how complete a project is in order to run revenue recognition. In addition, companies need to do so in a manner that is justifiable to its board, shareholders, auditors, and the IRS, all while decoupling the messy worlds of project management and resource scheduling.
Recognize revenue too slowly, and you get accused of sandbagging. Recognize revenue too aggressively, and you go to jail.
Yet, what if there was a secret to easily and accurately performing revenue recognition for fixed-price contracts? A world in which you no longer have a series of spreadsheets and whiteboards that tell the “true” mid-month revenue or profitability story but instead, one core operational system that tells you at any point in time where your project stands.
Does this sound intriguing? If so, let’s dive in and learn everything you need to know about fixed-price contracts and revenue recognition to gain a competitive advantage.
Fixed Fee Project Definition
A fixed-price contract for services, or fixed fee project contract, is a contract structure in which a client is billed a fixed amount of money, no matter how much or how little effort is invested to deliver the project. As a result, fixed-price contracts can either represent an opportunity or a risk to the organization, depending on how well the work is scoped and executed. A firm fixed price contract is an example of shifting risk from the buyer to the seller.
For example, if the seller can efficiently manage the fixed-price project and control costs, the service provider will recognize a significant reward. On the contrary, if the seller exceeds its budget and allocates more resources than intended, there is maximum risk that the project will be delivered at a loss.
According to SPI Research’s latest Professional Services Benchmark, nearly 39% of projects are delivered on a lump sum or fixed-price contract basis. Thus, this leads us to the question, when to use a fixed price contract? To help answer this, let’s take a look at some of the advantages and disadvantages of this type of contract structure.
Pros and Cons of Fixed-Price Contracts
Advantages of Fixed-Price Contracts
- Guarantees an agreed upon amount of revenue for your firm; this means no surprises
- Pricing can be based on value rather than effort
- May be simpler to sell to clients (less uncertainty on price)
- If managed well, can return strong margins on your financial statements
- If you have a well-defined service offering, a low risk of exceeding your project budget, and the possibility for a competitive advantage by agreeing to absorb more risk, you might consider this type of contract to reap the rewards
Disadvantages of Fixed-Price Contracts
- Heightened risk, as you may not receive the full value of the project. It is essential to closely monitor the delivery process to ensure you don’t start running over budget
- Arguments of scope can arise when projects go over budget
- Special attention needs to be paid to contingency planning and performance obligations to safeguard profit margins and control costs
- Revenue forecasting requires robust operational tools to decrease the administrative burden; however, with the right tools in place, you can position this disadvantage into a competitive advantage for your firm
The Secret to Revenue Recognition
The thing about how to manage fixed-price projects is that there’s a bit of a complex interplay between the process of fixed price contract revenue recognition and having sufficient forecasting methods to make sure the project isn’t going off the rails. Professional services automation (PSA) solutions can help manage these complexities.
There are three goals that need to be achieved in regards to revenue recognition visibility for fixed-price contracts.
Revenue Recognition on Project Management Fixed-Price Contracts
- Easily Executable
In many software solutions, once the organization decides how much revenue should be recognized through, say, the end of the year, the system fixes the hourly rates for the remaining work through the end of the project such that the contract’s value is respected. That process actually works well, and provides an accurate view of the project…but only for that instant in time.
Fast forward a week, and what the system now tells you may deviate from reality, sometimes by a little, sometimes by a lot. Hours reported in the last week may differ from hours that were planned. Resources may have gotten swapped in and out. Schedules may have changed or tasks reassigned. Contracts may have been renegotiated with the client or delivery dates re-planned. All of these variables make that picture that was spot-on accurate the second after the last rev rec either slightly or significantly inaccurate just a week later.
In talking with a host of experienced professional services managers, we’ve seen a variety of workarounds:
- Spreadsheets or whiteboards maintained outside the PSA with full responsibility to tell the “true” mid-month revenue or profitability story.
- The weekly Gallup poll of project managers who manually compute and submit revenue and labor forecasts outside the PSA, subject to any adjustment.
- The periodic “trial” fixed-price contract revenue recognition to get a realistic view with true up accounting.
As you can see, there are several approaches but none of them are particularly accurate, easy, or real-time. Professional services automation software solves this problem and ensures accurate, real-time, and dependable visibility into fixed-price projects.
PSA Software Functionality for Fixed-Price Contracts
PSA software should handle the hard work for you in regards to something we call “Dynamic Revenue Allocation”, or DRA for short. The cool part about DRA is that it’s dynamic. Rather than taking a frozen-in-time snapshot of the last rev rec run, DRA continually re-evaluates the world whenever you ask it a question… whether it’s in a dashboard, on a project, or in a report.
What to Look for in a PSA Solution
Many PSA software solutions are only capable of achieving some of the three revenue recognition goals (accurate, real-time, and easily executable), rather than all three. Make sure you review the features below, determine what’s important for your organization, and ensure your PSA tool performs those functionalities, and performs them well.
Some PSA tools require you to purchase a separate integrator for some of these functionalities, or batch limits in terms of revenue recognition. Keep these helpful tips in mind for what effective PSA revenue recognition software should be able to understand:
- The contractual terms that you negotiated with your client
- What labor you’ve expended to date and what you’re projecting to have to invest going forward
- When you last ran revenue recognition, how much you’ve recognized to date, and how much revenue you’re projecting
- The rules you’ve agreed upon with your auditors around how to proportionally allocate that revenue or if you’ve pre-established revenue schedules
- The cost of labor against both fixed-price and time and materials contracts so that organizations can get a full understanding of project (and resource) profitability
- Detailed labor rate inheritance structure to allow organizations to model labor rates at different levels of granularity, from blended rates by generalized job title and experience level to specific rates per individual and per project
- How to model team members as paid on a salaried or hourly basis, and ability to make the appropriate calculations to allocate those labor costs across the work that they do
- Profitability analysis inclusive of billable projects and/or billable staff only, or inclusive of billable plus non-billable/admin activities, effectively helping organizations understand margins inclusive of overhead as necessary
- Ability to support GAAP (Generally Accepted Accounting Principles) as well as cash based accounting
Finding the Right PSA Vendor
Now that you have an idea about the critical components to successfully manage fixed-price projects, how do you go about determining which PSA vendor is best able to meet your organization’s needs?
This really boils down to one thing: engage in conversations with a few vendors and start diving in. Vendors that make great partners will be able to recognize when business professionals are trapped with less than capable systems, and they should be able to help you move from inefficient business processes that require clumsy workarounds to better ways to do things—ways that provide a truer picture of reality.
We talk with all kinds of prospects and work with all kinds of clients. Some are just starting up their professional services firms and may not know the term “Professional Services Automation” (PSA). Others have decades of experience running services firms, understand the complexities of managing long-running fixed-price contracts, and have been burned by other PSAs or clumsy business processes in the past. But no matter what your past experiences entails, it is always best to begin with a conversation.
That conversation will often sound something like:
|Prospect:||Can you forecast revenue accurately in Projector by BigTime? Because if you can’t, this will probably be a short conversation.|
|Me:||Yes, no problem.|
|Prospect:||What about for fixed price projects?|
|Prospect:||What if the project is already underway?|
|Me:||That’s not a problem.|
|Me:||Definitely. Let me explain…|
Or sometimes the conversation is focused on the shortcomings of a former system:
|CFO:||We have to be able to perform trial rev recs in bulk at the end of each week. How easy is this to do in Projector by BigTime?|
|Me:||Can you tell me a little bit about why you need to do this?|
|CFO:||Well, it’s the only way to see where we are on fixed price projects. (Pause) Isn’t it?|
|Me:||Not really. Let me explain…|
It has taken over a thousand words for me to narrate the story to you about how to think about managing a fixed-price contract, but there are some things that just can’t be condensed into a nice, tight sound byte. In summary:
- Make sure that your professional services automation system works for your business—naturally, accurately, and in real-time.
- Have strategic conversations with software vendors to see how their product handles fixed-price projects.
- Challenge vendors and ask them questions about blended rates in project management, lumpy scheduling, resource history, false positive overallocation warnings, hierarchical rate inheritance, project accounting subledgers… you get the idea!
It’s important to find a professional services automation system that actually works for you, rather than one that you have to work around. This can mean the difference between thinking about a fixed fee contract as an opportunity rather than a risk; and between thriving rather than just hanging on.
Take a look at more resources for managing fixed-price contracts and projects. Download our e-book on How to Drive Growth and Profit while decreasing revenue leakage on your fixed-price contracts. Or, check out our blog’s Guide to Project Accounting or our webinar on sustaining the life of your accounting system.
Frequently Asked Questions About Fixed-Price Contracts
What is a fixed-price contract?
Fixed-price contracts (or fixed-price projects) for professional services use a contract structure in which a client is billed a fixed amount of money, no matter how much or how little effort is invested to deliver the project.
What is an example of a fixed-price contract?
A fixed price contract is an example of shifting risk from the buyer to the seller. For example, if the seller can efficiently manage the fixed price project and control costs, the service provider will recognize a significant reward. On the contrary, if the seller exceeds its budget and allocates more resources than intended, there is maximum risk that the project will be delivered at a loss.
When to use a fixed-price contract?
Fixed-price contracts (or fixed-price projects) are generally used for more straightforward projects where the service provider can plan for predicted costs with confidence.
What are the pros of fixed-price contracts?
Pros and advantages of fixed-price contracts for projects include:
• No surprises; guarantees an agreed upon amount of revenue
• Pricing can be based on value versus effort
• Can be easier to sell to clients with less uncertainty on price
• Can return strong margins on financial statements if managed well
• Lower risk of exceeding project budget and possibility for competitive advantage
What are the cons of fixed-price contracts?
Cons and disadvantages of fixed-price contracts for projects include:
• Heightened risk; essential to closely monitor service delivery to ensure there’s not budget overrun
• Scope arguments can arise if projects go over budget
• Special attention is needed for contingency planning and performance obligations to control costs and protect profit margins
• Revenue forecasting requires robust operational tools
What are three goals needed for revenue recognition visibility for fixed price contracts?
Three goals to achieving revenue recognition visibility for fixed price contracts include:
2. Real-time visibility
3. Easy execution
How can you manage fixed price contracts?
Fixed price contracts can be managed by robust operational tools such as professional services automation (PSA) software. PSA software ensures accurate, real-time and dependable visibility into fixed-price projects.