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Hedging For Success
Which is better: a fixed- or variable-price contract? Savvy customers are trying a hybrid approach to negotiating offshore services agreements.
One of the biggest decisions a manager makes when offshoring services is how to pay. In the past, it was a pretty simple decision. If the project outcome was uncertain, the client typically paid fees on a variable, time-and-materials basis. If cost-control was the client's main objective, they negotiated a fixed price. Today, in an attempt to more evenly share risk and reward, offshoring clients and vendors are agreeing to new types of hybrid contracts. Can offshoring customers and vendors enjoy the best of both types of engagements?
But while the potential upside is greater with hybrid contracts, so is the potential downside for managers who get it wrong. Negotiate an offshoring contract poorly, and the result can be work that is behind schedule, low quality, and too expensive. "Don't assign away your responsibilities for owning the project," warns Wesley Bertch, director of software systems at health and fitness chain Life Time Fitness and the veteran of one disastrous fixed-price project. "It's tempting, but time and again, the vendor will do what's in the vendor's interest."
Deciding which approach is best for a particular project is no small matter. A recent University of Michigan study finds that there's a positive correlation between your choice of contract and the vendor's profitability. If there's uncertainty, the vendor will aim for a time-and-materials deal; often, it's the most profitable option. But it turns out that what appears to be a safer course of action-haggling for a fixed price-isn't necessarily the key to a successful offshoring outcome. For this reason, a carefully chosen, carefully negotiated contract is a must. Let's look more closely.
Fixed price, as the name implies, involves a vendor charging a single, prenegotiated fee for an entire project. First, the client and the vendor jointly create a clear, detailed set of project specifications, a plan for getting there, and, usually, deadlines and performance requirements. Then the vendor takes that information, estimates its internal costs for fulfilling the terms, and submits a bid to the client. So even before the project actually begins, both sides know what the fee will be. "I know exactly what I'm getting at the end of the day," says Aldo Moreno, CIO of Herbalife International, which has several large fixed-price contracts with Indian outsourcing vendor Infosys. "And I know exactly what the cost is." In this instance, the vendor carries the greater share of financial risk. Not surprisingly, about nine in 10 offshoring agreements are fixed-price deals, Meta Group estimates.
By contrast, in a variable, time-and-materials arrangement, the vendor tracks the labor and materials it uses to complete the project, then charges the client accordingly. Within certain predefined limits, the client pays only for what it uses. "To develop our software, we collaborate with our customers and work together to define the software's functionality," says Jim Beattie, chief technology officer at CCC Information Services, which builds technology services for the auto-claims industry and works with outsourcing vendor Cognizant Technology Solutions. "So we need the flexibility of time and materials."
TALE OF TWO CONTRACTS
Over roughly the last three years, fixed-price has become vastly more popular with clients than time-and-materials, industry observers and participants say. That's been especially true at client companies that seek to control variable costs. "Clients like knowing their time line and their financial commitment," says D.K. Sinha, VP and general manager at Cognizant.
Yet fixed-price and time-and-materials contracts both bring disadvantages as well as advantages for clients and vendors alike. A choice either way inevitably involves making trade-offs.
With a fixed-price contract, the client manager begins the engagement knowing exactly what the project will cost. Assuming all goes as planned, there will be no unpleasant surprises at the end. For many, that's extremely attractive.
But the predictability of fixed-price also brings serious constraints. One is a loss of flexibility. Once the two sides have gone to the trouble of carefully specifying the project, the client is locked into the contract's terms. Vary too much, and the client will have to pay higher fees or penalties, renegotiate the contract, or both. Another constraint is extra work involved in specifying a fixed-price project. Risk-wary vendors require much more clarity up front for a fixed-price project than they would for a time-and-materials one. In fact, the work required may even exceed what a company would do for its own in-house projects. "Internally, if a requirement changes, I have the resources to handle it, and I'm going to pay my staff no matter what," explains Herbalife's Moreno. "But if it's outsourced and it isn't scoped out carefully, that's going to cost us hard dollars."
Also, fixed-price contracts can be unwieldy for complex, unpredictable projects. "If all you need is a run-of-the-mill Web site that's been done a million times before, then fixed-bid may be fine," says Bertch of Life Time Fitness. "But for large, sophisticated projects, the vendor is likely to either underbid, because they don't know what it will entail, or protect themselves by inflating their proposal."
Bertch learned this the hard way. In March 2003, Life Time awarded a fixed-bid contract to a leading Indian offshore vendor for a Web application used by its real-estate division: $20,000 for nine weeks of work. Three weeks into the project, however, Life Time found problems in the original functional specs. Bertch and colleagues agreed to extend the project time line, and they paid the vendor an additional $7,000 for new analysis and design work. At last, the project was completed-but with more than 100 database flaws, software code that failed to meet Life Time's standards, and more than 35 defects, including some showstoppers. At that point, the tired and disappointed Life Time managers opted to take the faulty code and fix it internally. "Fixed-price creates skewed incentives that are probably not in alignment with the best interests of the organization that is hiring the consultant or firm," Bertch says today.
"A pure fixed-price bid works best only where the specs are very well spelled out and there is no significant change expected over the lifetime of the project," says Girish Paranjpe, president of the finance-solutions division at Indian outsourcing vendor Wipro Technologies.
Time-and-materials contracts, by contrast, require the client to pay only for the resources the work actually requires. It's akin to a pay-as-you-go approach. While the time-and-materials approach may bring unpleasant surprises, if managed properly, it can end up costing less than a fixed-price contract. It's also appropriate for projects that contain a great deal of uncertainty, are likely to change midstream, or are simply too large and complex to specify with any degree of completeness and accuracy.
The downside of this approach? It can provide nasty surprises in the form of fees that are much higher than expected. Also, when fixed-fees are negotiated down by hard-bargaining clients, it can be a money-losing proposition for vendors. Some clients have reportedly bargained their hourly time-and-materials rates as low as $11 an hour, which leaves the vendor little margin for profit.
HAVING IT BOTH WAYS
Because the fixed-price and time-and-management approaches aren't perfect, some companies are experimenting with hybrid contracts that involve elements of both. These contracts typically break a large project into phases or subprojects. Often, there is a master contract that defines the overall project, then separate statements of work that specify how the smaller portions will be handled.
Variable scoping, fixed implementation. These hybrid fixed/variable approaches are increasingly popular for development projects. For example, a vendor may help the client define the project scope on a time-and-materials basis. Then, once the project is fully defined, the vendor can bid for the rest of the project on a fixed-cost project. From a cost perspective, managers can expect to spend roughly 10% to 15% of the project's total budget on the preliminary scoping work, says Wipro's Paranjpe.
Stop loss. Another type of hybrid approach is a "capped bid" that looks like a time-and-materials contract but limits the client's risk by setting a ceiling on how high the total price can go. CCC Information Services is one company using this approach. There, CTO Beattie says it gives him "room to maneuver," adding "it's not actually fixed, but it gives you some variability. You know the application is not going to cost you beyond a certain dollar amount without lots of bells and whistles going off. It really is a way of managing change."
Fixed with incentives. Yet another hybrid approach is fixed-price with penalties and rewards. In this variation, the client pays the vendor a set price for the project but also pays rewards if the vendor exceeds certain milestones and deducts penalties if those same milestones are missed. The milestones can be nearly anything the client identifies as important: service levels, deadlines, error rates, and so on. "This creates more risk-sharing," says M.S. Krishnan, a professor at the University of Michigan Business School who has researched offshore outsourcing contracts.
WE'RE IN THIS TOGETHER, RIGHT?
When deciding which approach makes the most sense, managers also need to consider which approach will benefit the provider, too. When a company signs an offshoring contract, it's also initiating a potentially long-term relationship with the vendor. In this relationship, it's in the interest of each party to ensure that the contract is favorable to the other. If the margins are too thin, the vendor can't afford to assign its best people to the project.
Understanding what the other side wants is critical to a successful negotiation. For clients of outsourcing work, that information has been unavailable, except in anecdotal form, until recently. Research by Prof. Krishnan and three colleagues sheds new light on this important point. Their findings, based on their examination of some 95 offshore projects from a leading Indian software vendor, were published in December in the journal Management Science under the title "Contracts in Offshore Software Development: An Empirical Analysis." Here are the relevant highlights:
- All things being equal, offshoring vendors prefer time-and-materials contracts. From the vendor's point of view, such work is both more profitable than fixed-price and less risky. This creates tension, since most clients today prefer fixed-price.
- When the scope of a project is uncertain, vendors prefer time-and-materials contracts. Offshore vendors usually are smaller than their U.S. clients and can't afford to take on the extra risk uncertain projects entail.
- When a project is very large, vendors prefer time-and-materials contracts. The larger the project, the greater the complexity involved, and the greater the likelihood that original estimates on the amount of work it requires contain errors.
- When a project requires large amounts of training or retraining, vendors prefer time-and-materials contracts. Again, this comes down to the element of risk for the vendor. The knowledge needed for a project can be buried deep within the client's organization.
- When dealing with a large client, or a client with whom they have done several projects in the past, vendors are more likely to agree to a fixed-price contract. The client's size, clout, and value to the vendor translate into superior bargaining power. However, the vendor generally prefers to set shorter durations of fixed-price contracts due to profitability constraints.
- According to Michigan's Krishnan, the vendors are more inclined to assign their best workers to fixed-price contracts, as a way to lower their risk of failure and financial losses. On the upside, Krishnan adds, by putting their best workers on these contracts, vendors hope to deliver the projects with high quality and either on or before schedule.
CLEAR CHANNEL?
Risk assessment is another important piece of the offshoring-contract puzzle. Before managers hand a project over to an offshore vendor, they should first assess the risks of doing it in-house versus those of doing it with a vendor. Questions to ask include: How financially viable is the vendor? How will the client manage the relationship, and does it have the bandwidth to do so? How will it transfer expertise from the client organization to the vendor? Will it need to expand or improve its communications links, and, if so, at what cost?
In addition to some of the approaches already mentioned, leading-edge offshoring clients and vendors have developed several risk-reducing approaches to contracts. Here are some to consider:
- Ceiling and floor: This sets both a low and high limits on an otherwise variable contract fee. For example: "The fee will be $X per unit but won't under any circumstances be lower than $Y a month or higher than $Z." This seeks a compromise, offering price flexibility for the client and some guarantee of revenue for the vendor.
- SLAs with teeth: An offshore contract may set service-level agreements that the vendor must match at the risk of penalty. This gives the client guaranteed levels of performance and helps the vendor better estimate its labor and equipment needs. The key here is not to extract penalties so deep that the once-bitten vendor becomes twice shy about working with you again.
- Midcourse correction: Here, a vendor reserves the right to renegotiate a contract if the scope or requirements of a project changes beyond a predefined level during the contract's term. For example, if a project turns out to be highly unpredictable, the vendor may seek to convert a fixed-price contract to a time-and-materials one. While few vendors welcome such negotiations, they have in the past accepted them from customers that possess sufficient bargaining power.
- No-fault termination: Some vendors allow a client to terminate the contract, at no fault, if the conditions of the project change so radically that the original contract no longer makes sense. Indian vendor Infosys, for example, calls this "termination for convenience"-and will even offer to help the client (for a fee) bring the project back in-house, if that makes sense. "We make it very easy to do," says Richard Baldyga, VP of outsourcing solutions at Infosys.
YOUR NEXT STEPS
1. Consider a hybrid contract: Don't agonize over the whole fixed-versus-variable decision. Instead, ask your vendors to bid hybrid agreements that combine the price-protection of fixed-bid on your clearly defined projects with the flexibility of time-and-materials on your more cutting-edge, less-certain work.
2. Negotiate with knowledge: The more you know about the work you're seeking to send offshore, the better terms you can negotiate, and the more likely the project is to succeed. Sound out your vendor to determine its risk tolerance. Have a clear idea of what your vendor can-and can't-do. Does your vendor feel confident that it understands your team's approach? If so, it might assume more risk.
3. Seek a win-win contract: Sure, it sounds corny. But an offshoring contract that falls short of either side's goals is a recipe for disaster. "I've been involved in vendor relationships where it's take, take, take," says Moreno of Herbalife. "At the end of the day, you end up losing."
In the end, what's the best possible deal for a given company's given project? Fixed-price is generally best for well-defined projects and for containing costs. Time-and-materials is best when a project is large, poorly defined, and involves a cutting-edge technology or business process. And hybrid arrangements that balance safety and flexibility are best for experienced managers who want-and can handle-the benefits of both.
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