Previously we discussed the pros and cons of fixed price vs. hourly contracts. We followed up with a discussion about the difficulty of estimation, the importance of setting a "least acceptable outcome", and budgeting well above that point.
- Fixed price contracts provide clients with the illusion of budget clarity, but at the cost of inflexibility.
- Hourly arrangements seem ideal... for the agency. After all, the longer the project takes, the more money the agency makes.
For most clients, paying by the hour is a necessary evil. But is there a better approach?
Hybrid Pricing Is the Smart Solution
At Abstract Edge we have begun to offer a hybrid billing approach. We acknowledge that before a company can sign off on a project, it needs to be able to know, up front, how much to budget. It’s generally not going to be acceptable to say, “we think this is a $50,000 project, so budget $200,000 and that way we'll certainly come in under budget.”
The hourly model puts all of the financial risk on the client. The fixed price model puts all of that risk on the agency (or grossly over-charges the client in order to compensate for that risk.)
We think the risk should be shared.
In a hybrid model, the work is scoped up front just like in a fixed price project (though perhaps it’s not quite as critical to be so detailed). From that, an estimate is developed. We fix half of that estimate, plus we work at half of our normal rate for all hours of the project.
Crunching the Numbers
For example, to keep the math nice and easy, let’s say a project estimate is for 1,000 total hours at $100 per hour. That means the estimate comes to $100,000.
We fix half of that - $50,000. If the project ends up taking 800 hours or 2,000 hours, we get paid the $50,000 as a fixed, unchanging amount.
In addition, we also get paid by the hour, but at only half our normal rate. So, in this example, we are paid $50 per hour. If the project exactly hits the estimate, you will pay the $50,000 fixed part, plus another $50,000 for the hourly part (1,000 hours x $50 per hour.)
Again, assuming we are correct, and the project comes in at exactly 1,000 hours, you will pay exactly the same $100,000 you’d pay under any of these 3 models.
But, what if our estimate is not right? What if it only takes 800 hours? Or goes way over and takes 2,000 hours?
Let’s look at the project cost for each of the three models (fixed, hourly, hybrid) in the scenario of coming in under budget, over budget and severely over budget.
Let’s say the project comes in at only 800 hours in the end.
- Fixed price model – you pay $100,000
- Hourly model – you pay $80,000
- Hybrid model – you pay $90,000 ($50,000 fixed, $40,000 hourly)
The only model here that is good for both parties is the hybrid model.
In the fixed price model, the agency has a windfall profit (an extra $25 per hour) and you paid more than you should have. Agency wins, client loses.
In the hourly model, you may have saved money, but the agency made $20,000 less than they expected to on the project. Agency (marginally) loses, client wins.
However, with the hybrid model, it’s win-win. You paid $10,000 less than if you had contracted as a fixed price, and the agency made $112.50 per hour, making the project more profitable than expected.
What if the project comes in somewhat over budget at 1,200 hours?
- Fixed price model – you pay $100,000
- Hourly model – you pay $120,000
- Hybrid model – you pay $110,000 ($50,000 fixed, $60,000 hourly)
Again, the hybrid model is the fairest scenario here for both parties. Nobody really “wins” if the project takes longer than expected. However, in real life this does happen sometimes. It’s not fair for the client to have to pay in full for all of the overage, nor for the agency to work for free.
In the fixed price model, the agency ends up working for only $83 per hour. While this might still be profitable for them (it might not), at some level that would no longer be true. That’s not a good situation for either party. Agency loses, client wins (sort of).
In the hourly model, the client ends up spending 20% more than expected. That’s no good. Agency wins (sort of), client loses.
With the hybrid model, nobody “wins” per se, but everybody loses less. You paid 10% more than expected for 20% more time than expected. The agency has to keep working until the project is done at half of the normal rate (which would almost always mean the incremental work is being performed at a financial loss), but at least the agency is not working for free.
Severely Over Budget
What happens if the estimate was way off. How is the client protected in that case? Let’s say the project takes 2,000 hours – literally double the estimate. If you are paying strictly by the hour, you will pay double what you expected (though you will possibly fire your agency and start over before that happens, depending on the reasons).
With the hybrid model, your costs would be $50,000 less than the hourly model. The agency has no financial incentive whatsoever to let things get to this point. The overall project would only earn the agency $75 per hour, which is very likely below cost.
The only model here that matches incentives and shared risk fairly is the hybrid model. The agency still has financial incentives to not go over budget (or risk working below cost) and the client still has incentives to help keep the scope under control. It’s easier to allow for the kinds of changes where it’s not entirely clear if the request is in scope without having to get into a big negotiation.
The hybrid model acknowledges the impossibility of precisely or accurately estimating a complicated and creative project before the work is actually performed, but still allows for the reality that companies need to create and set budgets.
It’s not a perfect solution (change requests still need managed very closely), but it can help to minimize the biggest problems with the two more common models.
Do you have any suggestions for a more perfect pricing model for agencies? Let us know in the comments.