Table of contents10 sections
- Introduction
- T&M vs fixed fee. What is the difference?
- When to choose T&M?
- When does a fixed fee make sense?
- Why can a fixed fee put more strain on cash flow?
- A profitable project can also cause liquidity problems
- What else can reduce the profitability of a fixed fee project?
- Project cash flow depends on more than the billing model
- T&M or fixed fee? There is no single better model
- See earlier when a project starts to strain liquidity
The choice of project billing model affects not only its profitability. It also has a direct impact on the company’s cash flow, the level of risk, and how long the business has to finance the delivery of the project from its own funds.
T&M and fixed fee are two popular billing models used in service companies, agencies, software houses, consulting and project services. Each has its advantages, but each also spreads risk differently between the client and the contractor.
So the first question should not be: which model will let us earn more? Rather: when will we incur the costs of delivering the project, and when will the client’s money actually appear in our account?
T&M vs fixed fee. What is the difference?
The main difference between T&M and a fixed fee lies in how the work is billed. In the T&M model, or Time & Materials, the client pays for the time and resources actually used. Billing can be based on hours worked, working days or the involvement of specific specialists. In the fixed fee model, or Fixed Price, the client pays a previously agreed amount for a defined project scope.
In practice, this also means a different distribution of risk.
If delivering a T&M project requires an extra 30 hours of work, those hours can be billed to the client on top. If the same problem appears in a fixed fee project, the extra hours may simply increase the cost of delivering the project and reduce its planned margin. That is, of course, unless a scope change and additional billing procedure is triggered.
When to choose T&M?
T&M works best in projects where it is hard to predict the final scope of work exactly at the start.
It can be a good solution when:
- the client’s requirements may change during delivery,
- it is hard to estimate the number of hours needed precisely,
- the project is developed in stages,
- the team works iteratively,
- the client wants to be able to change priorities on an ongoing basis,
- there are many unknowns at the start of the project.
For the contractor, a big advantage of T&M is the ability to bill the work actually done. If the project requires more involvement from the team than originally assumed, the extra hours can also mean extra revenue. This does not mean, however, that T&M automatically guarantees safe cash flow.
If the company bills the client once a month, the invoice is issued after the hours report is approved, and the client then has 30 days to pay, the company may still finance the project from its own funds for a long time. That is why the billing model alone is not enough.
The invoicing moment and the actual date the payment is received matter too.
When does a fixed fee make sense?
A fixed fee works best when the project is predictable. The scope, schedule and requirements should be defined well enough for the team to reliably estimate:
- the number of hours needed for delivery,
- the cost of employees and specialists,
- subcontractor costs,
- the cost of additional services and tools,
- the delivery time,
- the planned margin.
If these elements are well planned, a fixed fee can be a very attractive model for both the contractor and the client. The problem starts when the reality of the project begins to depart from the assumptions.
- Additional revisions appear.
- The client changes the requirements.
- The project requires more involvement from the team.
- A subcontractor turns out to be more expensive than assumed.
- Delivery slips by further weeks.
- The price of the project, however, stays the same.
- Every extra hour then starts to hit the planned margin directly.
Why can a fixed fee put more strain on cash flow?
From a cash flow perspective, a fixed fee more often increases the risk of financing the project from your own funds. The reason is relatively simple: delivery costs arise on an ongoing basis.
The company pays employees’ salaries, subcontractors, licences, tools and other project-related costs regardless of whether it has already received money from the client.
Meanwhile, the invoice may only be issued:
- after a defined stage is completed,
- after the work is accepted,
- after a milestone is reached,
- or after the whole project is finished.
Then comes the payment term as well. If the client receives an invoice with a 30 or 60-day term, a significant gap can arise between incurring the cost and receiving the money. This is exactly where the cash gap appears.
A profitable project can also cause liquidity problems
Let us take a simple example.
A company delivers a fixed fee project worth 100,000 PLN. The assumed delivery cost is 70,000 PLN, so on paper the project looks good. The planned surplus is 30,000 PLN.
The problem: the company has to incur most of the costs during the first three months of delivery. During that time it pays salaries, pays subcontractors and finances the other costs.
The client, meanwhile, receives the invoice only after the project is finished, with a 30-day payment term.
So the project may be profitable and at the same time require financing from your own capital for several months. If the company delivers several similar projects at once, the scale of the problem grows quickly.
That is why margin and cash flow should be analysed together.
What else can reduce the profitability of a fixed fee project?
One of the biggest threats is scope expansion during delivery.
Another “small revision” appears. Then another. Each takes an hour or two. Taken separately they may look harmless. Over several months, however, they can add up to dozens of extra hours of work.
With T&M, the extra work can be billed. With a fixed fee, if the company does not control scope changes, the cost stays with the contractor.
Underestimating a project works in a similar way. Instead of the planned 400 hours the project consumes 550 hours, yet the revenue may stay the same. The real cost of labour rises, and as a result a project that looked very good when the contract was signed can end with a margin far below the assumed one.
Project cash flow depends on more than the billing model
T&M will not always be safer, and a fixed fee will not always mean liquidity problems.
Everything depends on how the contract itself is structured.
A fixed fee with a 30 per cent advance payment and payments after successive stages can be much safer for cash flow than T&M billed once a month with a 30-day payment term. That is why, before signing a contract, it is worth checking more than just its total value.
The following also matter:
Cost schedule
When will the company have to pay employees, subcontractors and suppliers?
Invoicing schedule
Does the invoice appear every month, after a stage is completed, or only after the project is finished?
Payment term
15, 30, 45 or 60 days can significantly change the project’s need for funds.
The client’s real payment behaviour
The date on the invoice does not always mean the date of actual payment. How did they pay in earlier projects? On time?
Cost to completion
How much more has to be spent to deliver the remaining scope?
Cash gap
How big a difference can arise between planned expenses and available inflows?
T&M or fixed fee? There is no single better model
T&M gives more flexibility and usually protects the contractor better against a growing number of hours. A fixed fee, in turn, gives the client a more predictable price and can be very profitable for the contractor if the project is well estimated and delivered efficiently.
So it is not about which model is better. It is about which one better fits the predictability of a specific project and the ability to finance its delivery.
And above all, about whether the company can answer a few simple questions at any time:
- How much has the project cost so far?
- How much will it still cost?
- How much has been invoiced?
- How much money has actually come in?
- When will the next inflows arrive?
- Before the client pays, will the company have to cover further costs from its own account?
Only the combination of this information gives a real picture of a project’s financial situation.
See earlier when a project starts to strain liquidity
Administy lets you combine data on the project, costs, issued and paid invoices, and cash flows.
This way you can monitor on an ongoing basis, among other things, the project’s actual cost, cost to completion, forecast margin and cash gap.
So you do not have to wait until the project ends to check whether its original assumptions still hold.
Do you want to see earlier when a project starts to strain liquidity? See how Administy supports the financial control of projects.
